Executive summary: Sales commission is a variable cost. While accounting for commissions, a common confusion is whether to add commissions under fixed expenses or variable expenses. We’ll go into detail in this blog on why commissions are a variable cost.
In the sales world, commissions are crucial in incentivizing sales teams to drive revenue growth. To truly understand their impact on the financials, it's essential to grasp the concept of variable and fixed costs.
Variable and fixed costs:
In simple terms, variable costs are expenses that fluctuate directly to sales or production volume. These costs rise and fall based on the level of business activity, making them flexible and directly tied to revenue generation.
On the other hand, fixed costs refer to expenses that remain constant regardless of sales or production volume. These costs are necessary to maintain business operations and do not fluctuate with changes in activity levels.
Is sales commission a fixed cost or variable cost?
From an accounting perspective, sales commissions are treated as a cost of sales, falling under the umbrella of selling expenses. When a deal is done, a portion of the revenue is allocated towards compensating the sales team for their efforts.
Sales commissions are rightfully classified as variable costs due to their direct correlation with sales volumes. As revenue increases, so do the commissions paid to the sales team.
Similarly, the associated commission expenses decrease proportionally during slower periods or when sales decline. This inherent variability aligns sales commissions with the characteristics of a variable cost, making them responsive to changes in business activity.
Why shouldn’t commissions be fixed costs?
Sales commissions are inherently dynamic and tied to the sales team's performance. Fixed costs, on the other hand, remain constant regardless of sales volumes.
But why?
Well, here are a few reasons.
- Performance-Based Incentives: Sales commissions are powerful motivators to drive sales representatives' performance. By offering a percentage or commission based on the value of each sale, companies can align the financial interests of their sales teams with the overall business objectives.
This performance-based structure encourages sales representatives to go the extra mile and achieve exceptional results, which will not be possible with a fixed-cost model.
- Flexibility to Adapt: In the dynamic world of B2B SaaS, market conditions, customer demands, and competition can change rapidly. Fixed costs can be rigid and difficult to adjust in response to these changes. Businesses can scale their sales operations based on market demands by treating sales commissions as variable costs.
- Managing Risk and Uncertainty: Fixed costs risk becoming burdensome during economic downturns or when sales volumes decrease unexpectedly. Businesses can better manage their financial risk during challenging periods by categorizing sales commissions as variable costs. During slower sales periods, commission expenses can be adjusted to align with the lower revenue, giving companies more control over their cost structure.
Wrap Up
There should be no confusion now regarding how sales commissions should be classified. They are variable costs, going up when revenue increases and down when revenue falls behind.
Wondering whether commissions are a period cost? We wrote a blog on whether sales commissions are a period or product cost.
