Sectors
Businesses, companies, or firms depend on knowing the size, scope, and vagaries of their trade, profession, industry, sector, or field. Learn about your field, whether you are in a retail sector, a professional-services sector, healthcare, manufacturing, construction, or another field. How large is your field? What percentage does your field represent of gross domestic product? Is your field larger inside or outside the U.S.? How does your sector perform in economic cycles relative to other sectors? Research until you can articulate your sector’s value to yourself, your family and friends, your business partners, your employees, and your customers or clients. If you don’t believe in it, no one else will.
Compensation
Know the compensation structure within your sector for every significant role on which your business, company, or firm will depend. Know how businesses in your sector compensate owners, managers, administrative employees, producer employees, laborers, and suppliers. Make sure you know how to engage and retain others in your business or to support your business, to secure work, manage work, complete work, and deliver goods and services. If owners secure the work in your sector, and employees perform and deliver it, then know the compensation arrangements for each, whether percentages, employee salaries, hourly wages, or vendor contracts.
⤠ Be sure you know the condition of your herds and flocks. ⤟
Owners
Businesses, companies, or firms generally compensate owners not to do the work but to finance the work, contributing the capital and accepting the financial risk of obligations. Businesses may also pay owners to secure or originate the work, supervise the work, produce some of the work at key stages, and deliver the work to the client or customer. When a business has multiple owners, compensation is generally by each owner’s economic value to the business. Economic value may depend on capital contributed, revenue generated through secured work, and profit from work the owner supervises, minus the owner’s share of business overhead. Even though an owner’s primary value may not be in the work the owner completes, when others could do so at a lower labor cost, for an owner to secure work may require the owner to demonstrate expertise in that work.
Criteria
Performance and compensation criteria can change for participants in a business over time. The traditional firm evaluates the work of a new associate based on training ease, learning ability, work commitment, and adjustment to the firm’s culture and personnel. Performance and compensation criteria then move to skill at assigned work, management of work, effectiveness with clients or customers, and community contacts. As associates near management and partnership, compensation criteria change again to business skill, client development, and leadership and development of new personnel within the firm. Firms tend to abandon lockstep compensation schemes as associates move closer to partnership, rewarding individual performance rather than seniority rank.
⤠ Don’t be hardhearted and tightfisted to the poor. ⤟
Objectives
Develop compensation objectives for your firm. Know why you pay each member of your firm at the level you do. Compensation should be reasonably transparent. Workers reasonably expect their compensation to bear a relationship to the compensation of other workers both inside and outside your company, and to the value of their work. Fair compensation does not mean equal compensation, but ratios of highest to lowest compensation can be important. Who decides compensation and how they decide can have a lot to do with whether workers accept compensation decisions. The book Results Oriented Financial Management states that more effective systems balance objective, formulaic measures with subjective, intuited measures. Compensation also constitutes both a look back at what a worker has done and forward at what the worker is about to do for the business and its clients or customers.
Compensation was the first major financial decision that Erin’s new company faced. Erin expected the two older partners to propose a formula, maybe a mix of billable hours and fees generated through client development. She was surprised when the partners instead suggested relatively modest salaries based on a wide range of criteria, with year-end bonuses based on the firm’s overall performance and additional individual criteria. Compensation suddenly looked a lot more subtle and variable than Erin had expected. For just a moment, Erin wondered whether the older partners might be manipulating things to their own advantage, but she quickly put the thought out of mind. Their proposal had been more than fair to Erin and the other younger partner. Erin realized then that companies in their financial management depend in large part on respect and trust among owners. Formulas can help, but each worker’s value and contribution is unique.
Pricing
Companies may price their goods and services based on the time workers must devote to producing them. Some goods and services take substantial preparation time and time developing and maintaining client or customer relationships, around the time the goods or services themselves take. Other goods and services require little time other than production of the goods or services themselves. Prices charged may also vary by the matter’s risk or value, by market supply and demand, by client or customer perception of value, and by factors peculiar to the workers who produce the goods or services and the company charging the price.
⤠ Riches are fleeting. ⤟
Calculating
External factors need not determine a company’s prices or rates. You don’t have to charge what everyone else does. The book Results Oriented Financial Management points out that a firm can calculate an optimal hourly rate for each worker from several variables that the firm may control. Begin with the worker’s annual compensation. Then add a percentage (25%, 33%, 40%, etc.) to account for the cost of overhead. Then add a profit percentage (25%, 30%, 40%, etc.) reflecting owner investment. Add a percentage (10%, 15%, 20%, etc.) reflecting the realization rate (uncollected billings). Then divide by the worker’s estimated annual unit of production to arrive at the price or rate. No variable is completely within the firm’s control. The worker may demand more in compensation, or the clients or customers may refuse to pay the firm’s optimal price or rate. Yet firms can still base price or rate judgments on internal more so than market factors.
Uncertainty
Do not mistake your field or sector as static. Fields always face social, political, economic, demographic, technological, and other changes. Changes have accelerated recently, as technology has made the world smaller and more interconnected. Events around the country and globe affect us locally more often and more significantly. We do not completely control our destiny, whether in finances or other things. Each of these factors can affect business finances, either directly or indirectly by their effect on customers or clients:
interest rate fluctuations and currency depreciation;
bursting value bubbles and other market changes;
energy prices, resource shortages, and supply chain issues;
industry reorganizations, mergers, and acquisitions;
legislative action and regulatory changes;
international politics and national security;
technology development and other invention; and
economic globalization and outsourcing.
Pressure
Changes can affect not only how workers go about the business but also the amount and variability of profit you earn from it. While clients or customers may have needs as great as ever, they may be less able and willing to pay for goods and services to meet those needs. Companies face revenue and cost-structure pressures. Companies must generally offer more goods or services at lower prices, while reducing their costs of producing those goods and services. That dynamic means constant downward pressure on worker wages because labor is often a company’s greatest cost. Expect to constantly adapt how and where your workers work, and at what compensation.
Pat puzzled over one unexpected challenge that he faced in his new solo practice. He had expected a ramping-up period where he would not be as busy as he wished but in fact almost immediately found plenty of work to do. He had a harder time discerning the right fee to charge for that work. Pat had expected that he would quickly discover a market rate for each service. He already had a good sense from his prior work for the company of the fees charged. Yet Pat soon learned that pricing his services meant a lot more than quoting the right fee. Other pricing variables were equally important including the timing of the fee disclosure, the value he communicated with it, pricing options clients seemed to expect, and payment terms. He had a steep learning curve.
Responses
Businesses have always responded to social, political, economic, demographic, technological, and other changes. Prepare for and respond to outside forces requiring change. Firms that continue growing during recessions make proactive rather than reactive changes. Firms merge, make lateral hires, change billing practices, contract out work, and form ancillary businesses. The book Results Oriented Financial Management indicates that these actions can increase financial resources, enable a firm to handle more matters for a single client or customer, serve larger clients or customers and handle larger matters, recruit new workers, strengthen branding, and enhance expertise. The question is not whether challenges will come but how you will respond to them. Consider responding to change in your field or sector in the following additional ways:
specializing in an existing business;
focusing on hot issues within an existing business;
expanding an existing business;
evolving an existing business;
spinning off a related business;
initiating a new practice business;
developing a business ancillary to existing business.
Billing
Companies may also respond to financial challenges by increasing or decreasing prices and rates, offering ranges of rates, and surcharging or discounting rates. Companies also respond by changing billing practices to include alternatives. Offering customers or clients a choice of billing methods can retain their commitment to paying for your goods or services. Consider the following billing alternatives:
hourly billing;
contingency-fee billing;
fixed-retainer billing;
fixed-fee per service billing;
blended hourly rates among differently skilled workers;
hourly rate with minimum and maximum billing (floor and ceiling);
hourly rate capped within budget categories; and
hourly fee initially followed by fixed fee based on predicted scope.
Finances
Firms also respond financially to market pressure by reducing their prices or rates. To analyze the cost of those reductions, a firm can divide billed rates by standard rates to produce a rate-realization ratio. If that figure indicates that the firm reduced rates by an annual average of five percent, then multiplying that five percent times the firm’s total revenues will approximate the annual cost of rate reductions, to adjust compensation or anticipated owner return. Firms may alternatively write off accounts receivable, when customers or clients are unable to pay charges. Anticipate, estimate, and plan around rate reductions and write-offs in your annual financial planning.
⤠ Don’t serve to gain. Serve to care, and gain will come. ⤟
Problems
Economic uncertainty and market pressure challenge businesses. Those challenges reflect themselves in specific financial problems. In managing their finances, businesses find several common internal financial problems from economic, market, and other external causes. The book Results Oriented Financial Management lists the following problems and suggested responses:
not enough work and associated lack of motivation, addressed by goal-setting, marketing, training, reassignments, or terminations;
lower work value and work inefficiency, addressed by improving work processes, increasing billings, and increasing prices or rates;
high write-offs and slow payment, addressed by shifting billing responsibility to workers better at it and increasing faster-billing work; and
inefficient collection practices, poor client communications, and the failure of alternative-billing practices, addressed by professional management of collections and improved communications practices.
Six months after the four partners started their new company, Erin had already had what she felt was her first real insight into the firm’s billing practices. After having studied the firm’s receipts yet again, she realized that some of the company’s partners were better at billing than others. The company’s billing basics all seemed to have been in place from the start. Each of the four partners worked responsible hours and timely billed solid fees. Indeed, the company’s accounts receivable were higher than the two older partners had expected. Yet Erin could see that the clients of one of the older partners and the youngest partner were not paying their bills at nearly the required rate. The clients could clearly afford the fees, and the services had significant value. Erin spent a weekend reviewing some literature on billing. That research convinced Erin that the two partners whose clients were not paying were not following some important choice, value, documentation, and satisfaction practices. So she spent about an hour making a short checklist with descriptions of those practices to hand out to all three of her partners Monday morning. She also decided that she would mentor the younger partner in those practices. Erin was beginning to feel like a responsible financial manager.
Constituencies
As you dive into your business’s finances, appreciate the several constituencies who share interests in those finances. Customers or clients have strong interests in the financial health of your business on which they depend. Employees likewise have strong interest in the business’s finances. The same is true for suppliers. Lenders to your business also have financial interests, as do your business partners who contributed capital and hold equity in the business. Your business may have other important constituents in the governmental agencies that tax, license, and otherwise regulate your business. Your financial judgments affect all these constituents, just as their expectations and actions affect your financial judgments. Keep them all in mind.
Checklist
Reflect, research, investigate, and act until you are able to confirm each of the following statements summarizing the advice and counsel in this section:
I convey confidently to partners, employees, customers or clients, and others that my business contributes substantial value to customers or clients and my community.
I am able to articulate the criteria by which my business establishes and adjusts base and bonus compensation.
I adjust the compensation my business pays participants based on overhead, return on capital, realization rates, and other variables subject to external influences.
I continuously improve and innovate in pricing and delivery within my business, in ways that respond to external influences including my customers’ or clients’ changing needs.
I am able to identify and articulate potential problem areas within my business’s finances and means for addressing them.