A common sales compensation question is whether sales commissions should be calculated based upon revenue or gross margin. The answer is...it depends.
If your salespeople sell from a fixed price schedule, and they do not have much latitude to change prices without management approval, then it makes sense to calculate commissions as a percentage of revenue.
You could even consider offering different commission percentages for different price bands, with the commission percentages declining as the profitability of the price bands declines. This would give your salespeople some pricing latitude, yet still motivate them to secure the highest possible price. It would also protect the confidentiality of your company's profit margins.
If your salespeople have considerable latitude when negotiating price, it is desirable to base commission calculations on gross margin. A common approach is to offer a "sliding scale" that increases and decreases the commission percentage based upon the gross margin produced.
For the sake of discussion, let's say your company's target gross margin percentage is 30 percent, and the target sales commission percentage is 10 percent of gross margin. In a sliding scale model, the commission percentage would be adjusted upward if the gross margin for a transaction is higher than 30 percent and downward if the gross margin is lower than 30 percent. An example is provided in the following table:
|Gross Margin||Commission %||Multiplier||Net %|
You can have as many or as few steps as you wish in a sliding scale. You also have complete flexibility when determining how much the commission percentage increases or decreases between steps.
Usually it is wise to cap the commission percentage on both ends of the sliding sale. For example, in the preceding table, the maximum commission percentage is 15 percent of gross margin, and the minimum commission percentage is 5 percent of gross margin. This approach protects your company's profitability while also motivating salespeople to pursue lower-margin opportunities.