There are two areas of a small business when an owner will resort to gut feel faster than any other; who to hire, and how to compensate that new hire.
We were a few months into coaching a business owner when the time approached for her to hire a new role in her contracting business. After helping her think through what to offload to the new team member, write the role, and determine the onboarding process (something she had never done before), the next obvious question came, “so how much will you offer in compensation?”
Her response, “I have no idea.”
The good news is that she is not alone. The bad news is that strategy will almost always lead to a bad outcome down the road.
Employee salaries are a bit like government programs, once set and offered they become difficult to retract and adjust.
What factors should be involved in determining a new hire salary? What factors should we pay less attention to?
It would first help to refocus on a question we rarely ask…what is the point of an employee salary?
Business owners often feel a responsibility to “provide for our employees”. That is not true. It is the job of the employee to provide for themselves and their family, and it is their decision on how that gets done.
The business becomes one vehicle that can be used for the provision for each employee in the business if the business is generating enough margin to indeed provide compensation.
Culturally we tend to believe that businesses magically make money and that employee salaries should naturally increase in direct response to time. In other words, the longer a person is on the job the more money they should make. Obviously, this is damaging.
I worked with a fellow employee years ago who was at the company for over a decade and was making double what myself and other less experienced employees were making, and yet he continuously underperformed. In essence, he was being rewarded year after year for simply showing up.
Employee compensation should be built and continued based on the value the employee brings to their role and overall to delivering on the mission of the business.
If you’re looking for more resources to work ON your business, we have them.
So how do we determine employee compensation that aligns with business revenue generation and profitability? We must listen to our business and hear what it is telling us based on what is actually happening in the business.
First, you must know your numbers.
As a reminder, we are not financial professionals and make it clear that we are offering suggestions based on what we have seen other business owners do. Make sure to consult with a financial professional when making these decisions.
Knowing your numbers sounds obvious and yet most business owners do not know their total revenue, cost of goods sold, or gross margin (or what Mike Michalowicz calls Real Revenue = (Total Revenue minus Cost Of Goods Sold)).
Seeing your net income on the bottom of a profit and loss statement is nice (and necessary), but it is not the entire story. We must be aware of all of the numbers below your total revenue and above your net income.
What percentage of your real revenue is spent on personnel, taxes, insurance, fees, dues, equipment, communications, marketing, etc?
Once you know those then you can begin to compare those numbers over the past few years and then determine if you are light or heavy in each area based on the return that you are receiving from each of those investments?
The money you are investing in marketing, is it generating leads?
The money you are investing in software tools, is it producing efficiency in production?
The money you are investing in people, is it producing sales?
It is impossible to set a new hire salary or to even know if you can afford to hire a new person if you do not listen to the numbers that your business is using to speak to you.
The second step to determine your new hire salary is to set your ratio. I heard years ago that the average new hire salary should be set around a 1 to 3 ratio (1:3 ratio).
What does that mean?
Essentially, for every dollar that you invest in a new employee role, that role should either…
- Generate an additional three dollars in revenue
- Or, free someone else up to go generate an additional three dollars in revenue
The 1:3 ratio is not set in stone and is simply a suggested starting point. We have found experientially that the closer the role is to sales, the higher the ratio will likely be.
One business we coach runs a 1:7 ratio for each salesperson they hire. In other words, if they compensate a salesperson at $100,000 annually, then they expect each salesperson to generate $700,000 in real revenue (total revenue minus cost of goods sold).
Using a ratio below 1:2 does not make much sense because you are simply breaking even on a role that is meant to help you generate additional profit.
The third step in determining a new hire salary is to run the calculation based on your ratio, and what your numbers are telling you.
As an example, let’s say that you have decided to pay your new accounting role a salary of $40,000 annually.
Before we apply your ratio, you must first apply a reality to your salary. When you compensate an employee a base salary, it is not the full story.
The business is also responsible for payroll taxes and a variety of other often unseen expenses like increased fees on software licenses and insurance premiums.
As a practice, we calculate an additional twenty-six percent on each employees annual salary when running our budget numbers for a new hire.
When deciding to pay $40,000 in annual compensation, we are actually budgeting a salary of $40,000 plus twenty-six percent on top which comes to a total of $50,400 annually that the business must budget for.
We then apply our chosen ratio not to the $40,000 annual number, but instead to the $50,400 annual compensation number.
In this case, we will select a 1:3 ratio to run our calculation. This means that for every dollar we invest in our new hire at a compensation level of $50,400, we expect to see a return of three dollars from our new hire at a real revenue level of $151,200.
Again, either A) this new hire will directly generate an additional $151,200 in revenue each year, or B) this new hire will free up another employee to go generate an additional $151,200 in revenue each year.
The final step in determining a new hire salary is to set the number and run the model.
Your starter salary is always going to be a bit of an educated guess. Of course, you can consult Human Resource databases of market and industry compensations, and this is not a bad place to begin to get some initial numbers in your head.
Determining salary is both art and science. The art is having your head on a swivel and looking around. The science is to know your numbers, set your ratio, run the simple calculation, and then determine your final number.
If you have to negotiate up on your salary in order to be more competitive in bringing in a new hire, that is fine, just know that it will also increase the real revenue number that the new hire is expected to generate.
Having that conversation with a new hire can be very freeing for you as a business owner, and also very eye opening for the new hire to let them know that you’ve done your homework and have been very thoughtful about their role.
Know your numbers, set your ratio, run your calculation, define the number, and have confidence in your new hire process. Your business and your new hire will appreciate the hard work.
Scott Beebe is the founder of Business On Purpose, author of Let Your Business Burn: Stop Putting Out Fires, Discover Purpose, And Build A Business That Matters. Scott also hosts The Business On Purpose Podcast and can be found at mybusinessonpurpose.com.