How Much is a Fair Profit? Part I of V – Owner Compensation
A fair profit for a small business is between 9% and 37%.
To me, 100% is a fair profit. The customer hands me their money and I do nothing in return. The problem with that scenario is that the customer will never come back. If I go to the other extreme, and I lose money on each transaction, then it would be cheaper for me to pay the potential customer to stay away. I’ll get plenty of those types of customers. Somewhere between a loss and a 100% profit lays the answer.
There are many factors used to determine the fair profit for your business. They are grouped into four major factors. The first factor has the greatest impact on the final profit calculation and that is the compensation package afforded the owner. The second factor affecting profit is the economic cycle of the industry the small business operates within. The third factor with significant impact is risk and finally the fourth factor group is return on the capital investment.
This is the first in a five part series explaining how much is a fair profit. This article identifies the key factors and their corresponding elements in determining the real profit based on owner compensation and the legal status of the entity. The second article in this series addresses the economic cycle of the industry you are associated with and how the profit from one year mitigates recession or depression related years. The third in this series covers risk. Risk is comprised of many elements and each has a bearing on determining the profit you will need to mitigate exposure to risk. The fourth in this series address return on capital. The final part in this series uses a mathematical formula to assist the small business entrepreneur in determining a fair profit for his/her business based on the four major contributing factors.
In every small business there are one or two key individuals that not only provide the primary expertise but the labor investment as well. If the owner of the business works in the small business as an employee, how much does he pay himself? If he pays a reasonable compensation package to himself, then the compensation package has little to no effect on the fair profit percentage. If he underpays himself, then the profit percentage needs to be higher to offset this lower compensation package. If he overpays himself, then a lower profit percentage is expected. The following chart illustrates this concept:
Compensation Package Effect on Profit
The key question to this section is ‘What is a fair compensation package for the owner?’
The answer depends on two important variables. First, what do others performing a similar function in the same industry get paid? Secondly, ‘What type of legal status is the business?’ This has a bearing on the compensation package. The following describe and illustrate these two variables.
Reasonable Comparative Compensation
The primary variable affecting owner compensation is the test of reasonableness. The key to this principle is to investigate what others doing the same work and having the same knowledge and background get paid to perform similar services for the company. Here is where the owner should be reasonable in his expectations. Let’s assume the owner runs a restaurant and by his nature prefers to be the short order cook; then a compensation package to the owner is around $35,000 per year. The management component is handled by some other staff member and that individual receives a high compensation package to cover those responsibilities. If the owner goes beyond the scope of a short order cook and manages the restaurant, then the compensation should tend towards the mid $60,000 range.
Now suppose the owner is a general practitioner of medicine. A general practitioner gets paid around $140,000 per year in reasonably price geographical areas. If the doctor owns his practice, he should receive a compensation package approximating this sum.
Overall, any business owner providing the knowledge, experience and the energy resources to perform the service; manages the overall operation and is responsible for the revenue element; that owner should receive no less than $100,000 per year as compensation. Think about this for a moment. Rarely does the owner just work 40 hours per week. A more reasonable expectation is 60 hours a week including weekends, evenings, and emergency hours. Thus, anything less than $100,000 per year is only justifiable if the owner truly limits his responsibilities and obligations. Using the restaurant example above, assume the owner only cooks and that is all he does. The restaurant has been around for many years and runs smoothly on its own or by the performance of the other staff members. In this case, his responsibilities are significantly less and therefore there is no underlying justification to have a high compensation package.
But in the small business world, this is the exception not the norm. The normal small business operation requires absolute devotion by the owner and therefore the reason for the $100,000 a year compensation package as a minimum. Again, use your judgment associated with the responsibilities of the job. Licensed individuals require greater compensation. This compensates them for their years of education and higher responsibilities. Examples include doctors, lawyers, accountants, engineers and highly skilled owners.
Business Entity Status
The second variable affecting the compensation is the type of legal status as a business. There are four different legal forms in the United States and the following describes the overall adjustment to the compensation package for the legal status of the business.
Sole Proprietorship – in this entity format, the business is usually a one person to just a few staff involved in providing the services. In this business formation, the owner is most likely the key man and in addition provides all the knowledge and experience to get the work done. A reasonable profit percentage is unknown, but the minimum compensation package should be no less than $100,000 plus approximately $7,650 to cover the one half self-employment tax. This is the tax that the employer pays to the Internal Revenue Service on wages paid to staff. In the sole proprietorship world, the owner must pay this tax via estimated tax payments. See Self-Employment Tax for more information about estimated tax payments to cover income and self-employment taxes.
If your small business operates under this legal format and total revenues are $200,000 or so, you can see that the minimum profit should be more than 53.5% to cover a reasonable compensation to the owner. This percentage does not cover the other three factors of economic cycles, business risk, and return on capital.
This one business format generates the unusually high profit percentages needed to cover compensation for the owner. When you are talking to other business owners and they say their profit percentage is xx%, make sure you understand their respected business legal status. Sole proprietorships require significantly higher profit percentages to cover or adjust for owner compensation.
If you want more information about Sole Proprietorship, go to The Sole Proprietorship – The Basics.
Partnerships – this business entity type has two or more key individuals involved in the business operation. In the perfect world, the two partners would perform at the same level of service and provide the same knowledge to the business. However, this is never true in the small business environment. There is usually one partner that works harder and/or is capable of bringing in more money for the business. Partnerships financials work in a similar pattern to sole proprietorships. Whatever is left over from business operations is split between the partners based on their respective contributions to the business. Often the business provides a core compensation package via the use of draws (regular payments to partners similar to a paycheck) and the partner generating greater value receives a form of guaranteed income adjustment (this is a K-1 term, but the closest concept in compensation is a bonus).
Most partnerships exist in the professional world, typically doctors, lawyers and accountants use this entity format. Here the profit percentage is significantly higher because the associated draws and guaranteed income are paid out of the profits of the business. It is not uncommon for partnerships to have a 60% profit and then the partners receive their respective compensation from this profit. Here too, just like the sole proprietorship, the partner requires additional compensation to cover the self-employment tax assigned to the partner for tax purposes.
For more information about partnerships, please see The Basic Principles of a Partnership.
The best way to illustrate this is via a financial profit and loss for a partnership as shown below:
Wonderful Partnership – A Law Firm
Year Ending December 31, 20122
Service Revenues (Adjusted) $408,208
Staff Costs 87,402
Office Operations 36,911
Other Costs 3,222
Net Profit $280,673
Profit % 68.76%
Partner Draws 210,000 (*105,000 each)
Guaranteed Income to Partner #2 9,400 (Bonus to Partner)
Sub-Total Draws to Partners 219,400
Profit Retained (Net Profit) $61,273
Net Profit % 15.01%
Note the two different levels of profit, because a partnership doesn’t pay its partners until the profit is calculated. Even here, the partners didn’t really take home a lot of money at $105,000 for one partner and $114,400 for the second partner. With this case the 15% net profit covers the remaining factors of economic cycles, risk, and return on capital.
Profit percentage can be misleading and the small business owner needs to understand that profit should be interpreted based on the form of small business legal status.
Limited Liability Corporation – this form of legal status provides the civil protection of a corporation yet, the income reporting and tax status is exactly like the partnership. Here, please refer to the regular partnership description above.
Corporations – both regular and S-Corporations behave similarly in activity above the net profit line. The owner is paid as an employee. Again, depending on the nature of the owner’s duties, knowledge, and responsibilities; compensation is calculated using these variables. Typically corporations are larger in size and have many employees. The owner is referred to as an officer is paid just like any other employee. Here, the compensation is paid above the net profit line. In the partnership example above, the owner is paid after the net profit is calculated. In the corporation status, the owner is paid before the net profit is calculated. If you keep the owner/officer’s compensation low in comparison to what other companies pay similar positions, then the profit will be higher on the bottom line. Thus a higher percentage of profit. See the chart above illustrating the effect on profit based on compensation. This makes it very easy to mislead or deceive a reader of financial reports for corporations. The key here is, ‘What is a reasonable compensation package for the key owner/officer’?To determine the correct profit percentage, the compensation package for the owner should be reasonable in nature based on his respected duties and responsibilities. The following example illustrates how the profit is derived in the same business operation as illustrated in the partnership section above:
Wonderful Corporation – A Law Firm
Year Ending December 31, 20122
Service Revenues (Adjusted) $408,208
Lawyer Compensation (2 Owners) 219,400
Employment Taxes for Lawyers 18,057
Staff Costs 87,402 (Includes taxes)
Office Operations 36,911
Other Costs 3,222
Net Profit $43,216
Profit % 10.59%
Did you notice anything different in this scenario against the partnership scenario?
Yes, that is right, the profit is less! The reason is the employment taxes the corporation pays on the officers (the 2 lawyers). The Internal Revenue Code defines payroll differently for corporations than for the sole proprietorship or the partnership format. In the latter entity formats, the owners pay this employment tax as self-employment tax via estimated payments. Again, note that the profit percentage is only 10.59% for a small law firm. As you read Parts II through V in this series, you will learn that this is inadequate to cover all those other factors in determining a fair profit.
If you have any questions or concerns after reading the entire series, feel free to contact me via the my services page in the footer below.
In this article you learned about the effect owner compensation has on the profit percentage. You should remember that the key to calculating a fair profit is how much the owner is paid. If his compensation package is reasonable given the job duties, responsibilities and his obligation to generating revenue, then the only factors affecting the profit calculation are economic cycle, risks, and return on capital. Please be sure to finish reading the series before calculating what you believe should a fair profit in your business. Act on Knowledge.
Do you want to learn how to get returns like this?
Then learn about Value Investing. Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.
There are four key principles used with value investing. Each is required. They are:
- Risk Reduction – Buy only high quality stocks;
- Intrinsic Value – The underlying assets and operations are of good quality and performance;
- Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
- Patience – Allow time to work for the investor.
If you are interested in learning more, go to the Membership Program page under Value Investing section in the header above.
Join the value investing club and learn about value investing and how you can easily acquire similar results with your investment fund. Upon joining, you’ll receive the book Value Investing with Business Ratios, a reference guide used with all the decision models you build. Each member goes through three distinct phases:
- Education – Introduction to value investing along with terminology used are explained. Key principles of value investing are covered via a series of lessons and tutorials.
- Development – Members are taught how pools of investments are developed by first learning about financial metrics and how to read financial statements. The member then uses existing models to grasp the core understanding of developing buy/sell triggers for high quality stocks.
- Sophistication – Most members reach this phase of understanding after about six months. Many members create their own pools of investments and share with others their knowledge. Members are introduced to more sophisticated types of investments and how to use them to reduce risk and improve, via leverage, overall returns for their value investment pools.
Each week, you receive an e-mail with a full update on the pools. Follow along as the Investment Fund grows. Start investing with confidence from what you learn. Create your own fund and over time, accumulate wealth. Joining entitles you to the following:
- Lessons about value investing and the principles involved;
- Free webinars from the author following up the lessons;
- Charts, graphs, tutorials, templates and resources to use when you create your own pool;
- Access to existing pools and their respective data models along with buy/sell triggers;
- Follow along with the investment fund and its weekly updates;
- White papers addressing financial principles and proper interpretation methods; AND
- Some simple good advice.