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Structuring Sales Commissions

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Structuring Sales Commissions
What is Commission?
According to Merriam-Webster Dictionary, a fee paid to an agent or employee for transacting a piece of
business of performing a service.
Types of Commission Usually Given to Salespeople:
1. Commission based on sales
2. Commission based on salary
3. Commission based sales and salary(combination)
But, commissions based on sales dollars can lead to lower profits.
Illustration:
Consider Pipeline Unlimited, a producer of surfing equipment. Salespersons sell the company’s products to retail
sporting goods stores throughout North America and the Pacific Basin. Data for two of the company’s surfboards, the
XR7 and Turbo models, appear below:
Models
XR7
Turbo
Selling Price
$695
$749
Variable Expenses
344
____________________
410
___________________
Contribution Margin
$351
$339
Required:
Which model will salespeople push hardest if they are paid a commission of 10% of sales revenue?
Answer:
Turbo model, due to higher selling equals larger commission.
Illustration:
For Turbo:
$749 x 10% = $74.9
Expected Salespeople Commission = $74.9
For XR7:
$695 x 10%
Expected Salespeople Commission = $69.5
On the other hand, from the company’s standpoint:
Profits will be greater if salespeople steer customers toward the XR7 model because it has the higher
contribution margin.
Thus, higher contribution margin means greater profit.
Formula:
Contribution Margin = Selling Price - Variable Expenses
Illustration: (refer to the table above)

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For XR7:
$695 344 = $351
Contribution Margin = $351
For Turbo:
$749 410 = $339
Contribution Margin = $339
To eliminate such conflicts, commissions can be based on contribution margin rather than on selling price.
Reason:
If this is done, the salespersons will want to sell the mix of products that maximizes contribution margin.
Providing that fixed costs are not affected by the sales mix, maximizing the contribution margin will also
maximize the company’s profit. In effect, by maximizing their own compensation, salespersons will also
maximize the company’s profit.
AN ALTERNATIVE APPROACH TO SALES COMMISSIONS
Thrive Networks, located in Concord, Massachusetts, used to pay its three salesmen based on indi- vidually
earned commissions. This system seemed to be working fine as indicated by the company’s sales growth from $2.7
million in 2002 to $3.6 million in 2003. However, the company felt there was a better way to motivate and compensate
its salesmen. It pooled commissions across the three salesmen and compensated them collectively. The new approach
was designed to build teamwork and leverage each salesman’s individual strengths. Jim Lippie, the director of business
development, was highly skilled at networking and generating sales leads. John Barrows, the sales director, excelled at
meeting with prospective clients and producing compelling proposals. Nate Wolfson, the CEO and final member of the
sales team, was the master at closing the deal. The new approach has worked so well that Wolfson plans to use three-
person sales teams in his offices nationwide.
Source: Cara Cannella, “Kill the Commissions,” Inc. Magazine, August 2004, p. 38.
WHAT IS SALES MIX?
The term sales mix refers to the relative proportions in which a company’s products are sold. The idea
is to achieve the combination, or mix, that will yield the greatest profits. Most companies have many products,
and often these products are not equally profitable.
Hence, profits will depend to some extent on the company’s sales mix. Profits will be greater if high-
margin rather than low-margin items make up a relatively large proportion of total sales.
Changes in the sales mix can cause perplexing variations in a company’s profits. A shift in the sales mix from
high-margin items to low-margin items can cause total profits to decrease even though total sales may
increase. Conversely, a shift in the sales mix from low-margin items to high-margin items can cause the
reverse effecttotal profits may increase even though total sales decrease. It is one thing to achieve a
particular sales volume; it is quite another to sell the most profitable mix of products.
Sales Mix and Break-Even Analysis
If a company sells more than one product, break-even analysis is more complex than discussed to this
point. The reason is that different products will have different selling prices, different costs, and different
contribution margins. Consequently, the break-even point depends on the mix in which the various products
are sold. To illustrate, consider Virtual Journeys Unlimited, a small company that imports DVDs from France. At
present, the company sells two DVDs: the Le Louvre DVD, a tour of the famous art museum in Paris; and the Le
Vin DVD, which features the wines and wine-growing regions of France.

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Structuring Sales Commissions What is Commission? According to Merriam-Webster Dictionary, a fee paid to an agent or employee for transacting a piece of business of performing a service. Types of Commission Usually Given to Salespeople: 1. Commission based on sales 2. Commission based on salary 3. Commission based sales and salary(combination) But, commissions based on sales dollars can lead to lower profits. Illustration: Consider Pipeline Unlimited, a producer of surfing equipment. Salespersons sell the company’s products to retail sporting goods stores throughout North America and the Pacific Basin. Data for two of the company’s surfboards, the XR7 and Turbo models, appear below: Models XR7 Turbo Selling Price $695 $749 Variable Expenses 344 ____________________ 410 ___________________ Contribution Margin $351 $339 Required: Which model will salespeople push hardest if they are paid a commission of 10% of sales revenue? Answer: Turbo model, due to higher selling equals larger commission. Illustration: For Turbo: $749 x 10% = $74.9 Expected Salespeople Commission = $74.9 For XR7: ...
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