What Is a Commission and How Does it Work?

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For career professionals in the sales industry, getting paid via commissions is a fact of life - it's how many salespeople earn an income, one that's built more on hustle, smarts and guile than earning a traditional salary.

There are upsides and downsides to a commission income arrangement, and employers and employees should know the deal going in.

What Is a Commission?

In the sales world, a commission can be the complete or partial means of getting paid. Some salespeople earn their entire salary based on a commissioned salary, which is based on the amount of sales the employee generates.

Others in sales may take their pay in a hybrid fashion, part of it coming from a traditional base salary and part of it coming from commissions earned on sales.

In terms of structure, a commission is money paid by an employer to an employee on a regular basis, in payment for services rendered on the job.

Upon being established as a for-commission worker, fully or partially, that employee will receive his or her paycheck, either via regular paycheck or automatic deposit.

Paychecks are issued at the employer's discretion, and are usually issued bi-weekly or monthly.

A commission can be paid to that employee in several ways:

  • As a percentage of total sales generated by the employee.
  • A commission can also be paid via a flat cash amount based on sales productivity or other benchmarks established by the employer and agreed to by the employee.

In legal terms, the Internal Revenue Service deems a commission-based payment structure to be supplemental income for the employee, paid out by the employer. They're not considered to be regular wages, as is a salary. Additionally, company bonuses, overtime wages, back pay, and time-off pay can technically be considered in the employer commission model family, at least in the eyes of Uncle Sam.

A Commission Payment Example

In real-world terms, here's how sales commissions work.

Let's say an automobile salesperson sells a $50,000 new set of wheels and earns a 5% commission on the sale. That means the salesperson earned $2,500 on sales commissions alone on the deal, along with base salary, as well.

If that salesperson works on a commission-only basis, and does not have a base salary, he or she can earn a larger percent on the sale of that $50,000 vehicle, since the company is saving money by not paying the employee a base salary.

Benefits of a Commission for the Employer

For companies who rely on commissions as a payment method to (mainly) sales and marketing employees, multiple benefits apply:

They Only Pay Out on Performance

For an employer who pays employees via commission, that employer is making a straight payment against the employee's sales-generating performance. The more successful the salesperson, the more revenue flowing into the company.

Base Pay Is Lower

A company can leverage a commission-based salary to pay an employee a lower base salary. That's because that commission-based employee has the incentive to earn more money in commissions, which helps him or her cash a bigger paycheck. But the employer wins, too, as any commission earned means the employee earned more money for the company.

The Employer Can Weed Out Lax Producers

It's harsh, but in a commission-based salary structure, a company isn't paying for poor performance. If a sale isn't made, then a commission isn't paid out. Only the big earners get paid regularly by a company, and under a commission-based payment model, it's apparent who will wind up getting paid for their production and who will not - all at little or no cost to the company. That scenario allows companies to rid themselves of weak producers at little cost, an advantage a company that operates on a salary-only model does not have.

Benefits of a Commission for the Employee

Company staffers on a commission compensation model can benefit, too, if the conditions are right:

Still Gets a Guaranteed Paycheck

If the employee earns a guaranteed salary plus a commission (and most do), that employee knows that he or she will get a paycheck no matter what sales targets or other incentives are. That could translate into peace of mind knowing money is always coming in the employee's bank account.

Still Gets a Regular Paycheck 

When a commission is paid in addition to a salary, it may be included in the employee's paycheck or, paid on a separate schedule, usually bi-monthly or monthly.

The Benefit of Time

Career professionals in sales tend to need a longer period of time to build those relationships that yield long-lasting commission checks that are derived from a steady sales relationship. A commission-based payment structure can keep that sales professional afloat while he or she builds those relationships that result in sales.

Freedom

With a commission payment model, good, solid sales professionals can earn as much money on as they wish, and put as much time and effort into the sales process needed to get the job done. As long as their sales benchmarks are hit, commission-based employees will be largely left alone by their employers, thus giving them a stronger sense of freedom and flexibility on the job.

Commission Payment Models

Commissions can be structured either as the employer sees fit, or if the model is structured in a specific fashion after a deal is struck between employer and employee.

Typically, that commission payment model is structured in the following ways:

A Basic Salary and a Commission

This is the most common form of commission payments between employer and employee. Here, the employee earns an agreed-upon salary, along with an agreed-upon percentage of sales earned by the employee in the fulfillment of his or her duties, over a specific time period.

Full Commission

On a straight commission compensation model, the employee earns his or her entire paycheck on a commission-only basis. This means the employer's pay is based on a percentage of either sales made for the firm, or by reaching other incentive-based company directives (like a social media coordinator who earns a company a desired number of followers on Twitter,  (TWTR - Get Report) LinkedIn, and Facebook, (FB - Get Report) for example. True-blue sales professionals tend to embrace full commissions, as the payment percentages are higher, since they're not getting a base salary.

A Commission Draw

Some commission-based sales professionals may opt for a draw against commission payment model. In this scenario, the employee is allowed to "draw down" their pay at the start of a pre-agreed payment period. In doing so, they're borrowing against future commissions earned, and must pay the money back. Having a commission draw model enables an employee to "dip in the till" as needed, especially if the household budget is tight and cash is needed immediately.

Payment on Residuals

Residual payments to an employee are a novel concept, as they reward a sales employee for selling a product or service to a customer who continues to buy from the employer over a period of time. The longer they remain a cash-generated client, the longer a sales employee can earn a residual payment based on sales to that client. This commission payment model is popular in the financial sector, especially in insurance sales, where residuals are paid out over a long period of time as long as the customer stays with the company, and their insurance policy remains active.

The Takeaway on Commissions

A commission-based employee payment model, no matter how it's broken down, can be considered a "win-win" for both the employer and the employee.

The company only pays for production and the employee is highly-compensated for being a great seller for the company. That arrangement historically works for both sides of the deal, and that's why commission-based sales models are still highly in vogue today.

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