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14 March 2008

The Road to a Healthier Brokerage: Commission Plan Indexing

Posted by Nicolai Kolding

If you’re a broker, go grab your P&L.  Look to see when the last year was that had GCI about the same as 2007 and then compare the two years’ percent retained (the percentage of GCI kept by the house after sales agents receive their “splits”).  My guess is 2007 was worse. Maybe a lot worse.

This despite the fact that over the same time period most of your expenses, like rent, increased (thanks to nothing more than simple inflation, which is only slightly easier to control than death or taxes).

One solution I’ve seen savvy brokers apply to maintain profit margins is called commission plan indexing.  The idea is pretty simple:  each year, increase the dollar thresholds that make up the different bands of your commission plan(s) by some multiplier (usually the CPI).

For example:  say you have only one commission plan for your office and it resets every January 1st.  It goes as follows:  each agent gets a 55/45 split on the first $50k of GCI, 65% for everything between $50k and $100k, and 75% on everything above $100k

Although most brokers have more complicated plans (and probably many of them), the concept of getting higher splits as production increases is very common so let’s work with this example.

Without indexing, your schedule stays the same year in and year out.  But what if you increased the thresholds by only 4% every year?  Your first band (where the agent gets 55%) now runs from $0 to $52k (not $50k) while the second band (where the agent gets 65%) is now from $52k to $104k.  Fast-forward another year.  The targets are now at about $54k and $108k.  After year three they’re at about $56k and $112k.  And so on.  It’s not too dramatic a change from one year to the next but the cost of not doing this is ever-shrinking margins that get really uncomfortable over time.

Let’s look at what this example would mean for a couple 20-agent companies.  Company #1 has twenty agents who each produce $60k GCI every year (pretty close to average production for the industry) for a total of $1.2mm GCI.  Company #2 has 20 agents who each produce $125k GCI (therefore $2.5mm GCI in total).

With no indexing, Company #1 would make $520k (or 43.3%) of gross profits year after year while Company #2 would make $925k (or 37.0%) year after year.  Unless you live in a world with no inflation, this means your “ins” are stable while your “outs” are rising.  Result:  less profits.

If the plans were indexed, then the broker could keep more to offset rising costs felt elsewhere.  For Company #1, indexing would increase the percent retained from 43.3% to 44.4% over the 3 years.   On Company #2, it would go from 37.0% to 38.5% (returning nearly forty grand to the company).

As margins get dangerously thin in these tough times we all need long-term solutions, not temporary fixes.  Play with the math and see what it would do to your numbers.  Happy indexing.

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6 thoughts on “The Road to a Healthier Brokerage: Commission Plan Indexing

  1. Nicolai: I read your blog on commission indexing with interest. After much thought, discussion and trepidation, we instituted a commission schedule in the mid-90s which did not change commission splits, but which did index the earnings amount to qualify for each level to CPI increases. We kept the explanation to the agents straightforward and totally grounded in business sense noting, for example, that our office leases – our biggest fixed expense – were adjusted exactly the same way, as were other expenses such as salaries. We were prepared for the worst, which never came. Most agents understood – didn’t like it, of course, but couldn’t deny the validity of the policy. Having earnings levels change slightly was far more palatable than any change to their % split.

    In order to achieve, essentially, 100% compliance, we had to avoid the “exceptions to policy” which are so common in our industry – particularly in the commission area. Again, by presenting this in an accurate, straightforward manner, we accomplished this as well. We explained that, to get commission checks to them quickly and accurately, all of this had to be on a computer program in our accounting department and there was no possibility of cutting checks ‘by hand’, nor of trying to track individual schedules outside of the system (we had about 600 agents). To the very few agents who still objected, we simply sat firm on our reasons for instituting these policies and no one left the firm on that basis. By the next year, everything was firmly in place.

    For a firm like BH&G who is re-entering the market, the process should be even easier because it would be Day One policy. Thanks, Marc

  2. @Keith – those are horrible assumptions indeed and, truthfully, it's one of the reasons many firms are struggling as much as they are right now. When times were good, there wasn't careful management of the basic revenue drivers (here I'm defining revenues as gross profits or "company dollar"). The bottom line was being propped up mostly by average sales price increases (the one driver the broker has least control over) while the other drivers (especially broker commission rate and commission rate) were too often heading sharply in the wrong direction (and way more so than a "good market" would indicate they needed to).

    The most successful brokerages I have seen have a system to maintain a fair commission split balance between agent and broker. Most either index or do something similar.

  3. Seems rather obvious to do this, even though not many of us are. I guess most firms see the reason not to do this as “If homes go up 4% each year, our commissions will go up 4%, and thus our revenues will go up 4%.” However, this assumes there are no downward pressures on commissions, no increased costs of doing business and that sales will stay constant.
    All horrible assumptions.

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