Cost of Commissions

Commission means the amount of compensation a salesperson is paid for selling a product or service to a customer. Companies structure commission plans in different ways, but it is common for commissions to be based on a percentage of sales or on a per-unit basis. For example, someone who sells clothing in a boutique might get a small percentage of what each customer spends, or that salesperson might get a set amount for each dress or suit sold. Because the number of sales a salesperson completes in a given period can vary, this is a variable cost for the company.

Accountants categorize commissions as a selling expense. Selling expenses are costs incurred by the company's sales division as they sell a product or service. Examples of selling expenses, besides commissions, include noncommission sales employee salaries, sales travel costs, and other sales employee benefits. Sometimes a company's sales division also includes a marketing or advertising department. In this case, the department will incur selling expenses, such as the costs of promotional materials. Though commissions are variable costs, they are not included in a company's variable manufacturing costs.

Distinguishing between commissions and variable manufacturing costs is critical because they need to be recorded differently. Commissions are selling expenses that are reported on a company's income statement as operating expenses under "Selling, General and Administrative Expenses (SG&A)."

The income statement is one of the four major financial statements a company records. It measures revenues minus expenses and therefore reveals the net income or net loss during a specific time period. Income statements matter because they tell investors, the government, and the public how well a company is performing. For this reason, it is important that they always be accurate. Falsifying an income statement can lead to criminal penalties.

Because sales commissions are not part of the cost of a product, they are usually not factored into the cost of holding inventory or the cost of goods sold. Costs associated with holding inventory typically include warehousing and insurance. Cost of goods sold (COGS) refers to manufacturing costs that are incurred as part of producing the product.

Recording commissions also differs depending on the type of accounting a company is using. Accrual basis accounting means recognizing revenue when earned and recording expenses when incurred, regardless of the cash received or paid, in accordance with generally accepted accounting principles (GAAP). An expense is recorded and balances out the liability for commissions for the same period that the salesperson completed the sale. Accordingly, a debit is added to the commission expense account, and a credit is generated to the commission liability account. This credit is usually categorized as a short-term liability, unless the company has a policy of paying commissions more than a year after the sale was generated.

Cash basis accounting is recognizing and recording revenue or expenses in the period when cash is received or paid. The company records the commission when it pays that commission to the salesperson. This payment creates a credit in the cash account and a debit in the commission expense account. GAAP requires accrual basis of accounting for all publicly traded companies.