On the commission side of our graph (see the article from September 2023), we are moving toward using some sort of “goal” to affect payout, rather than simply paying a straight commission from the first dollar. One of the ways companies initially think of doing this is by deducting the salary or a “seat cost” from the commission calculation. This ensures that commissions are not paid until the employee as covered their costs to the organization, which is usually an approach that CFO’s like… a lot. And it can have it’s place in an organization, particularly when it is just starting up. However, it does have some downsides.
Let’s start with some basic brokerage economics. In the world of spot market truckload brokerage[1] it’s desirable to have 5% operating or net income. If you have 15% Gross Margins your Net income is 33% Gross Margin. This means you have two thirds of your gross margin available to run the business. It really doesn’t matter that much how this is divided up, but you can’t have your total compensation and operating expenses exceed 67% of your Gross Margin and retain a 5% Net Income level (again assuming 15% margins – change it up if you need to for your reality). Much inherited wisdom suggests that about half of the remainder should be allocated to cover compensation expenses and the other half for things like TMS fees, rent, utilities, insurance, etc. This is why so many of the original cradle to grave brokers that paid 100% commission used rates that are between 25% and 35% to pay their brokers. In a split model, you need to ensure that each “side”, when added together, doesn’t exceed around 30% total. This means if you have a customer side and a carrier side (but no Customer Operations support), then each side can only cost you around 15% (some do not divide this evenly, of course). If you have Customer Operations (or Account Management) then you divide the ~30% into 3 buckets instead of two. In any case, and no matter what your operating model, your total cost of compensation for sales and operations shouldn’t exceed around 30% of your gross margin, to allow enough room to cover compensation costs for all of your support staff and managers.
When you want your sales compensation to align with the math you have laid out perfectly, then you may want to use one of the two options below (but they are not the only options, by the way). If you have decided that your sales resources can only cost you 20% of your gross margin dollars, then your math may look like the following:
Option #1: Pay a draw against the commission. In this method, you take production x 20% and then subtract any advanced payment (draw) made before paying the difference. If production was $20,000 for the month and the draw was $3,333 (equivalent to $40k annual salary), then the math works as follows:
$20,000 x 20% = $4,000 - $3,333 = $667 paid in commission above the draw.
Option 1 is mathematically pure and therefore very appealing to CFOs. You know with 100% certainty that you are always retaining 80% of the Gross Margin, provided the draw is considered “recoverable.” This means that if a month happened when the draw was not covered, then the negative is carried forward and must be covered the following month, as follows:
$15,000 x 20% - $3,000 - $3,333 = Negative $333
The negative is added to next month’s draw, meaning $3,666 needs to be covered before payout happens. As should be obvious, this can become a downward spiral very quickly and tends to lead to very high turnover rates among new employees who have a bad month or two and get themselves into an ever-deepening hole. The recruiting costs of this model are very high and probably costing more than the company is “saving” by sticking to the pure economics.
You can, of course, phrase the draw as “non-recoverable” so you don’t carry the negative forward. What you have really created then is a salary + commission plan that has a threshold. The threshold in this case is $16,665 in Gross Margin as this is the amount that must be produced to cover the draw and start earning any incentive. You are really paying 0% commission below $16,665 and 20% commission on all dollars ABOVE $16,665 (check the math – you’ll see it works!).
One of the biggest challenges with this approach is the “push me-pull me” that happens between getting the draw level high enough to compete with market salaries while considering the limited production ability of new hires and the need to cover their draw relatively quickly. This tension tends to push commission rates higher so the draw is covered faster and can lead to astronomical payouts for top producers and overall problematic economics for the business.
Option #2: Calculate a “seat cost” and pay commission once seat cost is covered. This may, on the surface, seem the same as Option 1 but it is different and usually leads to a more attainable threshold production level with the benefit of a fixed salary for recruiting. In this method, a multiple of the salary (which often includes allocation for overhead) is used to calculate a threshold below which no incentive pay is earned. Once the seat cost is covered, then commission turns on. For example, if we used 3x the salary of our $40k earner, the monthly threshold is $10,000. A commission rate of 6.67% for all dollars above $10,000 would yield a total payout of $4,000 for the month at $20,000 in GM$ (the same as in Option 1).
$20,000 - $10,000 seat cost = $10,000 x 6.67% = $667 commission + $3,333 salary = $4,000 total paid.
But you can see how the trajectory for higher performance is now reduced from Option 1. In Option 1, pay at $40,000 in production is $8,000 ($40,000 x 20%). Pay under Option 2 at $40,000 is $5,334. ($40,000 - $10,000 = $30,000 x 6.67% = $2,001 + $3,333 salary = $5,334). Your effective rate is now 13.34% and it will REDUCE at higher production levels until it reaches 6.67% (in math this is called the asymptote because it will approach ever closer but never completely reach 6.67% because of the salary). Under Option 1, your cost of compensation is ALWAYS 20%.
There is a third option still, and that is to break the mathematical connection between threshold and salary and instead to set threshold based on realistic production levels according to time in position. This can allow new employees to get a taste of incentive compensation sooner (pay them a lower rate, of course), and give them an understanding of career progression that aligns with performance and tenure. As they are in the position longer, their production threshold will increase (as it should) but they may also be able to achieve a higher commission rate once they get over the higher threshold. This method also allows you to reward top performers with salary increases that do not carry within them a negative consequence. Under either the draw or the seat cost approach, a raise in salary means an automatically higher threshold. When you decouple them, you now have TWO motivational tools at your disposal instead of one.
In the next article, we will move one step closer to using true goals in a commission plan by using either retractive or progressive tiers to generate a commission rate. I must give one caution before leaving this discussion and it has to do with setting goals. In ANY plan that uses goals, you must be sure that the goals you are using are economically sensible. If you have jumped onto the “goal-based incentive” train, that doesn’t change the brokerage economics outlined above. Goals that are used for compensation (I’m not talking about ramp goals that are used solely for performance management), must be economically sensible. If your company is a true cradle to grave broker (one person does everything from landing the customer to finding the carrier to doing track and trace), then the goal should be no less than their target total compensation (salary + incentive pay at 100% of goal) divided by 30%. If you have a two-way split model, then you should be in the ball-park of Target Total Compensation divided by 15%. In a three-way split model, you probably need to be closer to Target Total Compensation divided by 10%. We will spend more time on goals in future editions.
[1] These ratios do not apply to managed transportation, LTL, contracted freight, heavy haul, or specialty freight or any heavily technology enabled brokerage business model.
Beth Carroll is the founding partner of Prosperio Group, a compensation development firm that helps transportation & logistics companies use compensation to drive profitable growth through enhanced employee motivation and rewards. Beth is based in Chicago, IL and has over 25 years’ experience developing incentive compensation plans for companies across the globe in a variety of industries. Beth and her team have designed plans for more than 500 Transportation & Logistics companies. Beth can be reached at 815-302-1030 or via email at beth.carroll@prosperiogroup.com.