We’ve been working our way through the various ways you can calculate incentive pay and have covered quite a few so far. As a recap, here are the various methods and the articles you can reference to find the content on that method.
As you can see, it’s time we turn our attention to the right side of the diagram and look at various options for paying a % of target incentive amount rather than a commission which pays a % of the gross margin or (less frequently) revenue. Note that many people refer to all incentives as “commissions”, but this is technically and legally incorrect. Many states have legal requirements for true commissions, such as how frequently they must be paid, how quickly they must be paid after being “earned”, how they must be documented and what requirements the company has for paying them after an employee has left the organization. These rules may not apply to goal-based % of target incentive plans. Therefore, it’s important to be clear in your terminology and not call something a commission when it really isn’t one.
When you pay using a commission, you define a commission rate (such as 5% of gross margin). When you are not using a commission, then you must define a target incentive amount (such as $1,000) and the activity which will result in the payment of the target incentive (i.e., the goal).[1] There are best practices for how you should set each of these numbers and we’ll work through them one at a time.
First, you need to look at the market to determine the appropriate amount of total compensation for the role. Your organization should have a stated “compensation philosophy” that may sound something like this: “We are going to pay market rate for salary, but above market rate for total compensation.” You should also consider your benefits and other perquisites as these affect the value of your overall total rewards package. If you are weak in these areas, then you may need to literally overcompensate in terms of cash compensation. Conversely, if you are strong with benefits then you may be able to be slightly below market from a cash compensation perspective. You can find the market value of a job by using salary surveys and/or doing internet research but be careful about any site that relies on self-reported data or provides “average” results. Any good compensation survey will report medians and percentiles and be based on actual incumbent level employee pay data. It should also be able to provide you information on the sample size in terms of companies reporting[2] and number of employees included.
Once you have determined the target total compensation, then you need to split this between salary and incentive. It’s unlikely for any role that you are considering paying using a goal-based plan, that you would want to pay zero salary. You should also be aware that the first test the FLSA uses for exempt status (not having to pay overtime to a role) is the salary test. Currently, the Federal minimum required salary is $684 per week ($35,568 annually). Several states (AK, CA, CO, ME, NY, WA) have higher requirements and there is a proposal to increase the federal minimum to $1,059 per week ($55,068 annually). [3] For those of you using a non-recoverable draw or any 100% commission plan, you should check with your legal counsel on their ability to defend this approach for exempt status.
The amount of pay at risk should be determined by the nature of the role. Those with more individual ability to affect measurable financial outcomes should have more pay at risk than those with less individual control over financial outcomes. Roles that are only measurable on a team basis probably should have no more than 25% of their pay allocated to incentive pay (this would be called a 75/25 pay mix). Those with more control might go have a 50/50 pay mix. You now will have a few very important numbers, such as in this example:
Target Total Compensation: $100,000
Pay Mix: 80/20 (80% salary, 20% incentive)
Salary mid-point $80,000 (a 40% range would give us a min of $64k and a max of $96k)
Target incentive $20,000
We can now use the target incentive to tie to our goals, and we know that if someone is achieving their goals at 100% they will get 100% of their target incentive, or $20,000.
In our next few articles, we will look at Elements and Weights and various methods of setting (and adjusting) goals.
[1] Note that a target incentive amount and an associated goal can also be defined for a commission plan, but unfortunately, it’s usually done as an afterthought by reverse engineering the math (if the rate is 5%, and we want someone to earn $25,000 in commissions, then they must produce $500,000 ($25,000 / .05 = $500,000). It’s a good idea to set the target total compensation first based on the market pay required to attract and retain talent, then set the desired pay mix (% of salary and % of incentive) and then consider reasonable production numbers, and let this math derive your commission % rather than the other way round ($25,000 target incentive / $500,000 reasonable production expectation = 5% commission rate).
[2] On February 3, 2023, the DOJ rescinded rules for compensation surveys, but companies should be aware that any survey can be reviewed for lawfulness on a case-by-case basis. Prior rules required 5 or more companies to provide data, the data needed to be anonymous and collected by a third party, no company could represent more than 25% of the sample size, and the data needed to be over 3 months old.
[3] https://sbshrs.adpinfo.com/blog/exempt-employees-minimum-salary-requirements-for-2024
Beth Carroll is the founding partner of Prosperio Group, a compensation development firm that focuses on the strategic management of compensation for global transportation & logistics companies. Beth is based in Chicago, IL and has over 25 years’ experience developing and administering incentive compensation plans for companies across the globe in a variety of industries. Prosperio consultants have completed projects with more than 300 Transportation & Logistics companies. Beth can be reached at 815-302-1030 or via email at beth.carroll@prosperiogroup.com.