The Realities of Incentive Compensation in A/E/P and Environmental Consulting Firms

Apr 23, 2007

I had a lengthy conversation the other day with someone who is currently in the throes of helping his company design a new incentive compensation plan. This fellow is a smart guy. He had done a better job with an unbelievably complex assignment than anyone else could have. He had an answer to every question I had and a good response to every objection I could come up with. But, in talking with him at length about how he was trying to meet every requirement of his firm— to promote cooperation, to reward individual office performance, to reward individual performance, to recognize hours worked and time with the firm— I was struck by a painful realization. And that is that most A/E/P or environmental firms will probably NEVER have enough money in their non-owner bonus pool to change anyone’s behavior. At best, the plan would be a profit allocation formula, not an incentive comp plan— albeit a well-thought-out one— but a profit allocation formula nonetheless. How can I say this? Consider this example that is representative of the typical A/E firm: Let’s say the firm does about $10 million in annual net service revenue (NSR) and has 70 employees, five of which are owners in the company. They are growing at an annual rate of about 15% and made a profit of about 10% of their NSR, or $1 million. Their growth rate, stock buybacks, and capital expenditure budget requires they retain about 25% of their profit, or $250K. Their owner profit distributions are about $400K. A lot of this money is paid out so the newer principals can make their stock payments. Finally, $100K goes for the company match on the 401(k). That leaves a whopping $250K to be paid out to the employees. With a payroll of about $5 million (50% of NSR is typical for total labor), they have a whopping total of 5% of their pay in their “incentive compensation” plan. Five percent of pay, on average, and we think that’s going to make a difference? I say, no way! It’s just not enough. Let’s say, for example, the company makes a 20% profit instead of a 10% profit. Let’s say that we now have $500K flowing into the incentive comp plan (outside of owner profit distributions). That’s 25% of profit going to employees. My experience is that’s probably MORE than most firms in this business actually pay out to this group. Still, this example only gives us $500K, or 10% of payroll, in total. Is 10% of pay really going to guide behavior? I don’t think so. The bottom line is we, as a group of companies, do not make the kind of money that affords us a chance to pay 30% to 50% of base pay to non-owner employees in an incentive plan. We aren’t that profitable to start with. We have to pay people big salaries just to get them to join the firm. We have to retain earnings to pay for the stuff we need, departing owners, and more. And, we have to pay out a good slug of profits to owners to make the ownership transition plan viable. Every dollar we take out of the owner distributions devalues the stock and makes it harder to have an ownership transition plan that works. The bottom line: While you need to dole out the profits in some fashion that’s fair, don’t kid yourselves into thinking your incentive compensation plan is some powerful tool that motivates everyone to do what you want them to. You will be much better able to motivate people by sharing performance data with them continuously, by giving them honest feedback, by promoting them into meaningful positions of responsibility, and by selling them stock, than you ever will with your incentive compensation plans. At least, that’s my opinion. Originally published 4/23/2007

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