Should Your Company Pay Commission on Sales Totals or Gross Profit?
Companies have contrasting views when it comes to paying salespeople commissions. Some think it’s best to use a sliding scale commission on sales totals, while others prefer to pay commissions on gross profit. While there are many arguments on either side, I am going to put forth some arguments about why paying commission on gross profit is the way to go. In doing so, we'll look at areas to be aware of when using gross profit to base your company's sales commissions.
Gross Profit is the Ultimate Measurement
For any company, the most important aspect of a sale is the amount of gross profit that sale generates. Regardless of the sales total, if that sale doesn’t generate gross profit, then there is little benefit to the sale itself. So, first and foremost, the gross profit on the sale is the most important part of the sale. Get your people thinking profit and the rest should follow.
Getting your salespeople to think about gross profit will ensure they protect the gross profit objectives of the company. Unfortunately, many companies don’t trust their sales team to protect their gross profit objectives. As such, they prefer to pay their salespeople commission on the sale's total value. However, this is simply a bad excuse for not having a disciplined sales force.
Here is the calculation for gross profit:
Sales Total – COGS ( Cost of Goods Sold) = Gross Profit
Paying Commission on Gross Profit is Simple
Many companies see paying commission on the sales total as a much easier and simpler way when compared to paying on gross profit. The reason is that companies sometimes aren’t able to capture all the costs of the product or service before the final sale.
In some cases, they lack the ability to capture these costs, while in others they don’t know what goes into these costs. In essence, it's about clarifying the product's COGS or Cost of Goods Sold. To provide insight into these costs, here is a short list of what to look for.
If the product has been in your inventory for months, then the cost of that product has increased. This cost must be captured on the final sale. Sales drives inventory, and if your company is properly managing its inventory, then there are bound to be products in inventory that are there because sales requested them to be.
A good rule of thumb is to add 3% holding costs to the inventory for every month product is held and not sold. Please note, this is not a hard and fast rule. However, it's important to be aware of how the holding costs of inventory affect your company's gross profit. While salespeople may have a hard time reconciling getting hit with this 3% inventory holding cost (penalty), they must nonetheless bear some responsibility for the company's slow moving inventory. To read more about getting sales people to sell slow moving inventory, please read Sales Management Strategies: Getting Sales to Sell Slow Moving Inventory
2. Have you captured all the freight costs?
Every company pays for freight to get product into their warehouse. In some cases, moving product from one warehouse to the next, is just another part of the
product's costs. Regardless of whether your vendors include freight in their price or not, your company is still paying to get that product into your warehouse. In the case of your vendor providing a delivered price, then they’ve done your work for you. However, if you pay a separate freight bill, or if you have to move product from one warehouse to another, then you must account for that freight cost in your gross profit calculation.
Measuring the value of a given sale must always take into consideration the amount of gross profit generated by that transaction. When salespeople are rewarded on gross profit, they continually base their approach on protecting the company's profit objectives. Take it a step further, and companies can base their entire budgets, sales forecasts and territory analysis on the steps needed to grow the company's profit. Here are some reasons for using gross profit to base your company's compensation structure.
- Gross Profit Empowers Your Sales Team
You need your salespeople protecting your company's gross profit. Your company's sales force must be aware of the gross profit objectives of the company. By understanding these objectives, salespeople will make sure to protect them when closing business. In addition, sales teams work with internal departments in order to close that business. As such, those departments must also be cognizant of protecting the company's gross profit objectives.
- Gross Profit is the Ultimate Equalizer
It can be argued that paying commission on gross profit is a powerful and impactful way of maintaining a balanced and proactive sales team. It discourages one individual from low-balling pricing to secure orders, and since every salesperson knows what each other’s gross profit percentage is, it helps to keep the sales department in constant competition on who can secure the best business.
- The Percentage Paid on Commissions for Gross Profit vs Total Sales
If you are interested in a sample commission excel table, then you can refer to a more recent post I included. It includes an excel table based on paying commissions on gross profit: Small Business Sales Management: Sample Commissions Excel Table
For those of you interested in knowing what the typical gross profit commission should be, it's typically 3%. For those companies wanting to pay commission on total sales amount, it's often down at 2%. In some cases, it's lower or around 1.5%. It ultimately depends upon the company and the industry.
Some companies pay a little higher commission to their salespeople for securing orders with prepaid accounts as they help in managing cash flow. In this case, faster payment means lower financing on receivables, which in turn means higher profit.
If you are interested in reading about the three most prevalent compensation strategies for salespeople, then please read: Small Businesses Compensation Strategies for Salespeople
The video below discusses outbound freight and its effect on profit. Standard accounting practices dictate that transportation-out freight is a cost of sale. In this case, it's not applicable to the cost of goods sold. However, what about covering freight because you didn't have inventory available? In this case, the cost of a stock out is a direct cost of inventory. To learn more please go to: Inventory Stock Outs: Transportation-Out Freight and COGS