Category: Uncategorized

Preface: When you appreciate that all the factors that result in a higher business value will also result in a higher probability of a the continued success of the next generation of ownership, you have now realized the fundamental purpose of why your business is an investment.

Your Successor Looks at Your Business as an Investment (Segment II)

Credit: Donald J. Sauder, CPA |CVA

Commonly, many business owners think about a business transition, and how they will accomplish the next generation succession, and even retain an advisor to begin work on transition, e.g., developing the succession plan. Yet, that is only one step of many in a successful transition. One possible counter argument may be that the value of the business is not really that important to the seller, and only a cohesive working relationship with the successor owner is desired as shares transfer, hence the need for an advisor. While that reality may be true, (and this article is written towards the financial context of business transition) so is the fact that a business may transition for many reasons, e.g., owner retiring, relocating, pursuing new opportunities or interests, or generally looking for reduced responsibility with the existing business venture.

The point is, all the factors that result in a higher business value, will also result in a higher probability of a successful next generation of ownership. This includes, a stable and motivated management team, operating systems that improve and sustain cash flows, realistic growth strategies, diversified business risks and minimized revenue concentrations, growing earnings, and effective debt or working capital management. Is your business an investment? Yes, it is.

Small business organizations supply ownership with the cash flow and net earnings to provide for current and future personal and family expenses, gifts to the community (it is not an oxymoron that the synagogues are credited) and thirdly for most small family businesses, it often is the key reason they are most often financially secure, e.g., the successful management and investment of time, talent, and resources that accumulate and compound with the years. Note: unreasonable transaction values do create substantial financial pressures for buyers if the business transacts at a price substantially above fair market value, and cash flows shift in the business. While fair market value is subject to debate, realistic fair market value is not.

If you do not want to be a statistical failure with business succession, here is one advisor’s words of advice. “Consistently adhere to strong bedrock values and work towards a clear and united vision as a team. That is the best way to sustain a healthy (business) organization.”

A Keystone Business Transitions, LLC article written from the desk of Donald Feldman titled: The 7 Deadly Transition Sins, outlines the following awareness of business transition risks: abbreviated,

1) Failure to have a solid buy-sell agreement for multi-owner businesses. Businesses without such an agreement are playing Russian roulette.

2) Failure to have a business Continuity Agreement for sole-owner businesses. If the sole owner dies or becomes disabled, the business is at risk of dissipation. A well-crafted Continuity Agreement might empower your key employees to run the business and give them compensation incentives to do it successfully.

3) Failure to choose among children to manage the company. Sometimes children can work cooperatively as business owners, but parents are generally poor judges of this and it is advisable to bring in an outside expert to assess the situation.

4) Reluctance to relinquish control. This problem is sometimes most acute in family businesses when mom and dad are reluctant to hand over control to the children. The longer this reluctance persists (men are much worse offenders than women here), the more difficult the transition will be. As a rule, ownership transfers should begin no later than age 65.

5) Failure to think clearly about the tax consequences of ownership and management.

6) Failure to sell at the right time. Owning a business is an inherently risky enterprise. If you are at an age when you cannot afford to wait out a prolonged slump, you should sell while the market is good. The strong M&A market we have enjoyed for the last several years won’t last forever.

7)Failure to transfer ownership to the next management generation.

End of Segment II. To be continued.

Preface: When a business transition occurs, approximately forty-five percent of  owners will sell to a key employee or family member, and fifty percent will sell to an outsider; and roughly five percent of the businesses will not sell or transact at all….here’s what you need know for your future transition.

Your Successor Looks at Your Business as an Investment

Credit: Donald J. Sauder, CPA |CVA

Small business organizations in the United States contain both future opportunities and risks for enterprising talent and business owners alike. First, seventy-five percent of these small business organizations have a majority owner that is fifty years of age, or older. For most business owners in this majority it represents a business risk that statistically says fifty to seventy-five percent of the owner’s retirement net worth is in their business valuation  or the fair market transaction value of the business. Yes, most of these business owners factually have only ten to twenty-five percent of their net worth in investment assets outside the business e.g., an investment portfolio or 401k plan. Therefore, in many cases, harvesting that business value is crucial to the small business owner and their family’s financial future. Business value is much like an agricultural crop of wheat or corn, a successful harvest is not guaranteed but always anticipated.

“One of the common, substantial, and problematic factors in harvesting business value is the expectation of that business’s fair market transaction value to a buyer i.e., the appraisal.”

When a business transition occurs, approximately forty-five percent of these owners will sell to a key employee or family member, and fifty percent will sell to an outsider; and roughly five percent of the businesses will not sell or transact at all. Of those businesses , fifty percent plan to transition shares within three years and seventy-five percent plan to transition in ten years.

Beyond statistics, if you are one of these small business owners in the majority, preparing and planning your business transition is certainly advised and necessary. One of the common, substantial, and problematic factors in harvesting business value is the expectation of that business’s fair market transaction value to a buyer i.e., the appraisal. While this variable changes from year to year based upon net earnings, cash flows and EBITDA, customer concentrations, revenue propellers, and other factors relevant to the future probabilities of discretionary earnings in the business, tracking and benchmarking that value helps set proper transition expectations.

Setting appropriate expectations early is a keystone of successful ownership transition. Strategic business owners will value  their business at least twice before beginning a transition of ownership. This helps benchmark value expectations and sets a realistic foundation to optimize appraisal values for a future transition of business ownership.

“Too often, for most business owners, they approach business valuation as a second step in the transition process.”

There are multiple business valuation metrics, approaches and variables in appraising an accurate and fair market business value. For instance, the Asset approach will arrive at an entirely different value than say, an Income approach or Market approach, and a Market approach is subject to likewise variables in comparisons of product, market depth, and business locale. A realistic business valuation will include at least two comparisons of value in the report, e.g., an Income and Market approach.

Business valuation is more than financial analysis; it is an art and a science that requires appropriate expertise to obtain accurate fair market transaction appraisal value. It is at the capstone, a prophecy on  the future cash flows of the business, discounted to a current value.

Too often, for most business owners, they approach business valuation as a second step in the transition process. It’s alike to savoring a large ice cream cone on very warm summer evening, i.e. they forfeit the opportunity to maximize appreciation [value] on the sale of the business (the investment) with proper planning and performance improvements that can sometimes substantially increase harvest yields, i.e., the business value.

End of Segment I. To Be continued.

Preface: What is the benefit of all this management of accounts receivable and inventory and accounts payable, i.e. the cash conversion cycle components? Naming only two characteristics: 1) improved liquidity, and 2) more efficient use of working capital.

Cash Conversion Cycles (Segment II of II)

By Jacob M. Dietz, CPA

Inventory

Mapleberrytown looked at some industry standards that their accountant gave them for inventory days, and they realized that the industry is at 100 days. They reviewed their historical inventory days, and they realized that 1 year ago they were at 127, two years ago 115, and 3 years ago at 110. They are currently at 130 inventory days.

What can they do? Inventory management is a huge topic. The specifics of inventory management go well beyond the scope of this blog, but they could begin to look for low-hanging fruit. For example, are they overstocking inventory? If inventory is being stocked at too high levels, it ties up cash.

Mapleberrytown realized that they were stocking too much Widget Component B. Their lead time to get it is 2 weeks, but they have a 2-month supply on hand. When the person responsible for ordering was questioned about it, he responded that he is petrified of running out of the product. After sitting down and discussing the needs for that component, however, they developed a plan to have an appropriate stock level without tying up too much cash.

If inventory is a major component of your business, consider taking the time and really learning about inventory management. If inventory management can be improved, it can make a significant difference on the bottom line.

If a company drags out accounts payable too long, however, then vendors may stop selling to the company, or make them pay on delivery. There are also ethical concerns about waiting too long to pay vendors.

Accounts Payable

Last, Mapleberrytown examined their accounts payable practices. accounts payable days are subtracted when calculating the cash conversion cycle because it is a delay in paying cash. From a cash point of view, longer is better.

If a company drags out accounts payable too long, however, then vendors may stop selling to the company, or make them pay on delivery. There are also ethical concerns about waiting too long to pay vendors.

Mapleberrytown compared their accounts payable balances to previous years, and they discovered that the accounts payable days were steadily getting shorter. Next, they realized that their accounts payable days were below the industry standard. They are paying their bills faster than they did in the past, and they are paying faster than their competitors.

Mapleberrytown decided to go ahead and keep paying so quickly. One factor in the decision was that some of their vendors give them a 2% discount if they pay in 10 days.

Benefits of Shortening the Cash Conversion Cycle

What is the benefit of all this management of accounts receivable and inventory and accounts payable? One benefit can be less cash tied up in the business operations. If less cash is tied up in the business operations, then the business may be able to operate without a line of credit, or with a smaller balance on the line of credit. If the business has no line of credit and funds its operations with cash, then more efficient operations may allow the business to have more money in the bank to fund operations if times get rough. Furthermore, if a business is profitable and uses good cash management, some of that cash may be available to invest in business growth.

How healthy is your cash conversion cycle? Do you have money locked away that you wish you could access?

This article is general in nature, and it does not contain legal advice. Please contact your accountant to see what applies in your specific situation.

 

 

Preface: Managing cash flows adroitly is an important task to every business owner. Continuing reading to learn how the cash conversion cycle works, and what you should be aware of to optimize its role in monthly and quarterly cash flows. 

Cash Conversion Cycles

By Jacob M. Dietz, CPA

Imagine if you had $5,000 in cash, and you locked it in your safe. Unfortunately, you dropped the key into the bottom of a river while walking across a bridge. You call the safe company, and they agree to come and unlock your safe for you – in 15 days. That $5,000 is legally yours, and it is sitting right in front of you. You have every legal right to it, but it does you no good without a key. Understanding cash flow and taking steps to improve it can be a key to unlock cash flow.

Specifically, the Cash Conversion Cycle measures the days your cash is tied up in accounts receivable, the days it is tied up in inventory, and then subtracts the amount of time you save by using accounts payable.

Cash Conversion Cycle

The Cash Conversion Cycle is a measure of how many days your cash is tied up in a noncash form during your business cycle. Specifically, the Cash Conversion Cycle measures the days your cash is tied up in accounts receivable, the days it is tied up in inventory, and then subtracts the amount of time you save by using accounts payable. The specific calculations are beyond the scope of this article, but in general accounts receivable days are a measure of how many days it takes to collect your accounts receivable, inventory days is a measure of how long your inventory is around, and accounts payable days is a measure of how long it takes to pay your accounts payable.

Cash Conversion Cycle = Accounts Receivable Days + Inventory Days – Accounts Payable Days.

Suppose Mapleberrytown Widget Mfg, LLC is a manufacturing company that buys in widget components, manufactures widgets, and then sells the widgets to distributors. When they begin looking at their Cash Conversion Cycle, it is 150 days. Their accounts receivable days are 35, their inventory days are 130, and their accounts payable days are 15.

150 days = 35 accounts receivable days + 130 inventory days – 15 accounts payable days.

Accounts Receivable

First, let’s look at accounts receivable. Is 35 days good or bad? Compare the number your business’ historical trends and to the industry. In this case, Mapleberrytown Widget’s industry standard is 30 days. Their historical trends reveal that 1 year ago their accounts receivable days were 33, and 2 years ago their accounts receivable days were 32.

Both the industry comparison and the historical comparison indicate a problem. What can they do? In Mapleberrytown’ s specific situation, they realize that they some customers are paying in 50 or 60 days, even though the invoices are supposed to be paid in 30 days. Upon closer inspection of the invoices, Mapleberrytown realizes that they do not indicate a timeframe to pay them. They immediately started printing a note on the invoices indicating that they are due in 30 days. Mapleberrytown decided to send out statements every month to late customers asking for payment.

Conclusion of Segment I.

Preface: As sales and use taxes can create a complex web for tax compliance, harnessing the right tools to manage and reduce those tax risk is advisable. With this three series blog, you should now have an awareness of what the advisable steps are towards that tax compliance.

Village Property Maintenance Company, Inc.

Credit: Donald J. Sauder, CPA | CVA

Managing more than 15,000 rental units within the state, from the metropolitan center to vibrant college town, Village Property Maintenance Company, Inc. (VPMC) management worked every angle for another dollar or two. When new management joined the business, they voted that a new accounting firm would provide high level CPA services with more conservative tax risks.

In initial meetings, VPMC’s CPA discussed all the relevant tax and accounting facts from multi-state tax nexus to sales and use tax, and inquired on compliance with applicable state payroll taxes. During the conversation, it became evident that the 2,000 wash machines and dryers the company purchased each year, were subject to sales or use tax that had not been paid. The CPA assessed the cost of compliance between $100,000 to $140,000 per year.

Management made the decision to have a thorough project evaluation of all tax filing compliance for the business. During that the compliance evaluation, the company obtained a compliance report on all relevant tax laws including the sales and use tax filings. With the assurance of appropriate accounting and tax oversight in place, the business fortunately was never audited for the pending tax risks, and never assessed a potentially alarming audit settlement for noncompliance with appropriate tax leadership.

Sales tax evaluations

So what should your business do? A sales tax evaluation should begin with assessing a company’s customer revenues, and taxability of those customer’s purchases. This is most easily managed with appropriate software. Sellers of services and goods that are taxable can obtain and keep on file, exemption certificates from customers that exempt the sale from sales tax. If this document is not on hand, the sale is subject to the applicable sales tax rules. For good accounting department management, a company should request this form from all customers in every state, and even if not registered in the state, to protect from nexus risks. Penalties if assessed can exceed 10% with interest. Every accountant should advise and guide your business compliance with all sales and use tax laws.

The evaluation of use tax requires an assessment of the vendors and purchasing of a business. One of the largest risks companies can have beside taking no action on sales tax, is to gamble with use tax compliance. The first place to start evaluating this risk is with recent vendor payments and high-dollar expenses. Paying appropriate use taxes is the advised business policy.

Summary: As sales and use taxes can create a complex web for tax compliance, harnessing the right tools to manage and reduce those tax risk is advisable. It begins with a review processes for tax compliance, then characterizing the taxability features of each process from customer sales to vendor payments. Sometime technology assessments and implementation are necessary. Working with an accountant who will invest the time with you to ensure your business is compliant with sales and use tax laws is advised and necessary. This advised compliance evaluation is one more step towards perpetuating your businesses long-term successes and managing your business with integrity.

Preface: Segueing into Segment II…. When sales and use tax compliance issues are located from uncollected or under-accrued tax payments, sometimes with substantial penalties and interest too, it can result in a few businesses even needing to embark on emergency measures…… 

Appropriate Steps to Avoid the Web of Sales and Use Tax Risks (Segment II)

Credit: Donald J. Sauder, CPA | CVA

Farm Manufacturing, Inc.

Farm Manufacturing, Inc. had been operating for a number of years as a successful metal fabrication company of agricultural equipment. The three-person office staff had rotated in recent years, with better job offers and changes of pace.  The experienced office manager was established, and had been there for more than five years, and Ephraim had reason to trust his team and placed confidence in their knowledge of accounting to keep his business running successfully. When he saw an tax audit notice on his desk for sales and use tax from the State Department of Revenue, he never envisioned the sales tax audit problems looming.

After his office manager advised him to contact his accountant with regards to the seeming complexity of the sales tax audit notice, Ephraim mentioned on the phone call to his accountant that he didn’t handle any of those tasks, and was assigning his accountant responsibility to resolve. The accountant responded that he was aware from notes and discussions that Farm Manufacturing, Inc. prepared and filed all sales tax forms in-house, but that he’d be happy to help with tax audit.

After reviewing the information document requests Ephraim forwarded, the accountant contacted the office manager for copies of the prior sales tax filings. The office manager replied, after talking with the accounting department that they were unaware of any necessary filings having ever been prepared for audit period, and more importantly, none had been prepared or filed since they had been at the company to their knowledge. In fact, and furthermore, the registration for sales tax filings, had apparently never been approved at the State Department Revenue.

The accountant began an assessment of the taxable sales from the business with a review of the vendor transactions and revenue type, and calculated the unpaid tax may be around $15,000 to $25,000 per year.

After scheduling the initial audit meeting, that included three days on site filed work, reviewing GL detail, tax filings, customers list’s, invoices, and sale records, it was apparent that the auditor was aware the filings had been both unpaid and unfiled, and that there was substantial tax assessments likely. Since there was no record of what was taxable and what was non-taxable, the auditor prepared their own assessment of $140,000 unpaid sales taxes for the audit period, assuming the tax filings had been appropriately prepared.

The accountant deemed the sales tax to costs or liabilities to be substantially less than the auditor assessment, and requested additional time to work through the details and prepare proper sales tax filings. After a several weeks’ project, the accountant had the revised numbers and prepared sales tax filings, with supporting documents, and scheduled a follow-up with sales tax auditor.

At the meeting, the accountant met with the auditor, to discuss the settlement cost of the Farm Machinery Inc. unpaid audit sales tax liabilities. The sales tax filings indicated the total cost was $92,000 plus accountant fees. The auditor wanted time to review the documents. After, negotiations, they agreed on an $105,000 settlement with an agreement the sales tax compliance would be followed in the future with all tax filings prepared, and taxes submitted to the state, plus penalties and applicable interest.

In this instance, Ephraim assumed his business was running with all tax compliance features in place, and since the accountant was not assigned to file sales tax reports, was unaware of the non-compliance and omission of a standard tax filing feature. More concerning, the accountant made inaccurate assumptions about his clients, given that no sales tax liabilities were ever listed on the balance sheet. The $105,000 settlement reduced working capital to critically low levels. The business survived. Yet, it is not always that way for small business organizations who contact sales tax shoals.

Any business that has experienced a field audit for sales and use tax examinations knows a sales tax and use tax audit can be expensive and create substantial financial problems for a business. When compliance issues are located from uncollected or under-accrued, sales and use tax, sometimes with substantial penalties and interest, can result in a few businesses even needing to embark on emergency measures as outlined in the prior two examples.

Conclusion of Segment II of III

 

Preface: As sales and use taxes in business can create a complex web for tax compliance, harnessing the right tools to manage and reduce those tax risk is advisable.

Appropriate Steps to Avoid the Web of Sales and Use Tax Risks

Credit: Donald J. Sauder, CPA | CVA

The new sales tax laws of 2018 following the SCOTUS “Wayfair” ruling, substantially increases the amount of compliance work already required in the perplexing field of sales tax. Let’s begin our work on the appropriate steps to avoiding the web of sales and use tax risk with these questions:

1. Do you ship products across state border’s?
2. Do you perform services across state border’s?
3. Do sell online?
4. Do any employees travel across state lines?
5. Are you registered in all the states you have customer in?
6. Do you know the state and jurisdictional rules for your revenue sources?

Specifically, the 2018 “Wayfair” ruling “bright-lines” that substantial nexus occurs for sales tax reporting when a value of goods exceeds $100,000, or the number of transactions is more than 200.

While the latitude of this field is advised to be managed with expert accounting advise, great decisions can only be made with even more precise and accurate information.

Let’s consider first some fictional stories with a pertinent hypothesis to gain an increased understanding of what sales tax non-compliance can cost a business, and then talk about easy (but not necessarily inexpensive) steps to proactively ameliorate the web of audit risks with sales and use taxes. Before we begin, there are 7,500 approximate taxing jurisdictions in the US for state and local sale tax, so the proper management of the fields risk, can quickly become challenging, for any tax professional or entrepreneur for that matter.

Residential Services, LLC

Residential Services, LLC was heading into a successful second decade of business having blossomed with a capable team and diligent effort. With superior earnings, the company had devised a strategy of purchasing supplies and materials for projects from a sales tax free state that was nigh and convenient, given their jurisdictional location. The Company then sold the supplies to customers, and other friendly competitors with appropriate markups for the industry. With more than $1.5m of these tax- free supplies transacted per year, the company was earning a comfortable net profit of other income from the “tax strategy.”

The Company had just finished a signature prevailing wage project, when an audit letter arrived from the State Department of Revenue.

The business owner called his accountant and requested their assistance with the documentation assembly response. The accountant sensed a larger problem when the client began to outline the requested items, and called a meeting.

As the accountant asked questions, and understood more about his client’s activities and transactions he realized the scope of the audit and the risk associated. The client was earning nearly $100,000 in net profit from the devised “tax-strategy.” The accountant realized that if they showed the auditor that tax had not been paid on the supplies purchased, the risk was concerning, but there was no escape route from the audit.

At the first meeting with the auditor, the accountant began answering questions and providing requested documents. One question they ask was, “Why did you purchase out of state?” The answer, “Lower prices!” Searching the vendor records and purchase amounts, it was obvious the auditor knew what they were looking for, and requested copies of vendor invoices for the prior two years. Working together with the client, the accountant could only provide 10% of vendor invoices requested.

Given the substantial risks, the auditor realized that they had located a treasure trove of tax collections. Using general assessments, and estimates of material purchases, the auditor assessed a $570,000 audit settlement. The client and accountant realized they had a substantial and going-concern risk from lack of compliance with state sales tax rules.

The accountant told his client that appealing the assessment would likely lead to only more scrutiny and that the “tax strategy” was clear non-compliance with tax rules. After numerous conversations, the client agreed to cooperate and request a negotiated settlement.

The auditor was surprised. The accountant walked with the auditor through the obscure laws of sales tax compliance, and admitted the non-compliance factor, asking the auditor for an affordable settlement. The auditor didn’t agree, and the owner had to obtain a seven-year business loan to finance the payment. Good New? The “small business organization” has survived and is flourishing today, albeit somewhat indebted.

Segment I of III

Preface: “People will pay more to be entertained than educated.” Quote from: Johnny Carson

Implementing a Bonus Plan in Your Business (Segment IV)

Construction Example

Jaden was so pleased with his new bonus plan that he told his friend Brendan about it. Brendan runs a construction company.

Brendan loved the idea, but he realized he would need to adapt Jaden’s bonus plan to make it work for his company. Why? Some of Brendan’s profits came from work his men did as subcontractors for other businesses. In those situations, labor was pretty much his only direct cost. Therefore, it was a significant percentage of sales. Some of his other sales came from projects he did for homeowners, such as adding a sunroom. In those situations, his direct costs were labor and materials. Although labor was still a significant percentage of sales, it was decreased. Some of his sales came from general contracting jobs, where his direct costs were labor, subcontractors, and materials. On these jobs, sometimes labor was a relatively small percentage of sales.

Brendan realized that to create an effective bonus plan, he could not simply base it on a reduction in the direct labor percentage. If he did that, then employees would receive a bonus or be denied a bonus based mostly on what type of jobs the company was doing, and not based on their performance.

He and his accountant Jonas sat down and discussed the specifics of Brendan’s business. They realized that for every job the company did that included labor, Brendan calculated an estimated cost for labor. That cost was then marked up and put in the bid. After the job was finished, Brendan would see what the cost of labor was for that job.

They opened a spreadsheet and started calculating. Eventually, a formula appeared that would give the employees a bonus based on coming in below estimated cost for the labor portion of the job. If they performed well, the company would benefit, and the employees would benefit.

What if Brendan simply started estimating the cost lower so that he no longer would need to pay the employees a bonus because they could no longer perform under the estimated cost? Jonas encouraged Brendan to tweak and modify the bonus system as needed, but to always remember fairness. If he lowers the estimated cost, for example, then perhaps he should increase the bonus in another way. If the bonus does not benefit the employees, then it may fail to motivate.

Alignment

A variable pay plan can help align the goals of the employees with the owner’s vision. If your company could use a realignment, consider implementing a variable pay plan.

This article is general in nature, and it does not contain legal advice. Please contact your accountant to see what applies in your specific situation.

Jake Dietz is a CPA, Business Consultant, with Sauder & Stoltzfus, LLC, a certified public accounting firm, in Ephrata, PA, specializing in entrepreneurial business accounting and tax services, bookkeeping, business valuation, and peripheral CPA services. Jake can be contacted at 717-961-9811, or jdietz@saudercpa.com

 

Preface:  “Hard work most often leads to success, but it’s not every day, and it’s not every week. It will pay off at different times over the course of your career.”  Quote from Sallie Krawcheck

Implementing a Bonus Plan in Your Business (Segment III)

Credit: Jacob M. Dietz, CPA

Evaluation

Jonas suggests that Reuben and Justin implement the new bonus plan for the next quarter. They agree to sit down and review the bonus plan after at least the next two quarters and see how it is working. They should likely tweak the bonus plan to get it working properly.

Manufacturing Example

Suppose that after several quarters Reuben and Justin are delighted with their new variable pay bonus program. In fact, they are so delighted that they tell their neighbor Jaden, who is also a businessman. Jaden really values the idea of aligning his employees’ goals with his goals. Armed with a copy of the bonus plan that Reuben and Justin implemented, he excitedly goes back to his office to implement a bonus plan.

The excitement melts away as Jaden realizes that the bonus plan designed for car washing does not work well for Jaden’s manufacturing company. His employees punch the time clock in the morning and then get to work manufacturing wood structures in the shop. They punch out for lunch, and then they punch in again for the afternoon. There is no tracking of billable versus non-billable hours. The only way Jaden’s company gets paid is when they sell a wooden structure. It doesn’t matter if they made the wooden structure in 10 hours or 30 hours, or if they were efficient or inefficient. The customer pays them the same price.

Jaden calls his accountant Jonas, and together they discuss the nature of his business and what metrics (standards of measurement) might work. As part of the discussion, Jaden shares his goals for the variable pay program.

• He wants to align the goals of the employees with his goals
• He wants to increase profits
• He wants to share a portion of those increased profits with his employees
• He wants to fairly compensate the employees so that they continue to work for him and can provide for their families

As they brainstorm for ideas for a bonus plan, they come up with these ideas to base the bonus on:

• Total units manufactured
• Total square feet of units manufactured
• Reduction in gross labor percentage

Jaden and Jonas agree that in Jaden’s specific situation, the best method is to give the employees a bonus based on a reduction in the gross labor percentage.

How will they calculate the bonus? Fortunately, Jaden’s financial reports are accurately prepared every month and examined and adjusted as necessary. By looking at historical reporting, Jonas and Jaden can easily see that his average direct labor percentage is 28%. That means that for every $100,000 of sales, Jaden pays $28,000 to his employees, on average. They structure the bonus so that for every 1% decrease in direct labor percentage below 28% (excluding the bonus), the employees get a bonus equal to roughly 30% of it, as calculated on a spreadsheet.

How will the employees earn the bonus? It is earned by striving for efficiency and productivity. In the past the employees produced $100,000 of sales per month and were paid $28,000 per month. That calculates to a 28% direct labor percentage. If, by striving to improve with the new bonus plan, the employees manage to start producing $110,000 of sales per month while maintaining labor at $28,000, then the direct labor percentage would then drop to 25%. That calculation is 28,000/110,000. The difference between a 28% direct labor percentage and a 25% direct labor percentage, with $110,000 of sales, is about $2,800.

The variable pay bonus plan calls 30% of it (about $840) to go to the employees. 840/28,000 is a 3% bonus for employees that month. Ideally, the extra bonus for the employees will compensate and reward them, and the extra profitability from increased productivity will reward the owner.

Jaden and Jonas agree to monitor the bonus plan over the next quarters to see if it is working to improve the company by aligning goals, and what tweaks and modifications may help make it more effective and fair.

Segment III

Preface: “Keep God first, chase your dreams, and everything will pay off.” Quote from Jacob Latimore

Implementing a Bonus Plan in Your Business (Segment II)

Credit: Jacob M. Dietz, CPA

Practical Steps

Now that their accountant Jonas understands what they wish to accomplish, he begins drafting a bonus plan with them.

Here are some questions they go over:

• Who is eligible for the variable pay program?
• How frequently should the bonus be paid?
• What triggers the bonus?
• How much should the bonus be?

They discuss who should be eligible for the plan. They decide that all full-time (40 hours or more per week) employees will be eligible for the plan. In the specific situation of Ironville Car Washing, LLC, the part-time employees spend vary little time that is non-billable. Reuben and Justin will just make sure they pay a fair and competitive wage to the part-timers, and they will avoid the hassle of including them in the bonus program.

Next, they discuss how frequently the bonus should be paid. Immediately they agree that once or twice a year is not frequent enough for their company. Too much time would pass from when the employees do the work until they get the bonus. They agree that such an infrequent bonus would do little to incentivize the employees.

They agree that a monthly bonus would likely be effective for their employees, but they are not sure how much work it will be to calculate it. They think that a quarterly bonus would still incentivize the employees, although not quite as much. A quarterly bonus would be less of an administrative burden since they could calculate it less frequently than monthly. They therefore decide to implement a quarterly bonus.

Next, they discuss what should trigger the bonus. They realize that a 90% billable rate is good, and that 95% is ideal. They also recognize that their workforce is only at 80% billable, currently. To avoid demoralizing and failing to incentivize the workforce with an unattainable goal, they decide the trigger should be set at 85%. If an employee is 85% billable, then they receive a bonus. The bonus increases with the billable percentage, up to 95% billable. If the employee exceeds 95% billable, no increase above the 95% billable increase is given because the company believes above 95% billable is not helpful to the company in the long run.

Next comes the work of deciding how much the bonus should be. This process takes some judgment. If the bonus is too low, it might fail to incentivize the employees to perform. On the other hand, they do not want it to be so high that the employees rely on the bonus for living expenses.

After the meeting is over, Jonas sits down with the Eagle Business Software file that Ironville Car Washing, LLC uses to record their financial transactions. Jonas considers the working capital of the company, their profit margins on jobs, their labor rate, their labor percentage, benchmark labor percentage data, and comes up with some options for Reuben and Justin to use to calculate the bonus. Jonas recommends that they use from 3% to 5% of the quarter’s base wages as the bonus. Reuben and Justin discuss the numbers and agree with using 3% to 5%.

The brief silence following the agreement is interrupted by the office phone. Reuben and Justin are urgently needed at a job site to help soothe a customer upset by a flooded lawn, so Jonas agrees to write up the bonus plan for them.

In the bonus plan document, he explains that the full-time employees will be eligible for a bonus after the quarter is over. If an employee is 85-89% billable, then they get a bonus equal to 3% of their regular and overtime pay in the last quarter. If an employee is 90-94% billable, then they get a bonus equal to 4% of their regular and overtime pay in the last quarter. If an employee is 95% billable, then they get a bonus equal to 5% of their regular and overtime pay in the last quarter.

Bonus Percentages

• 85-89% Billable = 3% bonus
• 90-94% Billable = 4% bonus
• 95% Billable     = 5% bonus

After reviewing and approving the bonus document, Reuben and Justin send it to their attorney at Jonas’ advice to make sure it does not violate any labor laws.

Segment II