Ask the Experts | How to Calculate Commissions

Question: How should we calculate commissions for our salespeople?

James Leichter; President, Aptora Corporation & Mr. HVAC, LLC:

Interesting I get this question, because this morning I was discussing this with someone – be funny if it was the same person. He wanted to pay his salespeople based on net profit. I recommend that you – generally speaking – pay your salespeople based on gross profit.

Now you have a couple methods here. Let’s say that you use what we call cookbook pricing. So you have a menu of prices and those retail prices are the prices that a salesperson has to quote, except for maybe promotional items that you offer and pull away as your schedule permits.

If you use cookbook pricing, then you could offer them what I’ll call a flat rate sales commission: $100 for this, $50 for that, etcetera. Because you’re dictating the retail price anyway, it’s a fixed cost, it’s guaranteed, so you could also guarantee a commission on each of those menu items.

If you don’t have that, then you would pay them based on gross profit, which of course is the sales price minus the cost of doing the job. That’s your gross profit of course, and you could pay them a percentage of that. Typically, I like to pay them 20% of gross margin, gross profit dollars – 20% -- and I would also offer them full benefits.

So they’re typically commission-only, 20% of gross profit dollars, you might offer them a draw every week. By that I mean a small amount of money to get them by, it’s basically a loan against their future commissions. That number could be anything you like, but it might be $500 a week; so they might get a $500 a week draw.

Here’s something that’s really important, in my opinion: In order to make them feel like employees, part of the team, and not an outside subcontractor, I think it’s important to offer them the same benefits you would offer everyone else. So they get paid time off, paid vacation, paid holidays, etc. And that way they are part of the group. If they are paid just a commission and nothing else, oftentimes they feel like outsiders. And let’s face it, they’re not going to enjoy holidays like everyone else. Everyone’s going to be talking about getting Thanksgiving off paid, and he or she isn’t going to get it, so they’re not going to like that. So I like to pay them for their time off.

Now why don’t I want to pay based on net profit? As everyone knows, net profit is gross profit minus overhead. It’s the overhead I have a problem with. They don’t have control over overhead, and if you buy yourself a new pickup truck, they might question you. If you give yourself a raise, they might question you. If you remodel the building, or remodel your office, and you didn’t need to remodel your office – your office looked just fine – they might question you. Because, if you think about it, all of those things lower their sales commission. And because they have no control over sales commissions, they’re always going to second-guess your decisions.

But they have full control over gross profit margin, because they control the retail price and, to some extent, they control how much they’re paying for the materials and the equipment and they could also have a hand in controlling labor costs. So I want them focused on not overhead, which is not under their control; I want them focused on direct costs. And that would directly offer them more money, if they keep those costs under control. So pay them a percent of gross profit margin, not net profit.

One final thing I’d say is I’m not a fan of paying a percentage of the sales price, because then the emphasis becomes making a sale; who cares about profitability? I would offer a 10% discount in a minute to make the sale, and what difference does it make to me? It only cuts my commission by 10%. But that could completely eliminate the contractor’s profitability. If you’re a net profit of 10%, and they offer a 10% discount, you’re a zero net profit, and I would still get my sales commission.

So I don’t like paying commission on retail price. I don’t like paying commission on net profit. I like paying a percentage on gross profit where they have control over how the job ultimately plays out.

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