April 15, 2023

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OK. Let’s assume you have a profit plan, you’ve estimated your pipeline for the coming year, and you understand your requirements for full time equivalent personnel. If not, check out the ‘Thinking’ tab on my website.

Now you need to determine your firm’s payroll requirement. Payroll is the total amount spent on wages for all staff and principals over the course of the year. Think of your payroll allocation for the upcoming year as your firm’s salary cap.

If you have 3 staff at salaries of $50K, $60K and $70K and you pay yourself $120K, your total payroll cost is $300K. If you pay by the hour for some or all your people, that portion of the payroll will be the total of all hours worked, multiplied by the hourly rate you pay each person. It will also include any eligible overtime pay at 1.5 times each person’s hourly rate.

The total payroll number includes allocations for statutory holidays as well as paid personal time off for vacations, sick time, and any other amounts captured within the payroll number. Payroll should also consider contract labour. If you will employ contract labour to perform certain tasks you should provide an allocation for that labour.

Payroll does not include benefit costs. Benefit costs are part of your operating expenses. Benefits include such things as retirement matching funds, insurance (health, dental, life), and so on. We’ll discuss operating expenses in a future post.

Its important to ensure principal pay is adjusted appropriately. Some principals are paid via a draw on operating profits and some receive a regular salary. The payroll number must be adjusted to reflect market salaries for principals, otherwise you won’t have an accurate picture of your financial health.

Some firms underpay principals in relation to market rates. One reason is for tax purposes. Another reason may be because the firm is not profitable enough to afford a market salary for its principal(s).

Its important to assign a market rate for principal pay when using the Scoreboard. Overpaying principals understates the actual profitability of the firm. Underpaying principals overstates the actual profitability of the firm.

Payroll does not include distributions, bonuses or profit sharing. Those amounts are distributed after operating profits have been determined.

In a ‘Strong Practice,’ the adjusted payroll amount should be approximately 50% of net fee.

If your payroll is significantly less than 50% of net fee, it may be indicating premium pricing and/or your staff are being very efficient in delivering value for your clients. That’s a wonderful situation, but beware. It could also be indicating:

  • you are underpaying principals(s) and/or some personnel in comparison to the marketplace. This can result in poor morale and higher than desired turnover.
  • corners might be cut that may come back to haunt you in the form of extra effort later, to correct mistakes, or potential errors and omissions claims
  • your firm is running too hot and some form of personnel burn-out may be just around the corner.

If your payroll is significantly greater than 50% of net fee, you are likely allocating too much of your net fee toward payroll. There are two remedies. Boost your net fees or reduce your payroll costs. Increasing net fees takes time. Reducing payroll costs (ie. layoffs) is just plain painful.

All these impacts create great incentive to keep a close watch on your payroll number.

For more detail on establishing a reasonable payroll number for your practice, check out my book, Scoreboard Your Practice: 7 Numbers to Understand Your Design Firm’s Financials (Available at Amazon).