{"id":64668,"date":"2019-08-18t11:00:01","date_gmt":"2019-08-18t15:00:01","guid":{"rendered":"https:\/\/48e130086c.nxcli.net\/?p=64668"},"modified":"2024-08-14t09:35:01","modified_gmt":"2024-08-14t13:35:01","slug":"the-finance-side-of-goals-and-compensation","status":"publish","type":"post","link":"\/\/www.g005e.com\/2019\/08\/18\/the-finance-side-of-goals-and-compensation\/","title":{"rendered":"the finance side of goals and compensation"},"content":{"rendered":"
<\/a>remember the “one firm” concept is at the core of this discussion. by tommye barie previously we reviewed the goal-setting process, including which person or group should orchestrate which parts of it. now we will conclude the discussion by walking through the financial side of assessing goal accomplishment and how it works when considering actual firm profits.<\/p>\n more:<\/strong> the partner comp battleground<\/a> | if you don\u2019t eat what you kill, what do you eat?<\/a> | 3 ways to emphasize the one-firm concept<\/a> | 8 steps for a successful change process<\/a> | building competency on every level<\/a> | change happens: how to master it.<\/a> let\u2019s start with some statistics from our latest succession planning survey, which we did in partnership with the aicpa\u2019s pcps. the following tables show information regarding compensation systems, broken down by size of firm (by full-time equivalent [ftes] which includes everyone, from administrative to staff to partner): <\/p>\n <\/a> now that we have considered these compensation system statistics, let\u2019s back up a little and start from the beginning. the first concept to discuss is base pay. then we will discuss incentive pay. and then within incentive pay, we will cover two common variations. for simplicity of this potentially complicated discussion, we will start drilling down from the number we call budgeted expected pay (bep).<\/p>\n bep is pretty straightforward. it is that amount the firm budgets in the planning process that is what it thinks each partner will earn, assuming normal expected performance.<\/p>\n while this sounds simple, for many firms, this concept is unsettling. why? just looking at the table above, 43 percent of firms believe all pay to partners is just a draw against final profits. because of this they take the idea that \u201cowners don\u2019t get paid until there are profits to share\u201d to an extreme.<\/p>\n we believe that all partners should make more than the people below them in the organizational hierarchy. and we totally understand, being entrepreneurs ourselves, that if there is not enough money to go around at the end of the day, then the owners are the ones who get to eat the shortfall. but i can also tell you that any going concern that doesn\u2019t pay its partners as well or more than the highest-paid employees doesn\u2019t have much of a future either. why not<\/b> be an employee if you can make more, and have less responsibility and less liability than an owner? while this is a conversation for another time, the point here is that there should be a total pay expectation that is budgeted for every partner that is in excess of that paid to principal or managers. we will share later how to reconcile a budget shortfall, as well as reconciling profits in excess of expectations.<\/p>\n to begin with, you need to set the right expectation. so, whether your firm utilizes a compensation system based on all objective (quantitative) measures, a combination of objective and subjective (qualitative) measures or some hybrid, the reality is that if the firm makes about the same in profits and a partner performs similarly this year to last year, he or she will make about the same amount of money this year as last year. so the idea of starting the budgetary process with an identified bep per partner is a logical way for a firm to create a realistic plan, as well as to identify potential hurdles that need to be overcome if partners want to improve their earnings in the coming year.<\/p>\n with that in mind, consider the following table:<\/p>\n <\/a><\/p>\n in this case, we set up a budget based on past typical earnings. if we earn the expected profits, and everyone performs at an expected normal, then each partner will make his\/her bep. if we don\u2019t meet budget, and partners perform at various levels over and under expectation (which is normal), then we will simply adjust partner pay based on performance to the amount we have actually earned (more on how that works later). the key to consider in our example is that bep is comprised of a base salary (often called guaranteed salary) and incentive pay.<\/p>\n in our case study for this article, we used an 80\/20 ratio, but firms use every imaginable variation to this, based on what they think is best for them. this could just as easily be 70\/30 or any other ratio a firm decides upon. what is important to understand for this case study is that some portion of pay is guaranteed (meaning you have earned that by coming to work every day and doing what you do) and the rest is earned based on what you actually accomplish during the year.<\/p>\n a point of confusion that usually arises here is \u201cwe don\u2019t have the money to pay out that level of pay every month of the year\u201d or \u201cwe are very risk-averse and we don\u2019t want to borrow to fund operations so we don\u2019t want the obligation to pay out our partners at a guaranteed level until the end of the year.\u201d it doesn\u2019t matter what the specific objection or comment is because our response is the same. don\u2019t confuse bep with cash flow. and don\u2019t confuse guaranteed pay with a guaranteed monthly draw. what we agree to pay a partner by the end of the year, versus how we manage our cash flow, is rarely the same. we see a wide range of payout percentages.\u00a0 for example, one of our firms pays out at a rate of 100 percent (spread out monthly) of expected bep during the year, and on the other extreme, we have a firm that pays out expected bep at a rate of 35 percent (spread out monthly). managing your cash and managing overall partner pay expectations are two different issues and should be dealt with independently.<\/p>\n now, back to the numbers above. once you\u2019ve established what a reasonable bep is per partner (usually based on past earnings, average earnings, earnings expected based on the partner compensation model, or whatever makes sense at that firm), and once you have established the compensation framework variables as to the base and incentive portions, the rest is simple math. in the case above, if you look at the pay for the partner with the name of alpha, he\/she has a bep of $175,000. incidentally, it is often common for a new partner to make somewhere between $175,000 and $200,000 annually. in that sense, it might represent the floor for partner pay at the firm (obviously, this varies between firm size and the economy of the area the firm practices). eighty percent of $175,000 is $140,000 for the guaranteed pay, with 20 percent ($35,000) expected as incentive pay.<\/p>\n as we have covered in our previous columns on this topic, the incentive pay we are introducing here (the $35,000 in this example) represents 100 percent of expectation, with 100 percent being what every partner should achieve, with a range of actual achievement pertaining to incentive pay typically being from 50 percent at a low (technically it could be zero but we have never seen that level of poor performance) to 200 percent (we have seen goals achievement in excess of 200 percent, but 200 percent normally is at the high end of the range).<\/p>\n next, we\u2019d like to recommend that you consider reviewing, if necessary, the previous installments in this series that cover how we set up partner goals. once those partner goals are established, and they are monitored with clear communications from the managing partner to the partner throughout the year, at year-end a final determination is made. for simplicity for our case study, let\u2019s assume that alpha had four goals that made up his\/her at-risk or incentive pay. see the table below:<\/p>\n <\/a><\/p>\n as you can see, it was determined that alpha overachieved goal 1 by 25 percent, underachieved goal 2 by 10 percent, overachieved goal 3 by 50 percent and hit goal 4. this kind of pattern is common as some goals are easier for different partners to overachieve and vice versa. the key here is to understand that normal performance, not excellent performance, should meet the 100 percent mark, so paying the 20 percent at-risk portion of a partner\u2019s pay is expected to occur if they just have an average performance year. if a partner underperforms, then they don\u2019t earn their expected pay. similarly, they can earn more than expected when they have a better than average performance year. it is also common for your top partners to overperform in every category.<\/p>\n now let\u2019s take a summary view of all of the partners, assuming each had a number of goals, and their incentive pay was finalized according to the table below.<\/p>\n <\/a><\/p>\n in the scenario above, the partners earned, according to their at-risk performance, $50,575 more than expected ($335,575 less $285,000 = $50,575). so, let\u2019s consider several scenarios on how we move forward from here.<\/p>\n be smart about how you view overall variances in bep and actual<\/strong><\/p>\n the first mistake typically made when assessing goal performance, especially when actual profits are in line with budget or a little less than budget, is that no incentives will be earned by any partner. in other words, given the lack of excess funds, it is assumed that everyone will just earn their bep.<\/p>\n this is a terrible conclusion because, when actual profits are hovering in this less-than-stellar range, the assumption that everyone equally pulled their weight is rarely true. so, the conclusion that because there is no extra money, no one should earn incentive pay is not only demotivating, but actually unfair. in this situation, the odds are that a partner or two performed well, maybe even exceptionally so, and just because that performance was not enough to make up for the other partners\u2019 shortfall in expectations doesn\u2019t mean that it is okay to simply write off the efforts of the performing partners. therefore, we recommend that you always assess goal accomplishment and incentive pay as if there are ample resources and then adjust accordingly as a subsequent step.<\/p>\n so now that we know to evaluate individual performance first regardless of the firm\u2019s budget-to-actual performance, next we have to adjust the calculated performance pay to actual available profits. this adjustment is almost always up or down as rarely does the performance evaluation independently line up exactly with profits on their own.<\/p>\n actual profits in excess of bep<\/strong><\/p>\n let\u2019s first take a look at a positive variance on profits \u2013 when profits are in excess of bep. there are many common approaches to this adjustment. the first, with which we disagree, is to adjust pay proportionally upward based on total pay. we also don\u2019t think firms should simply allocate the remaining profits based on ownership either. typically, ownership is reflected in pay in the first place as we tend to find the owners with the largest equity stakes earning the highest salaries anyway, so allocating excess profits based on total pay often isn\u2019t much different than allocating the excess profits on ownership. additionally, ownership often has an impact on retirement pay, so when this is the case, owners get the benefit of running a profitable firm there too.<\/p>\n what we recommend is that additional profits be allocated based on the incentive pay earned. this naturally favors the higher paid owners (because in raw dollars, their earnings at risk are greater and therefore still have a significant weight when it comes to the denominator for total earned incentive pay), but it also recognizes that any partner at any pay level may have contributed exceptionally and should be rewarded appropriately in that year for their accomplishments.<\/p>\n let\u2019s take a look at the table below to see these methods at work. assume actual profits were $125,000 more than bep, totaling $1,550,000 instead of the budgeted number of $1,425,000. the first step is to reduce the assessed extra incentive pay of $50,575 from extra profits of $125,000, because the incentive pay calculation already has accounted for this part of those excess earnings. this leaves a difference that is not already reflected in the numbers below of $74,425 ($1,550,000 – $1,425,000 – $50,575 = $74,425). that amount is then typically handled one of two different ways. the second column to the right distributes the excess of $74,425 by total pay, and the last column to the right distributes the excess based on incentive pay.<\/p>\n
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\nlooking at the three graphics above, you can conclude the following:<\/p>\n\n