How to calculate a commission
/A commission is a fee that a business pays to a salesperson in exchange for his or her services in either facilitating or completing a sale. Salespeople may be compensated solely on a commission basis, or they may be paid a base salary, on top of which a commission is also paid. Commissions are an especially useful tool when a business owner wants to reduce the breakeven point of a business by converting salesperson compensation into a variable cost.
Information Needed to Calculate a Commission
Calculating a sales commission depends on the structure of the underlying commission agreement. The following factors typically apply to the calculation:
Commission rate. The commission rate is the percentage or fixed payment associated with a certain amount of sale. For example, a commission could be 6% of sales, or $30 for each sale.
Commission basis. The commission is usually based on the total amount of a sale, but it may be based on other factors, such as the gross margin of a product or even its net profit. Management may use a profit-based commission when there are substantial differences between the profitability of different products, and it wants to give an incentive to the sales staff to sell the most profitable items. The basis may also be based on cash received from a sale, rather than from the initial sale; this is used most commonly when a company wants to involve the sales staff in collecting overdue accounts receivable. Another variation is to offer a special commission rate on inventory that management wants to eliminate from stock, usually before the inventory becomes obsolete.
Commission overrides. A different commission rate may apply if a certain target is reached. For example, the commission rate may be 2% of sales, but retroactively changes to 4% if the salesperson attains a certain quarterly sales goal.
Commission splits. If more than one salesperson is involved in a sale, then the commission is split between them. It is also possible that the manager of a sales region will earn a portion of the commissions of the salespeople working in that region.
Payment delays. Commissions are usually paid based on the sales from the preceding month. It can be difficult to accumulate information for a commission calculation, hence the delay in making payments.
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How to Calculate a Commission
A number of steps are needed to calculate a commission, depending on the circumstances. Here is the basic sequence of events:
Determine the period for the commission calculation. This may be the preceding week, month, quarter, or some other time period. Commissions frequently coincide with the pay period used to compensate all employees.
Determine the commission basis. This may be the sale price, gross margin, or net profit associated with each item sold. The same type of basis typically applies to all items sold. If there have been any product returns during the calculation period, then reduce the commission basis by the amount of the returns.
Calculate the commission. Multiply the commission basis by the applicable commission rate. Thus, a 10% commission on a $1,000 sale is a $100 commission. Different commission rates may apply to different products.
Consider commission tranches. Commission rates may vary, based on the amount sold. For example, the rate might be 5% on the first $50,000 of sales, after which the rate increases to 7%.
Split the commission. If the commission is to be split among several salespeople, then determine the amount of the split and apportion the commission accordingly.
Calculate the manager’s commission. If the sales manager gets a portion of each commission earned, then recognize the amount of this set-aside for the manager. For example, if the sales manager gets 5% of every commission, then a $500 commission will results in a $25 set-aside for the sales manager.
Accounting for Commissions
If commissions are not to be paid by the end of the reporting period, then the amount of commission expense is included in a reversing journal entry, along with the estimated amount of payroll taxes. This approach is only used under the accrual basis of accounting, and ensures that the expense is recorded in the same period as the sales transaction that triggered the commission.
Example of a Commission Calculation
The commission plan of Mr. Smith is to earn 4% of all sales, less any returned merchandise. If he reaches $60,000 in sales by the end of the quarter, the commission retroactively changes to 5%. In the first quarter, he has $61,500 of sales, less $500 of returned merchandise. Thus, the calculation of his commission for the entire quarter is:
$61,000 Net sales x 5% Commission rate = $3,050