sales commission and bad debt expense

Sales commissions are almost always based on the invoice amount whether it be a strict percentage of the invoice amount or the invoice amount as a percent of overall quota.  However, I am often asked what to do about sales commissions if the invoice is uncollectible (e.g. becomes bad debt expense)?  In a perfect world customers pay in full and on time however in reality:

How are sales commissions affected by not being able to collect on an invoice?

Most small companies pay their sales commissions thirty days after the month for which the cash is received on the invoice (e.g. customer is invoiced September 15th, payment is received October 20th and the commission is paid November 30th).  When Cash is King this is the only way small companies can manage their cash responsibly.  In this scenario the above question is not a problem (other than you have to admit defeat on your collections efforts) because no commissions are paid until the invoice itself is paid.  To be honest, this method of payment really aligns sales and finance collections efforts because the sales reps know they won’t get paid until collection occurs.

However, at some point (when cash is a bit more readily available - for instance you are carrying more than 9 months burn) you will find that commissions are paid thirty days after the month for which the customer is invoiced.  In this example you have two options:

1. in the sales letter to the individual outlining the mechanics of their annual variable pay (e.g. commission structure) include a clause that if the invoice is written off to bad debt expense (after all attempts have been made by both sales and finance) the commission earned on the sale will be returned back to the company; or
2. if your bad debt expense on average is quite small simply allow the sales rep to keep the commission earned on the invoice recorded to bad debt but include in the sales process a mandatory approval by finance of the terms of payment.  In this case the finance group MUST perform a credit check on all sales to determine if collectibility is probable and, if not, cash payment should be made in advance of the item being shipped.

Neither of these two options is appealing to the sales rep.  No one ever likes the thought of their pay being ‘clawed back’ and the extra administrative step in point two slows the sales process down and introduces another negotiating point.  If I had to choose one I would go with option 2.  It builds a strong relationship between sales and finance without leaving the sales person out of pocket.  Should it become a problem (e.g. large cash sales commissions paid and large bad debt expense recorded) then revert back to paying commissions on cash received.

With any of these options there are a few key points to consider:

• non-payment is usually a sign of the customer being unhappy.  Finance is usually the first to find out (through their collections efforts) so the open communication between sales and the product/services group is an excellent feedback loop;
• any way to strengthen the relationship between Finance and Sales is always a good idea which is why I am such a big fan of paying commissions on cash received;
• getting Finance involved early in the sales process means that the sales rep has a better chance of getting the right outcome for themselves as well as the company.

Happy selling!