Sales professionals are under constant pressure to close deals.
A good 53% say it’s harder to sell than a year ago.
Here are a few more numbers to look at:
- 80% of sales reps confess that prospecting is the toughest part of their job.
- 92% of reps give up after just four attempts to reach a prospect.
- Meanwhile, 80% of potential clients reject offers at least four times before finally saying yes.
With sales reps feeling the heat when it comes to meeting their targets—how do you keep your sales team on track?
The key is recognizing their wins with the right rewards.
Businesses rely on commissions as a way to reward effort and results.
Whether it's making that extra call or pushing for that final sale, commissions can fuel the drive to perform. That said, while commissions are essential for motivating teams, they also affect your cost structure.
It’s important to understand whether commissions should be classified as fixed or variable costs. Sales commissions directly impact the company’s gross profit margins and cash flow—reflecting the real-time cost of generating revenue. As such, accounting for sales commissions correctly is key to maintaining accurate financial records and maximizing net profit.
In this blog, we’ll explore why sales commissions are classified as a variable cost and what this means for your business.
Understanding variable costs and fixed costs
Before we tread deeper into the topic, let's take a closer look at variable and fixed costs.
What are variable costs?
Variable costs are costs that vary depending on the unit of production output or sales volume of a company. Higher sales volumes drive up variable costs, while a slowdown in sales causes these costs to fall or even become zero.
Variable costs include:
- Wages for production workers
- Cost of raw materials
- Sales commissions
- Fees for payment processing
- Costs for utilities based on usage
Key characteristics of variable costs
- Directly proportional: Changes in sales or production volumes directly impact variable costs. For instance, with an increase in sales volume, variable costs such as sales commissions and transaction fees also rise. A decline in sales volume leads to a corresponding drop in these expenses.
- Flexible: Variable costs can be adjusted based on business needs, making them easier to manage during periods of fluctuating sales. This flexibility helps in maintaining profitability and adjusting to changes in the break-even point.
- Customer demand impact: Changes in customer demand can cause variable costs—like marketing or delivery expenses—to shift accordingly.
- Budgeting influence: Variable costs play a crucial role in budgeting as they vary with changes in production or sales levels. Businesses must account for these fluctuations to accurately forecast expenses and manage their financial performance.
Examples of variable costs across industries
Here are a few examples of variable costs in different sectors:
- Manufacturing: Raw materials, such as metal or plastic, are variable costs that increase with production volume. Direct labor costs, which cover wages for workers involved in the production, also rise with the number of units produced. As production increases, both direct materials and labor costs impact the total cost of goods.
- Service Industry: Consulting fees are variable costs tied to the number of hours worked or projects completed. Travel expenses, such as those for client meetings, fluctuate based on the amount of travel required. These costs directly affect business expenses and overall project budgets.
- E-commerce: Shipping costs are a variable expense that increases with the number of orders fulfilled. In a similar way, the transaction fees charged by payment processors also vary with the volume of transactions processed, influencing the average variable cost per sale.
- Technology: Software licenses are a variable cost that scales with the number of users or licenses purchased.
What are fixed costs?
Fixed costs are expenditures that do not change, regardless of fluctuations in production levels or sales volume. Unlike variable costs—fixed costs do not change with the number of units produced or sold and are incurred even if the business produces no output or generates no revenue.
Common fixed-cost examples include:
- Equipment rental or purchase costs
- Lease or rent payments
- Employee salaries
- Insurance premiums
- Depreciation of assets
Key characteristics of fixed costs
- Constant regardless of unit of output or sales volume: Fixed costs do not vary with changes in production levels or sales volume. They remain the same whether the business is producing at full capacity or not.
- Associated with long-term investments: These costs are often related to long-term assets and commitments, such as leases, equipment purchases, or property taxes.
- Predictable: Fixed costs are predictable and consistent. This makes it easier to factor them into budgeting and financial forecasting. They help in understanding the total fixed costs required to keep the operations ongoing.
- Long-term obligations: Fixed costs often include long-term financial obligations that do not adjust based on short-term changes in production or sales. These costs are essential for calculating the break-even point and ensuring financial stability.
Examples of fixed costs across industries
Now, let's look at some examples of fixed costs:
- Transportation: Lease payments for company vehicles are fixed costs. Similarly, salaries for drivers or administrative staff do not fluctuate with the volume of shipments.
- Real Estate: Management fees for property management services are fixed costs. These fees do not vary with the occupancy rate of the property.
- Healthcare: Facility maintenance costs for hospitals or clinics are fixed, as are salaries for full-time medical staff. Equipment depreciation also falls into this category—impacting the financial planning and cost management of healthcare facilities.
Key differences between fixed and variable costs
The primary distinction between fixed and variable costs is that fixed costs stay the same regardless of sales volume, while variable costs shift with changes in sales activity.
A few other factors that will help you differentiate between the two are:
Is sales commission a variable cost?
Sales commissions are variable costs because they fluctuate with the volume of sales. The more sales a company generates, the higher the commission expenses—making them directly proportional to sales volume.
5 reasons why sales commissions are considered to be more variable than fixed costs:
1. Commission increases with performance
Sales commissions are directly tied to performance metrics, such as the number of sales or revenue generated. As sales figures improve, commissions naturally increase.
For instance, a salesperson might earn a 5% commission on each sale. If their sales volume doubles, their total commission will also double, as seen below:
2. Commissions vary with different product types
Sales commissions fluctuate depending on the products sold.
Let's say a salesperson earns a higher commission on premium items like the latest iPhone 16 compared to lower-cost products like the iPhone 15.
3. Tiered commission structures add variability
Many companies use tiered commission structures, where the commission rate increases after reaching specific sales thresholds. This further adds to the variability of commissions.
Consider a salesperson who earns a 3% commission on sales up to $10,000 and 6% on sales above that amount. If they make $25,000 in sales, their commission is calculated as follows:
4. Bonuses affect commission variability
Commission structures often include bonuses that increase as sales targets are surpassed. Such adjustments introduce greater variability in commission payouts.
Take the case of a salesperson who earns a 5% base commission but receives an additional 2% bonus for sales exceeding $50,000.
If they make $55,000 in sales:
Base Commission = $2,750;
Bonus = $1,100
Total Commission = $3,850
5. Commissions reflect changes in sales strategies
Sales commissions can vary based on shifts in sales strategies or promotional campaigns. This flexibility is crucial for businesses to adapt to changing market conditions and manage risks better.
This X user shares an example of how the rules for real estate agents in the U.S. have recently changed.
Scenarios where commissions might be considered fixed
In certain situations, sales commissions can be structured to appear fixed rather than variable.
This typically occurs when commissions are guaranteed or set at a consistent rate, irrespective of actual sales performance.
Here are a few scenarios where fixed commission structures might apply:
Fixed monthly commissions regardless of sales achieved
Some companies offer a fixed monthly commission to their sales team, providing a consistent income regardless of the number of products sold or total sales volume. For example, a manufacturing company might provide a $5,000 monthly commission, regardless of whether a salesperson generates $10,000 or $50,000 in sales in a month. This stability aids in budgeting but does not align with variations in individual sales performance or any increase in the level of production.
Guaranteed minimum commissions to ensure base earnings
Guaranteed minimum commissions provide salespeople with a baseline income even if their sales are low. For instance, if a salesperson is guaranteed $2,000 but only earns $1,500, the company covers the $500 shortfall. This structure ensures a stable income, though it might reduce the motivation to exceed sales targets.
Flat-rate commissions for specific product lines or services
Flat-rate commissions are fixed amounts awarded for selling particular products or services without changing based on sales performance. For instance, a company might offer a $500 commission for each unit of a high-end product sold, regardless of the quantity of output or total sales volume. This approach simplifies compensation but may not incentivize higher sales beyond the predetermined rate.
Benefits of sales commission as a variable cost
Sales commissions, classified as a variable cost, adjust with sales performance—providing multifold benefits for managing payroll expenses and aligning compensation with revenue earned.
The benefits include:
Enhanced sales motivation
By keeping commissions variable and tying them to sales results, businesses can boost employee motivation. This structure encourages salespeople to increase their efforts, driving higher revenue and positively influencing the bottom line.
Quick adaptation to market changes
As market conditions fluctuate, variable commission structures allow businesses to quickly adapt their sales strategies. Adjusting commission rates or structures in response to market trends can enhance competitiveness and responsiveness, helping to secure sales even in challenging environments.
Alignment with revenue goals
Commission structures that align with revenue targets ensure that sales incentives are directly linked to the company’s financial objectives. This approach supports growth and profitability by making sure that compensation reflects production costs and revenue generation—optimizing the total variable cost relative to fixed expenses.
Challenges of sales commission as a variable cost
Managing sales commissions as variable costs also poses challenges for budgeting and cash flow due to their fluctuating nature.
Consequently, proper management of these variable expenses is essential for maintaining financial stability and motivating employees.
Potential unpredictability in budgeting
Variable commissions can make it difficult to forecast and control operating expenses and other costs, as they depend on fluctuating sales volumes. This unpredictability requires careful planning and regular adjustments to maintain budget accuracy.
Managing cash flow with fluctuating expenses
Since commission expenses rise with higher sales and fall with lower sales, managing cash flow becomes challenging. Businesses need to balance these variable costs with their revenue streams to ensure they can cover both fixed and variable expenses without financial strain.
Ensuring fair and motivating commission structures
Designing commission plans that are both motivating and equitable can be complex. The commission structure must align with company goals and market conditions while being perceived as fair by the sales team to drive performance and prevent any form of dissatisfaction.
Impact on financial planning and analysis
The unpredictability of sales commissions poses challenges for long-term financial planning. Against this backdrop, businesses need to develop models that account for variable costs and incorporate scenarios of varying sales volumes.
Knowing how sales commissions impact financial planning will help you establish realistic financial targets and ensure that long-term strategies remain viable despite the fluctuations in commission expenses.
Financial projections shift as variable costs like commissions rise with sales
Variable costs, such as sales commissions, fluctuate with sales volume and performance. This variability can make financial forecasting challenging, as it requires accurate predictions of sales levels to estimate commission expenses. A sudden increase in sales can lead to higher commission costs, altering overall financial plans.
Importance of accurately predicting sales to manage commission expenses
If sales forecasts are too high or too low, the company may face unexpected costs or missed revenue targets. Accurate sales forecasting ensures commission expenses match budgeted figures and maintains financial stability.
Tools and techniques for managing and analyzing variable costs
Utilize budgeting tools, advanced sales commission software, and financial analysis techniques to manage and analyze variable costs effectively. These tools help track and predict operating expenses based on sales data, allowing companies to adjust their financial plans as needed.
Summing up: The power of sales commissions as variable costs
Sales commissions, as variable costs, can significantly influence your budgeting and cash flow. Creating a commission structure that effectively balances motivation with financial control is crucial for managing these expenses.
To explore more strategies for cost management and optimizing your commission plans, check out our resource library here.
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