What it means
Sales commissions are widely used by businesses to motivate their sales teams and tie staff costs directly to incoming revenue. Instead of relying solely on a fixed salary, workers receive variable pay based on the volume or value of the products and services they successfully sell.
This setup protects the company during slow periods because payroll costs decrease when sales drop, while heavily rewarding staff when business booms. From a financial planning perspective, commissions are treated as a variable operating expense.
Because they rise and fall directly with sales volume, managers must carefully factor these costs into their pricing strategies and profit margins. If a product has a very low profit margin, a high commission rate can quickly turn a seemingly successful sale into a financial loss for the company.
Businesses structure commissions in various ways to suit their specific goals. Some pay a flat percentage on every item sold, while others implement tiered systems where the commission percentage increases once a salesperson hits a monthly or quarterly target.
This encourages staff to push harder towards the end of a period to reach higher reward brackets. In accounting, it is crucial to record commissions in the correct period.
Under modern accounting rules, companies often spread the cost of acquiring a customer over the expected lifetime of that customer relationship, rather than writing off the entire commission payment in the single month the sale occurred. A sales commission is like a tip left for a waiter, except it is pre-arranged by the restaurant owner.
The harder and better the service, the more money the waiter takes home, and the more revenue the restaurant brings in.
In practice
Real-world examples
Example 1
Sarah runs a boutique marketing agency. She pays her account manager a 10% commission on every new monthly retainer signed. If the manager secures a client worth $2,000 per month, they earn a $200 bonus, and a second client of the same value would add another $200. Sarah records the payments as part of payroll costs in the month they become payable.
Example 2
A regional furniture store offers its showroom staff a 5% commission on all furniture sales. When a salesperson helps a customer buy a dining set worth $3,000, they receive an extra $150 in their next pay packet. If they sell $40,000 of furniture in a month, their commission is $2,000.
Example 3
An enterprise software company pays its sales representatives $8,000 for every annual corporate licence they sell, incentivising them to pursue large, high-value business contracts rather than smaller, quick deals. A representative who closes five licences in a quarter earns $40,000 in commission. The company pays it only after the customer's first invoice has been paid.
Think of it
A sales commission is like a tip left for a waiter, except it is pre-arranged by the restaurant owner. The harder and better the service, the more money the waiter takes home, and the more revenue the restaurant brings in.
Formula
Calculation
Commission = Total Sales Value x Commission Rate. For example, if a sales representative sells $10,000 worth of goods and their agreed commission rate is 8%, the calculation is $10,000 x 0.08 = $800 in commission pay.
Many companies use a tiered rate instead. Suppose the plan pays 5% on the first $50,000 of monthly sales and 8% on everything above that. A representative who sells $80,000 earns $50,000 x 5% = $2,500 on the first tier and ($80,000 - $50,000) x 8% = $30,000 x 8% = $2,400 on the second tier. Total commission is $2,500 + $2,400 = $4,900, an effective rate of $4,900 / $80,000 = about 6.1%.
Finally, test the plan against profit. If those $80,000 of sales carry a gross margin of 40%, gross profit is $32,000. Paying $4,900 in commission leaves $27,100, so the company still keeps most of the profit. If the margin were only 5%, gross profit would be $4,000 and the $4,900 commission would exceed it, creating a loss on those sales.Case study
Seen in the real world
This is a fictional, illustrative scenario. BrightWeb Solutions, a growing digital agency, wanted to scale its client base without inflating its fixed monthly payroll. The directors introduced a new compensation scheme offering a 12% commission on all new website development contracts. In March, a sales representative named David secured three new web build projects, each priced at $5,000, bringing total new sales to $15,000.
Using the new scheme, David earned a commission of $1,800 on top of his base salary. For BrightWeb, paying out $1,800 in commission was highly manageable because the $15,000 in new revenue comfortably covered both the delivery costs and the business overheads. By tying staff compensation directly to incoming cash, BrightWeb protected its cash flow while giving David a powerful incentive to close more deals. The finance manager checked the profit on the three projects.
Delivery costs were estimated at 60% of revenue, or $9,000, leaving a gross profit of $15,000 - $9,000 = $6,000. After the $1,800 commission, the agency kept $4,200, a margin of 28% on the sales. To avoid disputes, the contract also stated that commission would be paid only once each client had paid its first invoice, with any later refund deducted from future commission.
Watch out
Common mistakes
- Failing to account for product profit margins when setting commission rates, which can lead to losing money on sales.
- Delaying commission payments, which quickly damages sales team morale and trust.
- Not clearly defining when a sale is officially complete for commission purposes, leading to disputes over returned or cancelled orders.
Questions
People also ask
Are sales commissions treated as a fixed or variable cost?
Commissions are considered a variable cost because the total amount paid changes directly in line with total sales volume.
Do sales staff still receive a base salary if they get commission?
It depends on the company. Some roles offer a base salary plus commission, while others operate on a pure commission structure.
What happens to a commission if a customer cancels their order?
Most company policies state that if a customer cancels or requests a refund, the corresponding commission is either withheld or deducted from future pay.