One of the most fascinating business models is the hair salon industry. Many salons are poorly managed and rarely generate adequate profits. To make matters worse, the stylists are like professional sports players. One week they are playing for this team, and next week they are on a new team. In effect, they switch salons. It often happens because of personality conflicts, but the most common reason is that the grass is greener over at the other salon. That is; there is more compensation over at the other salon. How can this exist? How can one salon offer greater compensation than your salon? After all, they face the same economic barriers you deal with on a day to day basis. Given this, what is a fair compensation package? How do you create a model that not only entices better stylists but ensures adequate profit for your salon? This article is written to describe the current industry model, and then I’ll explain what is wrong with the model and finally how to change the model to create a fair compensation package for the stylist and still generate adequate profits for your salon.
This article is written to educate hair salon owners and managers. I do not offer any quick solutions; this is business, not one of those half hour comedies. To fully understand the underlying reasons for business decisions, small business owners must understand the concepts and math related to their decisions. This allows them to stay firm in their conviction when challenged by employees, customers, or vendors.
If you are interested in learning about the team based pay model some are currently advocating, I write a detailed critique here: Team Based Pay (Compensation) Model – A Critique.
Existing Industry Compensation Model
There are three primary models used in the industry. They are the booth rental, hourly, and commission models. The first two are forms of business relationships that are discussed in other articles. This article is about the commission model. Overall, the commission model is a percentage of the sales the hair stylist generates. Overall, the hair stylist has her own clientele and fills the voids in her schedule with the salon walk-ins. Some hair salons use a multi-tier commission format to entice the hair stylist in both marketing and working more hours.
From my historical clientele (I’m an accountant) that own and operate hair salons, I have seen commissions as low as 35% and as high as 65%. The overall standard is right at 45%. So let’s take a look at how this model works:
Let’s keep it simple and the sales for the week for this particular stylist are $1,000. How much does she earn in commissions? How much does it cost to the salon for her to provide these services?
Commission at 45% 450.00
Matching Social Security and Medicare Taxes 34.43 (7.65% of gross earnings,)
Workman’s Compensation Insurance 18.90 (4.2% of gross wages)
Back Bar Supplies 32.20 (Back Bar is 3.2% of sales)
Payroll Services Costs .75
FUTA/SUTA 6.35 (Fed & St Unemployment Tax)
Total Costs of Services Rendered $542.63
Notice that the additional costs related to the gross wage is $92.63 ($542.63 – 450.00). Now this does not include the cost of space in the salon, nor the water or electricity, this is the cost related to that employee providing the services. It is important to understand that the additional costs are 20.6% of the gross wage. In effect, the total direct cost to provide that service to the customer is 54.26% ($542.63 divided by sales of $1,000) of the sales price.
How much is the total cost if the commission were in the upper range? Let’s use 60% as the commission rate and here is the math:
Commission at 60% 600.00
Matching Social Security and Medicare Taxes 45.90 (7.65% of gross earnings,)
Workman’s Compensation Insurance 25.20 (4.2% of gross wages)
Back Bar Supplies 32.20 (Back Bar is 3.2% of sales)
Payroll Services Costs .75
FUTA/SUTA 8.47 (Fed & St Unemployment Tax)
Total Costs of Services Rendered $712.52
At 60%, the additional costs are $112.52 ($712.52 – $600.00) or 18.75% of gross wages. Total cost of services rendered is now 71.25% of sales. This is a 16.99% (71.25% – 54.26%) difference in cost of sales for a 33.33% ($600/$450) increase in commissions.
The key to understanding the two commission rates is the fixed costs that do not change no matter what commission rate is paid. The back bar supplies is fixed to the sales and do not change no matter the commission rate. The payroll service fee of 75 cents is a flat rate fee and doesn’t change based on the commission rate. In addition, FUTA/SUTA is actually a maximum volume issue. FUTA is only charged on the first $7,000 of commissions per employee and most states maximize the employee wage limit to $10,000 for the state unemployment tax. This means the state doesn’t charge the tax on earnings in excess of the limit each year. In the world of accounting we say the marginal costs of higher commissions decrease as percentage of gross wages.
Deficiencies of This Model
What you see above is why some hair salons are willing to pay higher commissions in order to acquire and retain the better stylists. They are relying on the marginal increase in costs of $170.26 per one thousand in sales to get better stylists with clientele. Let’s see what happens for the salon when you substitute a 45% commission employee that generates $50,000 in sales with a stylist that generates $83,000 in sales at 60% commission.
Lower Volume Stylist Higher Volume Stylist
Sales Volume $50,000 $83,000
Commissions 45% 22,500 60% 49,800
Matching Taxes (7.65%) 1,721 3,810
Workman’s Compensation (4.2%) 945 2,092
Back Bar Supplies 1,600 2,336
Payroll Service Fees (.75*50 payrolls) 8 38
FUTA/SUTA (Maximum Levels Met) 296 296
Sub-Total Costs of Services Rendered 27,100 58,372
Cash in the Bank after Costs $22,900 $24,628
The higher commission puts more money in the bank account! Why, because the stylist is bringing $33,000 more in revenue. The marginal contribution is $1,728. In addition, I’m sure there will be more product sales to boot due to more activity in the salon. The math is straight forward as to why some salons are willing to pay more in commissions.
This looks like it works well, doesn’t it? What is wrong with the model?
There are actually three flaws with the model. They are 1) a $33,000 increase in sales is highly improbable, 2) loss of opportunity value and 3) risk reward is not justifiable. The following sections explain each of these flaws in detail.
- $33,000 Increase in Sales – this is huge in terms of sales for a salon. Think about this for a moment, you are talking about bringing in a stylist that is generating over 550 more client visits annually (assumes a $60 sale per visit) over the lower volume stylist. If your haircut/styling price is lower, that is that many more client visits per year that the stylist must generate. At $50 per visit, you are talking about 660 more client visits per year. In effect, you are finding a rare gem of a stylist that has that depth of clientele. Most of the documentation I’ve seen is that most experienced stylists have about 80% of their scheduled booked with regular clientele. The remaining 20% of the open slots are available for walk-ins etc. Furthermore, as stylists age and a greater percentage of their available time is booked with regular customers, they have a tendency to reduce their overall availability. In effect, they are taking advantage of their experience and desire to coast with their workload.
- Loss of Opportunity Value – when a stylist comes into the shop with her clientele, she takes up a booth and that booth is no longer available for new clients for the salon. If your salon is able to keep the booths filled with regular clients and new clients, you are losing out on the opportunity value of paying a 45% commission on the marginal increase in sales. The difference in value related to the services rendered by a 45% commission employee over a 60% commission employee is over $11,000 annually.
- Risk/Reward is not Justified – think about this, you want to exchange a 45% employee with a 60% commissioned employee that is able to bring in an additional $33,000 in sales so that you can have an additional $1,728 in your bank account at year end. What if the 60% commissioned stylist only brings $60,000 of value? What is the reward? Well, simply stated, you spend $45,520 in costs for services rendered and generate a contribution margin of $17,480 whereas with the existing stylist, you will have a contribution margin of $22,900. That’s $5,420 more cash in your bank account with the existing stylist. To breakeven, the new higher compensation stylist will need to bring over $75,000 of sales. There is greater risk that the new stylist will not bring the volume as she may promise. In effect, the risk is too great to justify the marginal reward.
As the owner of a hair salon, your real goal is to get all the booths working as much as possible. This may mean that you will have to pay a 60% commission to a stylist that has clientele to entice her to move her book of business to your salon. This assumes you have an empty booth. But if you currently have a salon that is booked and you are turning away clientele, there is no justification to pay a stylist higher commissions unless the goal is retain this stylist, i.e. prevent a stylist from leaving the salon.
A Fair Compensation Model
How do you design a compensation model that is not only fair to both the salon and the stylist, but allows the salon to retain existing customers and garner new customers. Answer: A tiered compensation package works the best.
As a hair stylist starts out, their goal is to get customers. This industry is about the relationship the stylist has with the customer. My wife (as the customer) is the perfect example. She has changed her preferred stylist over the years as she ages. She no longer is interested in a young stylist because my wife doesn’t want to change her hair style. She desires a stylist similar in age and understands the style she wants. In addition, she tells me the younger stylists talk too much (yep, that’s a new one for me). As the stylist gains acceptance by customers and then starts to get loyalty from customers, that is the stylist you will want to retain. It’s at this point you will have to increase her commission rate solely to keep her portfolio coming to your salon.
Then the question becomes ‘at what point does the salon stop increasing the commission?’ Well, actually you shouldn’t. What you want is for the stylist to keep that booth producing money. You do this by changing the commission rates per sets of thresholds of sales. The following is a great example I found in one salon:
Sales Volume Commission Rate
Up to $1,000/Week 47%
$1,001 – $1,500/Week 52%
$1,501 – $2,000/Week 57%
Notice how at the top end of the sales, the commission rate is higher than what is described above? The reason is that the owner felt that if a stylist worked that hard and was willing to commit, then she deserved to earn more money. But the key to the above formula is that the commissions are calculated at each tier. If a stylist earned $1,750 in sales, then the first $1,000 is paid out at 47%, the next $500 is paid out at 52% and the final $250 is paid out at 57%. Not all of the earnings are paid out at the highest tier level reached that week.
The following is an example of one stylist’s paycheck related to $2,300 in sales using the above commission format:
Commission at 47% 470.00 (First $1,000)
Commission at 52% 260.00 (Next $500 Tier, total $1,500)
Commission at 57% 285.00 (Third tier of $500)
Commission at 65% 195.00 ($2,300 – $2,000 = 300 * 65%)
Total Commissions $1,210.00 (Gross Earnings)
Matching Social Security and Medicare Taxes 92.57 (7.65% of Gross)
Workman’s Compensation Insurance 50.82 (4.2% of Gross wages)
Back Bar Supplies 73.60 (Back Bar is 3.2% of sales)
Payroll Services Costs .75
FUTA/SUTA 17.08 (Fed & St Unemployment Tax)
Total Costs of Services Rendered $1,444.82
The total cost as a percentage of the sales equals 62.81 percent. The contribution dollar value for this stylist is $855.12 ($2,300 in sales less costs of services of $1,444.82). If this particular stylist could generate this every week for 50 weeks (assumes two weeks off), the contribution margin for that booth equals $42,759. This is outstanding in this industry. This is actually superior (for around 90% of the country, not so true in the higher cost of living zones). Imagine having 6 stylists producing at this level?
The advantages of the tiered compensation model include:
- Retention of existing stylists;
- Engaging the stylists to bring in more clientele (effective marketing for the salon);
- Overall higher compensation model in comparison to the industry norm;
- Entices better stylists to work at your salon.
- Competition with those salons for stylists that offer a pure flat rate commission above 52%;
- A higher cost of services rendered as a percentage of sales.
Now these two disadvantages may appear detrimental but in reality they are not. First off, those stylists that have a lower value book of business will prefer the higher commission rate as under the fair model, the commissions earned are less. In effect, they can’t reach the higher tiers of sales. The fair model above is very enticing for those stylists with a larger book of business.
Although the cost of services rendered appears to be higher, which would you rather have?
- A contribution margin of 45% (55% cost of the stylist under a 45% commission rate) on sales of $50,000; OR
- A contribution margin of 37% (63% cost of the stylist under the tiered program above) on sales of $115,000 ($2,300 per week for 50 weeks)?
Answer: B Why? Under A above, your contribution margin (net amount to the salon is $22,500) whereas under B the contribution margin is $42,550 (37% of $115,000 of sales). B puts more money into your bank account. It gets better. Many salons make a good margin on product sales. B brings in more customers, I would even say, better customers and those customers buy product. More product sales equal more money in the bank account.
Conclusion – Hair Salon Compensation Model
The multi-tier compensation model is much more effective at bringing in better stylists, retaining good stylists, improving the marketing program and generating adequate profits for a salon. If you currently do not use this model, give it serious consideration as the model for your salon. Act on Knowledge.