Commission-based compensation is valued by many employers who want to offer their employees a variable portion of their salary directly tied to the company's financial goals. How does commission-based pay work, what are its advantages and limitations, and which commission plan should be chosen based on the company and employee profiles? An analysis of the oldest form of variable compensation.
What is a commission-based compensation plan?
Commission-based compensation is a form of variable pay in which an employee is compensated in proportion to their contribution to the company's performance, in the form of commissions. These commissions are typically calculated as a percentage of revenue, sales volume, or gross margin generated by the company, though they can also be based on other performance criteria. This mechanism is defined by the "commission rate," which determines the portion of revenue allocated to the employee as a bonus.
This system has the advantage of being particularly simple and transparent. However, it can be refined through several more sophisticated mechanisms:
Progressive rates
Some companies opt for progressive commission rates to incentivize performance beyond certain thresholds. For example, the higher the revenue, the higher the commission rate. This type of plan requires a highly detailed budgetary assessment to prevent excessive payouts in the event of outstanding performance or to avoid disproportionately high individual bonuses that may not align with the company’s policy.
Tiered commissioning
This type of commission plan adjusts the commission rate based on the level of performance achieved. The goal is to enhance employee motivation by offering increasing commission rates as performance milestones are reached. A common example is the establishment of a trigger threshold, meaning that no commission is awarded below a certain level of performance.
Capped commissioning
To limit the maximum bonus an employee can earn or to prevent budgetary overruns, some companies decide to cap commissions beyond a predefined maximum amount. However, this approach, particularly in sales roles, can face resistance and may lead to strategies where employees deliberately avoid exceeding the cap even if they have the opportunity to do so. This phenomenon is known as the "freezer effect."
Which employees can benefit from commission-based compensation?
Commission-based pay is commonly used for sales teams and more broadly for employees directly involved in the company’s sales force. However, it is not limited to sales roles and can also be applied to other functions such as logistics, marketing, and more.
Additionally, commission-based compensation is often favored by startups that have an immediate and pressing need to capture market share. Established companies that are no longer in an aggressive growth phase tend to shift towards other variable compensation models, such as performance-based bonuses.
How to calculate the commission amount?
In theory, calculating commission amounts is relatively straightforward. Companies first determine which financial metrics will be commissionable, such as revenue, the number of products or services sold, or overall net profit. Next, they select the rate they wish to pay employees in the form of commissions. For example, this could be 3% of total revenue generated or 5% of total sales over a given period.
In practice, the complexity of commission-based compensation arises in the calculation of performance criteria. For example, if revenue is the standard criterion, several questions need to be addressed:
- Should all transactions be included, or should some be excluded (e.g., those involving non-priority clients or low-margin deals)?
- If the company has a diverse product portfolio, should each sale be weighted based on product category, profitability, or strategic importance to the company?
Why choose commission-based compensation?
Commission-based pay is well-suited to various situations, such as:
- Launching a new business or product – In these cases, it is difficult to set precise targets due to a lack of historical data. Additionally, each employee's potential is considered equal at the outset, with significant room for growth in the early months or years.
- Cultural factors – In some regions or industries, commission-based compensation is so ingrained that it becomes the standard. A prime example is the United States, where variable pay is almost exclusively commission-based. In such cases, companies that offer a different incentive model may struggle to attract talent.
Different commission models based on key indicators
Depending on a company’s size, maturity, and industry, various commission models can be implemented.
1. Commission on revenue
This is the most common model, where commissions are paid based directly on revenue generated. It is simple to understand and implement, making it a popular choice for sales teams. However, it may encourage employees to prioritize quantity over quality, potentially harming profitability if low-margin products or services are systematically pushed.
2. Commission on gross margin
Rather than paying a commission on every sale, this model calculates commissions based on the net profit generated from each transaction. It incentivizes employees to focus on high-margin deals. However, if the emphasis on profitability is too strong, employees may hesitate to negotiate flexibly with clients, which could reduce sales volume or customer satisfaction.
3. Mixed commission model
A mixed commission model combines multiple criteria, such as revenue, gross margin, and qualitative objectives. For example, part of the commission may be tied to total sales, while another portion depends on customer satisfaction or retention. This balanced approach motivates employees while aligning their efforts with the company’s broader strategic goals.
4. Team-based commissioning
In this model, commissions are not paid to individuals but rather to teams based on their collective performance. This approach is particularly effective in fostering collaboration. However, it can dilute individual motivation, especially if some team members feel they contribute more than others to achieving shared goals.
5. Commissioning based on personalized indicators
This more sophisticated model tailors commission criteria to specific employees or business segments. For instance, a salesperson working on a new product might be commissioned based on the number of trial runs conducted, whereas another salesperson in a mature market might be rewarded based on client portfolio growth. While this approach is highly flexible and relevant, it requires more complex management.
The limits of commission-based compensation
Despite its strong motivational impact, commission-based compensation has some limitations:
- It does not explicitly define performance expectations, meaning a company's overall performance is limited to the ambitions of its salespeople.
- It often leads to long-term earnings stagnation, where top performers remain the same over multiple performance cycles (usually the most senior or experienced employees), while new hires struggle to achieve significant bonuses.
- It can cause high turnover among newcomers and reduce overall team motivation, as the compensation ceases to be truly variable and no longer incentivizes incremental performance improvements.
Choosing between commission-based compensation and performance-based bonuses
Performance-based bonuses adopt a different approach from commission-based pay, as they evaluate results in relation to set objectives. For example, generating €500K in revenue—was this a strong performance? It depends on the market, products, and resources provided by the company. Setting goals allows for a more refined assessment of performance. If an employee's target was €300K, achieving €500K would be an excellent performance. Conversely, if their target was €1M, they would be underperforming.
Another advantage of performance-based bonuses is the ability to redefine new individual or collective goals at each performance cycle, resetting expectations and avoiding long-term earnings stagnation. In other words, this model prevents commission-based pay from becoming a static income rather than an incentive.
Commission-based compensation, in its various forms, remains one of the most widely used types of variable pay due to its simplicity, reputation, and effectiveness in certain contexts. However, to maximize its benefits, companies must carefully choose the model that best aligns with their strategy—and recognize when to transition to other variable pay models once the limitations of commission-based incentives become apparent.
