Organizations need to understand how their commission and bonus expenses impact their financials. Generally companies book accruals to best understand that impact. Using an automated system, such as Oracle Sales Cloud Incentive Compensation can streamline this process.
Typically, commissions and bonuses are paid after the actual sale is made. However, most companies need to determine such expenses in the period they are incurred in order to report their monthly or quarterly profits. This is known as the ‘Matching Principle’ in accounting.
Here is a definition of the Matching Principle from the Accounting Coach Dictionary:
“The principle that requires a company to match expenses with related revenues in order to report a company's profitability during a specified time interval, ideally, the matching is based on a cause and effect relationship: sales causes the cost of goods sold expense and the sales commissions expense.”
Quite often, commission and bonus accruals are determined in the following manner:Actual data used for calculating commissions and bonuses is used for the accrual. For example, calculation is run on the first day of the following month or interval for which sales were incurred, and earning results are used to book the accrual amount in the general ledger (GL). The amount sent to the GL will typically vary from the final expense paid because, during the following months (or quarters), adjustments and cancellations are received and processed along with the original actuals. The difference is then added as an adjusting entry for the period.
Companies manage accrual forecasting in many different ways. If a company does not understand the requisite factors for financial reporting, it can result in a significant impact to the company’s earnings. A very simple way to forecast is to take the actual expense from the first few periods in the current year, and project that amount across the remaining months for the year. Albeit overly simplistic, it’s easy to create a data set in this manner using reports or Excel.
Other companies base accruals on the previous year’s revenue, with a growth factor based on current sales activity and market conditions. The challenge with this approach is that prior year comparisons may be unpredictable due to market changes, company acquisitions, product changes, and new competition. Some organizations apply complex models or algorithms on top of opportunity data.
If your incentive solution is automated, then why not be creative? The first question to ask is what about the data? What kind of transactions do you use for forecasting accruals? And what kind of data is used to calculate commissions and bonuses? Companies are unique, and those sources are almost always different from organization to organization. However, when you have a flexible application there are different approaches you can take to manage this process.
Here are a couple of examples of how Incentive Compensation customers have leveraged the accrual and forecast accrual process within their solution.
Customer Example One
Comp Plan commission/bonus is cumulative for the year (attainment/quota). Earnings are paid out each quarter based on rate of attainment for the year. Payments are trued up (reconciled) each quarter towards annual earn rate.
Two pay components are used, one to track actual earnings and payment, the second to track accruals. The same data (booked orders) drives both commission accrual costs and actuals. There are two earning types associated to the performance measures; monetary, and non-monetary.
Accounting Codes are tracked at the product group level and included in the accrual report.
Customer Example Two
Commission payments are calculated and paid every month based on booked order transactions. This customer set up identical performance measures (non-monetary) and processes orders which are used for payment and opportunities with a close probability greater than 75%, which are used for forecasting costs. They have developed a report that tracks accruals compared to actual costs by month, and export those accruals to Excel to be used for journal entries.
This customer has also created a powerful report that compares the forecasted accrual rate, month over month, based on closed opportunities against the projected close.
An even more accurate way to forecast accruals might be to leverage Monte Carlo simulations. This approach can help predict those times when sales costs might increase significantly due to new compensation plan design.
(More about Monte Carlo later)