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Rep Talk

Independent contractor or employee? Commission or draw? This five-step plan can help you decide how to pay your sales reps.
October 1, 1998
URL: http://www.entrepreneur.com/article/16594

From a salesperson's point of view, the best way to measure success is obvious: paid commissions. But as a business owner, if you don't carefully structure your compensation plan, you can not only end up making less than your sales team, but you may also risk going out of business.

Recently, I've been receiving letters from business owners who want me to address the issue of commission structures and fair compensation. So I interviewed owners and sales managers from various industries to find out what works best for them. Hopefully, this information will assist you in evaluating or creating your company's commission plan. Let's take it step by step.

Step 1: Determine whether your salespeople should be independent contractors or employees.

The sales force of one business owner I interviewed consisted solely of independent contractors. Independent contractors are not employees of a company; they're paid strictly on commission and pay for their own expenses. Most independent contractors represent more than one company's product line--a line of sunglasses for Company A and a line of gloves for Company B, for example. These independent contractors are known as manufacturer's reps.

The other type of salesperson is an employee of the company. Some owners pay their sales employees a "draw" against commissions. It works like this: If I hire you as one of my commissioned salespeople and give you a monthly draw of $2,000 for six months, that $2,000 is an advance or a loan against commissions earned. So ideally, at the end of the six months, you will have earned at least $2,000 a month in commissions. If your monthly commissions top $2,000, I could end up paying you additional monies based on commissions earned. However, if you don't earn $2,000 in commissions for the month, you'll owe the difference to the company.

One owner told me she pays out "guarantees" to salespeople with impressive track records for the first six months they work for her company. She may pay a guarantee of $6,000 a month to a top salesperson, knowing the rep will earn more than that amount in commissions. She doesn't worry if the salesperson doesn't quite meet his or her quota in a particular month because by the end of the six-month period, it will be met.

This same owner pays a $2,000 guarantee to salespeople with no experience. Because this entrepreneur feels she has a very strong recruiting and training program in her company, she hasn't been burned using guarantees instead of draws. It's also an incentive for recruiting good salespeople, who prefer knowing they don't have to pay back a draw out of smaller commissions earned during a slower month. At the end of the six months, the guarantee stops and a straight commission plan is enforced. Another option is to pay a small salary plus commissions.

A good independent contractor is self-motivated, and hiring one means less financial burden for your company. The disadvantage is, if you hire the wrong person, you'll be dealing with someone whose time and prospecting activities you'll have little control over.

Step 2: Calculate commissions based on gross profit.

No matter what industry the business owners or representatives I interviewed came from, they all agreed that commissions must be based on gross profit. For example, say you sell widgets that have a retail price of $80. However, it costs your company $50 to either manufacture the widget or buy it from a wholesaler. If there are no costs over and above the $50, then the gross profit (the difference between the retail price and the cost of the widget) is $30. The commission to the salesperson is calculated based on that $30.

Typically, commission percentages rise as gross profit figures escalate. If you have high expenses on the back end, you can't offer your sales staff a big commission. Some businesses, such as telephone companies, have high profit margins, so they're able to offer their sales staff higher commissions.

Telephone companies maintain high profit margins by cutting back on certain services. For example, when was the last time you had a visit from your telephone man? I'll bet it's been a while. He comes out to install your phone, and that's generally the last time you see him unless there's a system breakdown. There are no "neighborhood service reps" that telephone companies must pay to call on us once a week. The money previously used to pay service technicians can then be used to pay commissions to sales reps.

In contrast, the computer industry markets complex items that customers often need help installing, running and fixing after the sale is made. Computer companies must pay several employees to assist with these tasks. In addition, because the computer industry changes so rapidly, sales forces in these firms constantly need additional training. The business owners pay for that education. These are all back-end costs that reduce gross profits and thus lower the commissions paid.

Step 3: Pay commissions based on collection.

An ideal payout time is after the order has been received and paid for by the customer. A successful eyewear business owner told me that from the first day he opened his business, salespeople have been paid commissions based on collection. When the customer pays, the salesperson gets paid. Some owners pay commissions when the product has been shipped to the customer, but that can be risky--especially for a new business.

Step 4: Consider using sales quotas.

If you're a new business owner, the sales quota approach may be difficult for you to implement at first. You need to hire a solid sales force and then watch the individual progress of each sales rep before establishing this type of plan.

Once you've monitored and watched your sales team grow--and gotten a good idea of the sales you can expect every month--you can motivate them by establishing a monthly figure that is a bump up from last year's achievements.

Step 5: Document sales compensation.

It's no fun for business owners to spend most of their time in disputes over commissions. And you certainly don't want to end up in court over it. Whether you're restructuring your company's sales compensation methods or just beginning to hire a sales staff, clearly outline your compensation plan in a contract. It's a good idea to consult an attorney to help you create an effective one.

Contact friends who are also in business, and ask to look at their contracts. Attend trade shows or business conferences, and compare commission structures with other owners. Realize that your salespeople are the heart of your organization and you need to keep them motivated, but that you also have to make a profit. You can't give away the store by paying out unrealistic commissions just to keep a good salesperson on your team. Nor can you be so miserly that you pay the bare minimum because you truly believe your product has more value than the salesperson who represents it.

Structuring your commission plan carefully can ultimately make a big difference in your bottom line.


Danielle Kennedy presents sales and marketing seminars and keynote addresses worldwide and is the author of seven sales books as well as audio and video sales training programs. Check local bookstores for Seven Figure Selling and her latest book, Balancing Act: An Inspirational Guide for Working Mothers (both Berkley Press). Write to her in care of Entrepreneur,2392 Morse Ave., Irvine, CA 92614.