Sales Commission Strategies

We are looking for data on sales-commission strategies in high-tech companies or general manufacturing environments. As a high-tech company, we have deferred revenues due to software loaded on our hardware. Therefore, I am looking for help for anything between bookings versus cash collections versus deferred revenues versus revenues.

Anonymous

Response:

We set up our compensation plans so that they are designed to achieve the sales objectives. In some cases, this can result in a significant amount of commissions paid that are associated with deferred revenues. When we reviewed this with our auditors, they agreed that we could defer the expense and match the commission expense with the associated revenues.

Nicholas C. White (nick.white@transitive.com )

Response:

There are no hard-and-fast rules on what is the commissionable event in a high-tech company (especially a software company). Your decision should be based on factors such as where your company is in its evolution as a business and the achievements that are most strategically important to your senior management and investors.

The bases you cite are the main ones, and all are widely used. Here are the advantages and disadvantages of each:  

1. Bookings – commission based on non-cancelable contractual commitments by the customer, even if billing or revenue recognition is not imminent. Advantages: (a) Salespeople are rewarded for “sinking the hook” into a customer, and for building big-dollar, long-term relationships. Disadvantages: (a) The definition of “bookings” can be vague and possibly controversial; (b) There is less direct connection between the commissionable event and events of tangible financial value to the company.
2. Billings – commission based on the amounts invoiced (and generally subject to the company’s standard payment terms), whether or not revenue is recognized. Advantages: (a) Regardless of all the GAAP folderol, it’s cash that’s central to a company’s success and survival; (b) A billing is a discrete, uncomplicated event that is easy to track administratively. Disadvantages: (a) For many vendors, there are many items that can be invoiced that are not central to the company’s mission; (b) A “moral hazard” exists that a billings-based commission plan will encourage salespeople to offer unreasonably large discounts for future products and services, in exchange for current-period prepayments.
3. Recognized Revenue – commission based on GAAP revenue recognition. Advantages: (a) For many companies, especially public companies, reported revenue is the single most important financial result; (b) Like billings, reported GAAP revenue is not subject to debate or administrative confusion (at least, once it’s been reported!). Disadvantages: (a) As accounting rules get more and more obscure and complicated – especially with respect to software – it’s less and less clear that advantage (a) above is actually the case; (b) It’s not necessarily useful or valuable to turn the sales force into revenue-recognition experts, which they will try to become when their commissions depend on it; (c) There is a “moral hazard” that on the one hand, reliable revenue recognition depends heavily on open and honest communications between sales and finance on all characteristics of a deal, but on the other hand, those communications can have a material effect on sales compensation. I know that this is always an issue, but an invoice, for example, is a lot less open to debate than the straight scoop on what the customer’s real expectations are.
4. Collections – cash collected. Advantages: (a) “Cash is king” (see Advantage (a) for Billings); (b) Sales involvement can often make collection a much easier task for the company. Disadvantages: (a) In many companies, salespeople play virtually no role in collections, and don’t need to; (b) Is this really what you want your salespeople focused on, or do you think other tasks are always more valuable to the company?

You should work closely with your CEO and/or your COO, as well as with senior sales management, to determine what’s most appropriate. Once you do that, it’s a lot easier to put the actual commission plan in place. A few other points worth noting:

 A.      Keep it simple – it’s essential that your sales force actually understand how the compensation plan works, or you lose the motivational value of the incentive scheme. A little “salesmanship” by finance and by senior sales management goes a long way.

B.      Don’t reward too many things – all of the above commission bases have their strengths, but if you try to reward too many of them, (a) you’ll probably end up violating the “keep it simple” rule and (b) the commission dollars associated with any one particular accomplishment might not be large enough to be meaningful as an incentive.

C.      Commissions on revenues not yet recognized – talk to your auditors about this, but a number of the approaches suggested above call for commission payments before any revenue gets recognized, and (if you pay on bookings) maybe even before there’s any balance sheet effect of the transaction. Many companies use the “matching principle” to defer the commission expense, treating the payments as a prepaid asset whose balance gets relieved as the revenue ends up being recognized.

Do this right, and you can have a very valuable sales motivation tool.

Randy Bolten (RBolten@aol.com )

Response:

I think the right answer for both the salesperson and the company is that if the company can invoice it (booking) then it should pay commission on it. I don’t see the merit in our sales folks having to be subject to deferred-revenue rules, especially when the cash is payable to the company. If the company gets the cash, it seems to me the sales rep should get paid commission. Also, to be clear regarding your question, if I invoice it, I pay the commission. I don’t wait for cash collection, as that is of course relevant, but one should not hold back commission payments.

J. Paul Quinn (PaulQ@vidiator.com )