The Compensation Dilemma
Sam had big ideas for his small service company. He had the first two of what he hoped would become a 25-truck plumbing and HVAC service company. As with any small business, getting started required a cash flow balancing act, especially in the payroll department. What happens when he hires someone just in time for the phones to go quiet? What happens when a tech spends half a day on a job that goes sour and doesn’t generate much income?
In order to attract the help he needed, Sam knew that he had to offer an attractive package, but he didn’t have enough resources to carry his payroll for more than two weeks if the phones went silent for a spell.
Like many contractors facing this compensation dilemma, Sam decided that a commission system would be the easiest way he could offer attractive compensation to his employees. This way, if they didn’t work, he didn’t pay. And when calls did come in, he hoped that the incentive would encourage his people to offer options and upgrades whenever they seemed beneficial to customers. He also liked the idea that he didn’t have to stay on their backs to make sure his crew wouldn’t be padding their hours and dragging their feet.
Sam knew of the horror stories some contractors had created when their commissioned sales techs had turned into mercenaries. Sam knew these contractors and knew they didn’t believe it was terribly important to check the credentials of their service professionals. Since they were paid by commission, their technical skills didn’t matter too much. What difference did it make if they took all day to do a simple job since they were getting paid the same regardless of the time it took to complete the job? And what difference did it make if the tech wasn’t capable of properly diagnosing a repair? If the tech could swap enough parts, eventually the problem would get solved. The more parts sold, the bigger the sale.
Sam was determined not to have those problems because he hired based upon character and technical skills first. To Sam, a good night’s sleep was just as important as his bank balance. For the most part, the commission plan worked pretty well. Occasionally, when a big job spanned a pay period, Sam had to loan his techs an advance but that wasn’t much of a problem.
What was a problem is that some jobs had a boatload of materials involved, resulting in a hefty commission for just a couple hours of work. Whenever his techs landed a job like that, they had a tendency to knock off early, having met what they felt was a good sales quota for the day. Although a big ticket with easy work was nice, it didn’t help cover the overhead as much as a similarly priced job which included more labor but fewer materials.
It Doesn't Add UpAs Sam’s company grew, it came time to add office staff and a move to new location. The cost of marketing was getting higher as well. Then, there were the legitimate expenses he hadn’t been funding during the start-up period. Fuel prices were climbing and it was time for him, as the owner, to start taking a paycheck. It was also time to add a company health plan. In spite of adding a couple of trucks, the new overhead items meant that overhead was growing as a percentage of sales, so it was time for a price increase. This is where Sam started running into trouble.
The new overhead costs added up to $20 per sold “hour” or “billing unit,” which, at a 30 percent net margin, would add a little over $28.57 to his selling price per billing unit. But since he pays a 25 percent commission, the company would only net $21.32 from the price increase. In other words, his techs would receive a pay increase of over $7 per sold billing unit while the company would only pocket a profit of $1.32 per unit. A great plan for the employees, especially since part of those new overhead costs included additional perks for the employees. However, this price increase wouldn’t work out so well for the company’s profits, so back to the drawing board.
In order to cover the additional costs, as well as the increased commission dollars, Sam decided to bump up his break-even cost to $27. This resulted in a new selling price that was $38.57 higher, of which the commissioned employees would get a raise of $9.64, leaving the company with a net of $28.93. This was enough to cover the additional costs as well as the desired profit dollars. In other words, $20 in costs meant nearly a $40 price increase.
In order to keep the selling price a bit more palatable, Sam decided it was time to make some adjustments to the compensation plan. One option was to reduce the commission rate from 25 percent to 22 percent. According to his numbers, this would cause the actual compensation to stay about the same while allowing the selling price to rise enough to cover the new overhead costs. But any way he looked at it, cutting the percentage was in effect a pay cut. Cutting pay for people who had been working for him since the beginning was just not acceptable.
Sam’s accountant offered a compromise solution. Sam was paying a 25 percent commission on total sales, yet his profit margin on total costs calculated at 30 percent. This was fine for the labor side of the equation, since each billing unit included his budgeted labor cost as well as overhead. But a 25 percent commission on parts, which were being sold at a 30 percent margin, didn’t leave much for the company coffers. If he could cut the commission down to 10 percent on materials, then the company could be recovering much needed profits.
But Sam decided this wasn’t a good compromise; it still meant that his employees would be taking a pay cut. To compound the trouble, he could envision his techs learning to “pencil-whip” invoices in order to reflect more “sold labor” and less sold parts. Yes, he had hired people of good character, but he knew that cutting their pay scale wasn’t part of the agreement. This rubs against a service tech’s unwritten code of justice.
A different approach was to shield the increased costs from the commission through an “administrative surcharge.” He would subtract 10 percent off the labor selling price before calculating commissions. Mathematically, this resolved the “automatic raise” issue without technically reducing the commission rate. Sam rolled out the new pricing, and the new surcharge calculation, hoping to capture the much-needed funds for the company with as little impact to the selling price as possible.
Unfortunately, his technicians didn’t see the equity of the plan. They had been accustomed to getting 25 percent of the selling price and now “the man” was starting to play shell games with the prices. One of the techs then realized that 25 percent of what was left after the surcharge was exactly the same as getting a pay cut from 25 percent down to 22.5 percent. After being turned down because of price twice in a row, that same tech decided that the higher prices were going to result in lower sales. Lower sales with lower commissions meant it was time to move on, which is what he did. Sam found himself being squeezed between a disgruntled production crew and rising overhead.
In order to regain control, Sam decided to go back to the original commission schedule and raise his rates enough to cover the commission burden and still provide for his growing overhead expense. He hoped that the major price increase wouldn’t hurt business but he knew that the next time he faced a cost increase the challenge was going to be even worse. He’d have more people and the stakes would be even higher. He needed a different plan.
Through the years, I’ve seen several stories similar to Sam’s. As the company grows, the original compensation plan gets tweaked and morphed into a grotesque creature that builds walls between management and employees. Next month, we’ll see how Sam solved his problems. Perhaps you’ll find an idea or two for your company.