10
Choosing the Right Elements: Build a Compensation Plan

“Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted.”

—Albert Einstein

In this chapter, we explore in detail two key elements that can be included in a compensation plan: base pay and bonus compensation. Makes sense we’d choose these two elements, right? As we discuss them, however, we challenge you to consider beforehand the many things about each of these elements that firms often find problematic. We also look at how to go about administering the plan.

Base Pay

Base pay is where a compensation plan starts. Base pay can best be defined as pay for work, excluding any additional bonuses, payments, or allowances. Setting base pay for employees is easier than for owners. Robert Half’s annual salary survey is an excellent place to obtain salary information for employees. Gathering base pay information for owners is another story. For many firms, there is no rationale for how much should be paid to owners. It’s fair that owners should be paid more than nonowners (reward for taking the risk of ownership), but there is usually no system to determine the base value of owner positions.

Before we provide ideas on setting owners’ base pay, we ask you to consider what you want to achieve with your firm’s base pay program. Please keep in mind there are no correct or incorrect answers in this exercise—just answers. Please see exhibit 10-1 for an exercise to help you.

Base pay is especially critical among owners because, regardless of whether we want it to or not, it sets up a formal or an informal pecking order. An individual’s base pay often represents his or her value to the organization. Most owners refer to their base pay as a draw or salary. We find owners tend to pay more attention to what they get paid in comparison with another owner (relative pay) than to the actual dollars they receive (actual pay). We have witnessed countless cases in which owner A is upset because owner B is paid $3,000 more when, in fact, each owner is paid well over $300,000.

Base pay for most accountants is still the largest portion of total compensation. This is a fundamental cause of a number of compensation issues faced by accounting firms today. A disproportionate percentage of base pay tends to create a system of entitlement and makes change to any compensation system harder to implement.

Peter T. Chingos points out in Paying for Performance: A Guide to Compensation Management several instances in which base pay may become too cumbersome for proper performance and rewards, including too

• much focus on base pay as the primary element of compensation.

• much effort on cheating the system.

• little education on what is required for performance increases.

• little emphasis on contingent compensation as a motivator.

We do not recommend that base pay be tied solely to wage trends or cost of living. The more base pay is tied to these factors, the fewer dollars available to pay for performance.

When we wrote Compensation as a Strategic Asset: The New Paradigm, we asked a handful of managing owners the following three questions:

1. Do you have a minimum level of compensation for a new owner?

2. If so, how is it determined?

3. How do you determine the market value (street value) of your owners?

These questions are still important. The variables for setting new owner compensation can be challenging when trying to get it right for all concerned. Let’s look at an example.

Compensation for the New Owner

Last year, as an associate, Sarah’s total compensation consisted of a $120,000 salary; a $16,000 year-end bonus; health, dental, life, and disability insurance; a 401(k) match; employer-paid payroll taxes; and reimbursements of business-related clubs and dues. Total compensation was $157,000. When Sarah becomes an owner, she must make 4 annual payments of $25,000 to buy into the ownership—this is her capital contribution.

Let’s assume that Sarah generated a healthy and typical 30 percent profit as a manager. Let’s also assume that Sarah has worked hard at positioning herself in the marketplace and has built a $400,000 portfolio that consists primarily of reassigned clients but also includes a few clients she acquired through her own practice development efforts. The new clients, although small in number, are “sweet spot” clients based on the firm’s strategic intent.

What is a fair compensation for Sarah, assuming this year’s performance is as good as her final year as a non-owner (before her promotion)? We also assume, for ease of discussion, that everyone else repeated their prior year performance, and the firm’s overhead remained steady. Consider the following:

• As an owner, Sarah’s compensation is no longer an expense to the firm and drops below the line to become part of the firm’s net income. The $157,000 compensation package ceases to be a firm expense. Good for the firm. Sarah is now “self-employed,” so she must now make quarterly estimated tax payments because the firm no longer “withholds” or remits the employer’s share of Social Security and Medicare taxes. The firm will continue to pay insurance premiums and remit the dues on her behalf, but the tax reporting and treatment of those items will change. To stay even, Sarah needs to draw distribution and payments in kind totaling $157,000. For the moment, we will ignore any individual income tax effects.

• What about a cost of living adjustment? If inflation was 2.1 percent, Wouldn’t she like to be immunized against economic forces? The firm wants Sarah to be excited about her first year as an owner and is concerned about the message that “No adjustment” may send her. Employees will receive increases, and the firm believes it should maintain separation between the young owner and its senior managers.

• Let’s also not forget that Sarah has that buy-in requirement of $25,000 for each of the next 4 years. Possibly more after that! To keep Sarah “whole,” her compensation package needs to be $182,000 ($157,000 + $25,000), but any increase over the $157,000 dilutes the profits for the remaining owners. Should they make less, so she takes home the same? Should the firm pay the new owner’s capital (which is essentially what this suggests)?

• Are newly minted owners still profitable? Sarah produced a 30 percent profit margin in her last year as an employee. What is typical when one becomes an owner? Owners share in profits, correct? Yes, technically they do share in profits, but as a practical matter, young owners slowly recapture that profit margin over a period of years, not immediately.

• What about locking Sarah in and saying that growth in her earnings is dependent on growth in firm earnings? She will earn more than her $157,000 as the firm earns more. There is a degree of logic here, particularly if the sharing of earnings growth is generous. In this situation, owners are saying they built the firm to “X,” and Sarah’s $157,000 is fair for that.

• Under a performance bonus plan, Sarah’s base compensation would be $157,000. For Sarah to make more, she needs to achieve specific goals to which she and fellow owners agree. The majority of these goals need to be financial in nature or have a direct impact on financial measures of the firm.

How Do You Determine the Market Value (“Street Value”) of Your Owners?

Many firms never consider “street value” of an owner, but they do tend to keep an eye on various firm surveys¹ to ensure owners are compensated similarly to firms of their size in markets that are similar.

To determine the base salary of an owner, Nicholas J. Mastracchio, in Mergers and Acquisitions of CPA Firms: A Guide to Practice Valuation, provides a formula to determine the fair value of an owner’s services. Mastracchio’s assertion is that the money owners take out of the firm is a combination of both fair compensation and return on their ownership investment. He believes if the firm has a simple or complex compensation formula for owners that identifies and values key criteria (for example, billable hours, new business, client service, and so on); quantifies each criteria as salary before equity distribution; and has a process and results that are reasonable, then fair compensation has been identified.

One could definitely argue about the reasonableness of many compensation processes. For those firms that do not use the above approach or do not know what fair salaries should be and do not want to estimate them, Mastracchio provides the following formula which can, at the least, serve as a starting point for further discussion about fair salaries for owners.

His formula is based on the salaries of others in the firm, mainly managers or directors. Staff salaries (A) are to staff billing rates (B) as owner salaries (C) are to owner billing rates (D). In other words, think of the following equation:

The calculation is based upon a ratio of known facts. Firms have information about A, B, and D. Having this information, they can then solve for C as follows:

(Staff Salaries × Owner Billing Rates)/Staff Billing Rates = Owner Salaries

For large firms, Mastracchio suggests using manager and senior salaries, and for small firms, he believes full-time professional staff salaries can be used.

Consider a hypothetical midsized firm. If the average salary for managers is $110,000, average manager billing rates are $185. This assumes the firm calculates billing rates by dividing the employee’s fully loaded cost by 2,080 hours and then multiplying that amount by 3.5 ($110,000/2080 × 3.5 multiple). By assuming the average owner rates are $270, owner salaries would be calculated as follows:

(Staff Salaries × Owner Billing Rates)/Staff Billing Rates = Owner Salaries

OR

($110,000 × $270)/$1,185 = $160,540

Under this hypothetical example, $160,540 is a fair base compensation for an owner in the firm. Any amounts paid over $160,540 would be considered a bonus or a return on ownership interest. Although this method is not without issues, it can provide a starting point for determining a fair base compensation for owners.

Developing Pay Ranges

In professional services firms, the compensation plan is initially tied to a given position: staff accountant, senior, supervisor, manager, principal, and owner. The individual’s initial base compensation is normally set to a local market figure and designed so that the greater the worth of a job, the higher the pay. Each position within a firm usually has a range in which the high end can overlap the next range.

To address this overlap, firms develop position descriptions and competency maps. Position competence involves collecting and evaluating relevant information about each position in the firm. Information can be collected from individuals already in the positions and their immediate supervisors. Collected information clarifies the nature and level of the work performed and the extent and types of knowledge and skills required for the work being performed. Table 10-1, included at the end of the chapter, is an example of what a typical competency table may look like.

A position description is a formalized way to document job content and has been used by accounting firms for decades. However, in a rapidly changing environment, dynamic position descriptions become more important. They can no longer be the static documents that were written once and never looked at again. They now must change more frequently, especially when a new technology or service line comes into play. We recommend an annual position description review, keeping in mind the critical need to keep all job descriptions up to date.

Developing Owner Pay Ranges

We see a trend in the marketplace toward career paths or tiers for owners. The old “finder, minder, and grinder”² concept has been around for a long time and has served firms well. However, it’s the twenty-first century and time to create a new paradigm by which we can categorize owners. This new paradigm can be used not only for compensation purposes but also owner career planning. The latter is something we don’t often hear too much about.

Owners come with various skills and talents. We venture that today brings us more than just the “finder, minder, and grinder” owners in a successful firm. Yet, we have found few firms that have taken time to identify the key characteristics of each owner type. At last count, we found at least seven common owner characteristics, but we are confident that some firms may find more than six types.

Let’s look at the types of owners found in most midsized and large firms today. They are as follows:

1. The leader owner. This is the individual with a vision who other owners are willing to follow. This person is willing to serve other owners. Without a leader owner, firms often operate more like a group of sole practitioners rather than a team with common goals. There is a shortage of true leader owners in most professions and industries, including the accounting profession.

2. The entrepreneurial owner. The entrepreneurial owner is often considered a strange breed. He or she is more than a rainmaker because he or she can operate successfully by himself or herself and continue to build volume. This type of owner often controls the largest books of business in the firm, thus keeping other owners and staff busy. Think of it as a microfirm within a firm.

3. The rainmaker owner. This owner knows how to bring in business but is abundant in nature, usually passing work on to other owners. The rainmaker owner usually has a book of business but may not be very active with it. Many times, rainmaker owners may not have the best client relationship or technical skills.

4. The expert (specialist) owner. This owner brings expertise to the firm. This is the owner others go to when they have complex and difficult technical problems to solve. This owner may or may not have good communication skills, but he or she has a reputation both inside and outside the firm as the expert in his or her area. Referral sources are generally comfortable when sending work to these owners.

5. The service-oriented (relationship) owner. The traditional “minder,” this owner knows how to maintain the relationship with the client by constantly meeting and anticipating client needs. Most likely, the majority of his or her work was given to him or her by other owners, especially the rainmaker and entrepreneurial owner. This manager can generally manage a large book of business.

6. The doer (pure technician) owner. Often considered lowest on the pyramid, this owner doesn’t often generate work by himself or herself; rather, other owners provide the work. Doers often have small books of business. We also find that much of the work performed by a technical owner could (and should) be done by a manager.

7. The new owner. This owner may have some of the characteristics of all the preceding types but is too new to know his or her true skills. If we were to look ahead to chapter 11 we would consider a new partner to likely be in the hidden or unknown areas of the Johari Window. Many times, this owner will keep himself or herself busy, get engagements from other owners, and may bring in a limited amount of work. What you do with this owner may determine the long-term future of your firm.

Bonus

The second element in most compensation plans is the bonus. The annual cash bonus is considered at-risk compensation designed to reward performers for achieving key operational goals that owners believe will provide the foundation for creating long-term value. Chapter 14, “How to Compile and Assimilate a Bonus Performance Plan,” discusses in detail how we believe bonus compensation should be allocated. Depending on an individual’s level within the firm, the bonus potential varies.

Bonus Compensation Criteria

A number of factors enter into the bonus compensation reward. Following are those we encounter most, listed in no particular order. Their order of importance and individual weightings and, frankly, whether they’re included in your firm’s list will depend, in large measure, on your firm’s strategy.

1. Billable work (production). Owners usually wear many hats (for example, production worker, manager, marketing and salesperson, client relationship manager, and so on). Although an owner’s compensation is not necessarily limited to the amount of his or her collected billable client work efforts, an owner’s work can have a considerable effect on the economic results of the firm, particularly in smaller firms.

2. New business development. The performance of billable work is easily measured with even the most basic time and billing system. Measuring the results of generating new business or retaining existing clients is not as easily or accurately measurable. Many firms recognize the value of these important functions and maintain records to allocate compensation for generating new business or maintaining ongoing business with existing clients.

3. Client profitability. More recently, firms have begun looking at gross profit margins of individual clients or books of business rather than just realization. It’s one thing to bring in new business and another to ensure new business is profitable.

4. Client retention and loyalty. We now recommend that firms consider client loyalty and retention as criteria for bonus compensation. This makes great sense because it does a firm no good to bring clients through the front door and lose them through a revolving back door.

5. Marketing. Marketing the firm (that is, enhancing its name recognition in the marketplace) and yourself (that is, becoming known in your area of expertise as a contributor and go-to person).

6. Owner seniority. Although seniority once had a strong influence on bonus compensation, its role is diminishing. Firms with point systems still overcompensate seniority, but it continues to diminish in percentage of total compensation.

7. Professional expertise. Owners who have developed a special expertise and personal brand recognition may be compensated more than a general practitioner. These owners usually have a higher billing rate or are able to charge a premium for their services.

8. Intangible contributions. Owners who add future value to the firm through training, systems development, new service lines, and so on are often rewarded for taking on those responsibilities and, ultimately, producing results.

9. Community involvement. Some owners are prominent leaders in various charitable, civic, or other organizations in the community. Such activities are generally regarded as having some value to the firm in the form of favorable visibility and may help attract new clients. Most firms do not reward for community involvement because the outcomes of this factor (new business and so on) are covered elsewhere in their compensation plans.

10. Firm leadership and management. More firms now recognize that growth and profit-ability require a leader at the helm. As firms get larger, owners are more willing to pay someone to lead and manage the firm. We strongly believe that managing owners and those who sit on the executive or management committee should earn a large portion of their performance bonus based on the overall results of the firm.

11. Firm ownership. Ownership interest or equity rank very low (as they should) in compensation plans today. No one questions that owners who have contributed capital to a firm are entitled to a return for their investment and risk, but capital investments and equity may be quite different. Assume that owner A has $150,000 in her capital account, and the firm pays 6 percent per annum on that amount ($9,000). Owner A would receive $750 per month as interest on the capital amount. Now assume that same owner has a 10 percent equity position in the firm, and the net income of the practice after owner draws is $300,000. Owner A would be entitled to $30,000, regardless of performance. Firms that provide a return on equity make it a very small percentage of total compensation: 10 percent or less.

Types of Bonus Compensation

Firms need to become creative when designing bonus compensation rewards. Following is a brief list of reward types:

• Individual reward. For achieving or exceeding predetermined individual goals. This is perhaps the most common of bonus compensation awards and the easiest to calculate. An individual reward does not preclude, nor should it, rewards for team, departmental, or firm goals.

• Special recognition reward. A one-time reward paid to individual or small teams for extraordinary contributions or significantly and consistently exceeding expectations.

• Long-term reward. For performance over a long-term period (generally over one year but not exceeding three years) and may be group or individual. Although long-term rewards are common in publicly held companies, we are beginning to see them appear in accounting firms. The reward may be based on long-term improvement in net income per owner, team profitability growth, and so on.

• Team or niche group reward. For achieving group, niche, or business unit goals. The entire firm or just a team may participate in this reward.

• Profit-sharing reward. Shares a percentage of the firm’s profits with employees on a nonqualified basis.

Combining Tangible and Intangible Compensation

Tangible compensation (the combination of base pay, bonus, and benefits) often gets the most attention; however, money is not necessarily always the most important aspect of a compensation system. There can and should be intangible ways of compensating employees that, according to Tim Swanson and John Vegt in “Payback from Your Compensation Plan,” “represents the benefits your people get from a sense of achievement, contribution, recognition, and from being part of a successful team. In the right environment it feels good to come to work. It’s not just about the money. Intangible compensation may be the most important and most effective component of how you attract, keep and motivate your people, yet may also be the most underutilized.”

Pay is important—salaries need to be competitive—but surveys have shown that employees often rank intangible compensation elements above pay and incentives when deciding whether to stay with an employer.

Intangible compensation can range from a simple thank you for a job well done to the provision of a work environment where team members feel valued. Intangible compensation elements can be low cost yet still deliver high value in creating the leverage to which Archimedes, the ancient Greek mathematician, physicist, and engineer, referred. Every organization has intangible compensation, but the best companies plan and manage this compensation, so team members believe they are valued and part of a special organization. Making money and having fun are not mutually exclusive. In fact, the ideal compensation plan should balance both elements.

Administering the Plan

Creating compensation ranges is not the final step when creating a compensation plan. A firm must also decide how to administer this compensation plan. This means deciding how to pay new employees; how and when to give employees increases; how to determine the pay increase for an employee being promoted from one position to another; and what influence, if any, cost of living increases will have on the determination of pay increases for owners and employees. Chapters 11 and 12 help you administer the plan.

Performance Management

If an organization chooses to pay for performance, the compensation plan must include a welldesigned and properly administered performance appraisal system in order to be complete. Part 3, “How to Reward Performance,” of this book deals with performance management process in some detail, and the reader is directed to that section. Following are questions that help determine if an organization’s current performance appraisal system meets basic goals:

• Is performance appraised on the direct measurement of an employee’s output or results?

• Does the performance appraisal system consider only job-related behavior rather than personality traits?

• Are evaluators trained in the performance appraisal process?

• Are the criteria used to measure performance as objective and quantitative as possible, or are the criteria open to too much subjective interpretation?

• Have written job standards been developed? Are they communicated to the owners and employees at the beginning of the appraisal period?

• Are job standards reviewed regularly to ensure relevance and importance to the department and firm?

• Is the employee actively involved in the performance appraisal process, or is a performance appraisal something that is “done” to the employee?

Final Thoughts

We trust this chapter has helped you begin to think in advance about the unique and idiosyncratic factors that impact decisions about base pay and bonus compensation so that you don’t experience the challenges with which we’ve seen other firms struggle. In the next part of the book, we show you how to reward performance, evaluate owners and the managing owner, and compile and assimilate a performance bonus plan into your firm.

Table 10-1: Sample Competency Table