commission
Payroll

5 Ways to Calculate Commission

Sales is a unique industry that not only requires a different breed of worker but also a particular payroll process. Typically, salespeople receive a base salary and can earn commission-based bonuses based on their closed sales.
 

So, how is commission calculated? Well, there are a lot of factors to consider in offering commissions, such as gross sales vs net sales, sales performance, and commission structure for which a commission rate is determined.

We’ve broken down your guide on how to calculate commission, including terminology, sales commission formula breakdowns, and best practices for commission pay.


What Is Commission Pay?

Commission pay is a sum of money given to an employee for a completed transaction, such as selling a good or service. Common industries that utilize commission pay include sales, recruiting, finance, and real estate.

Some employers provide commission pay in addition to a base salary, whereas others may create a commission structure to replace base salary. Commission pay is often used to increase worker productivity and attain organizational goals.

Commission structure often refers to how commission is calculated, such as the preferred sales commission formula, determining sales value (i.e., gross sales vs. net sales), sales performance (i.e., minimum sale requirement), and commission percentage or commission rate.

Commission, which comes with its unique tax rules, can be calculated in many different ways. 

We’ll go through five common ways companies calculate commissions, but before we delve into the calculations, there are some essential factors to consider in determining how to calculate commission.

Factors to Consider When Determining How to Calculate Commission

Before determining a commission rate or structure, it is important to review—and revise, if needed—your employment agreement. An employment agreement will typically lay out the details of how to calculate commission and other relevant compensation breakdowns.

Here are seven factors to consider in determining how to calculate commission:

  1. Base Commission: This outlines the amount for which commission is calculated. Basing it on gross sales, net sales, or market value is commonplace.
  2. Commission Rate: This refers to either a fixed number or commission percentage for each completed sale amount.
  3. Commission Period: This is the period for which sales amount and commission are applied.
  4. Commission Structure: This can refer to the policy dictating commission rates based on various factors (i.e., selling a product or service to a new client vs upselling a new product or service to an existing client).
  5. Split: Sometimes, the commission may be split if multiple individuals are involved in the sale. Another way commission might be split is if an employment agreement provides that a regional manager receives a percentage of the sales of all regional employees.
  6. Override: This can happen when a circumstance may impact the commission rate of a sale.
  7. Bonus: Just like with splits and overrides, bonuses can be presented when an employee exceeds sales expectations or as an incentive for those who successfully meet established goals.

How Is Commission Calculated?

Types of commission pay can mean different things to employees, so it is critical to determine a commission model that best suits your organization. 

Equally, it is essential to define how to calculate commission in a way that supports your commission structure. Here are five common ways commission is calculated.

1. Straight Commission 

Under the straight commission model, sales employees are compensated solely for their sales. Unlike some other models, workers are not entitled to a base salary. 

Companies may take this approach to reduce overhead costs or because they believe it motivates their salespeople.

Formula:
Earnings = Sale x Commission Rate

As a compensation model, straight commission can be polarizing. While it may make sense for high-yield sales roles like real estate, it’s an unforgiving model in industries where the buying process can extend over several months. 

Additionally, because it can take several weeks to prepare new employees for selling, individuals with a straight commission may struggle to make ends meet in the short term.

2. Base Plus Commission 

Call this model the closest thing to a “happy medium” when paying sales employees. The base plus commission approach involves paying workers a minimum salary and additional payments for each subsequent sale. 

By offering both stability and incentives for performance, this model is particularly well-suited in industries where it takes longer to “ramp up” employees or where deals can take months to close.

Formula:
Earnings = Base Salary + (Sale x Commission Rate)

The ideal ratio of guaranteed compensation to commission remains a subject of debate. If salaries are too high, will that demotivate employees? Get a pulse on regional and industry wages by using compensation benchmarking tools that consider both base salary and commission.

3. Draw Against Commission

Similar to the straight commission model, employee earnings under this approach are based entirely on what the employee wins in sales. That said, this model takes an unconventional approach. Employers make an advance payment to the individual, and then deduct that amount from any subsequent commission. In effect, salespeople are lent funds from their company, which they then pay back through their commission. Any leftover funds are kept by the employee.

Formula:
Earnings = (Sale x Commission Rate) - Advance Payment

While this approach isn’t as unforgiving as straight commission, it still poses significant risks. If a salesperson can’t close a deal for a prolonged period of time, they can accumulate heavy debts to their employer.

4. Graduated Commission 

The graduated commission approach involves setting up “tiers” where an individual’s commission rate goes up past a predetermined threshold of sales. For example, individuals may earn 10% on their first $10,000 in sales, 20% on their next $20,000, and so forth.

Adopting a graduated commission model is a great way to incentivize sales employees to increase sales volume and is especially popular in automobile and real estate sales. It may also be combined with the approaches described above. Below is a sample structure a company might use:

4. Residual Commission 

Residual commission is any commission an employee earns after a client completes a sale. This means that even if employees leave the company, they continue to receive commission from their sales as long as the client remains with the company. 

This commission model is popular in real estate and insurance industries and is well-liked from an employee’s financial standpoint and client retention perspective.

One disadvantage of the residual commission approach is if a client opts to leave due to no fault of the company or salesperson, the salesperson loses the commission. As a result, this can demotivate salespeople.

The terms, commission structures, and best practices listed here serve as a primer on some of the more common ways employers compensate sales employees. 

Payroll administrators processing commissions should remember that these payments, similar to bonuses, are considered “supplemental wages” by tax authorities.

Read our free Definitive Guide to Payroll to learn more about how these payments are taxed.

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