Referral Fees and Sales Commissions

We received a question from a contractor in the Philippines asking about sales commissions and referral fees. You can read part of his note (edited for clarity) here:

I would like to know your insight: is there a working standard sales commission percentage that you can share?

Three years ago a friend and I partnered for a project worth (between USD+/-250,000 and 335,000)… We paid a referral fee at 5%. That is 5% based on the project cost.

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Now recently a friend told me that we should have paid based on the net profit. Would that be fair if you were in the shoes of the referring party?

A higher commission based on total project cost may attract potential business, but it also may hurt the business on the net profit side or we can lose the project if we add the commission on the total project cost if the owner finds that the total cost too high.

We have to start by addressing an apparent confusion between referral fees and sales commissions.

A referral fee is what you pay to the person who provides you a lead. It’s not a requirement, it’s a courtesy, although some people won’t provide leads without the promise of a referral fee. Referral fees are most common between professionals; if you’re a remodeling contractor and your plumber suggests that an acquaintance contact you for a project, it would be appropriate (and in my opinion, expected) to offer a referral fee to your plumber if the project is sold.

I received many referrals over the years where the person giving the referral specifically told me they didn’t want any fee. They were just happy to connect their acquaintance with someone who could help them get their job built or repairs completed. But it should always be offered, especially between professionals.

A sales commission is what you pay a salesperson to close a sale. This is a requirement, not a courtesy. When you hand a lead to a salesperson, there will be an agreement between the two of you that they will contact the lead and attempt to sell the project, and they will be reimbursed for their effort.

A salesperson should also be paid a referral fee if they generate the lead. Any employee who generates a lead should be paid a referral. If you’re smart, you’ll let your employees know that you’ll pay a referral fee if they generate a lead that is sold.

Referral fees are a marketing expense, a payment for a lead (but it’s only paid if the sale is made). Sales commissions are a sales expense, a payment to a salesperson to close a sale.

The next question is how to value a referral and how to value sales commissions.

Referral Fees

A referral fee in construction should not exceed the amount you normally budget for marketing and advertising. If you build new homes, it might be one to two percent of your total yearly sales. If you are a specialty contractor it might be one and a half to three percent and if you do remodeling work it might be three to five percent. However, I would put a cap on the amount you will pay for a referral for any job. I’d add a not-to-exceed clause, maybe $1,000 or $2,000, $2,500; make it a figure that seems reasonable. However you choose to calculate your referral fee, make it clear and tell them right up front.

If you take that approach, you don’t have to worry about your sales price being pushed too high or your client finding out that you paid an exorbitant fee for their name. The referral fee is an overhead expense and is accounted for in your markup. It isn’t an add-on, and unless you (or the referring party) tell them, the owner doesn’t need to know it was paid.

Frankly, it is none of the client’s business how you arrived at the sales price for their job, but in the off chance they happen to find out that you paid a referral, the amount of damage they can do might take years to recover from. That’s one battle you don’t want to fight. That’s why referral fees are generally between professionals and why they should be capped.

Referral fees should be based on total sales price, not gross or net profits. There is way too much room for an argument and disagreement on gross or net profit because the referring party might want to see your company books to verify the amount. I wouldn’t want any outside party snooping through my books. In special circumstances, say a referral for a project exceeding $750,000, offer a gift instead of a referral fee. A trip to Hawaii for two. A cruise. Calculate for your business what works best.

Sales Commissions

A sales commission should be a percent of the total sales price of the job, without any cap. For new homes, the commission would be roughly one to two percent. Remodeling sales, the commission should be six to eight percent. Specialty sales should also be at least six to eight percent, although specialty contractors often pay far higher percentages if the average job size is considerably smaller.

Sales commission should only be based on total sales price, not gross or net profits. A salesperson has little or no say in the production of a project, so they shouldn’t be penalized if a job runs over because of inefficiencies in production. Some contractors prefer to pay on gross or net profit because they believe it forces the sales person to create a more accurate estimate. It’s far better to have every estimate checked by someone in the company before a sales price is presented to the client. That will lead to more accurate estimates, more appropriate sales prices, happier salespeople, and higher profits. Salespeople are happier when they don’t have to worry about being nickel-and-dimed by accounting and/or production. Company owners are happier when profits are higher. It’s a win-win.

Don’t cap the sales commission, because this is their livelihood. A sales commission isn’t a gift for doing something outside your job requirements; a sales commission is being paid for doing your work. When a salesperson sells a $1 million project, they’ll put in considerably more effort than when they sell a $10,000 project. They should be reimbursed appropriately.

A referral fee is just for the referral, which is why I’d put a cap on it. A sales commission is what you pay your salesperson to work with the client to put together the job and close the sale. It requires CONSIDERABLY more effort than just sending a referral. Remember, nothing happens until somebody sells something. Properly reward those who help you sell something, and your business will benefit.

Related Articles:
Pay Salespeople Fairly: Commission Sales
Paying a Salesperson: Commission on Sales, not Profit
The Downside of Commission Sales
Penciling a Salesperson
Should Salespeople Have to Generate Leads?
The Salesperson’s Real Job