As America continues to shift towards a service-based economy, compensation expense controls should become more sophisticated.  For a typical service business, compensation expense and associate fringe costs are the largest line-item in the profit and loss statement.  Small business owners must have a formalized set of controls in place to ensure that human resources are necessary, productive, and fairly-paid inside their businesses.

Pre-hiring Controls

Control over compensation costs begins in the pre-hire phase.   Owners of small to middle market companies should provide written approval to commence any recruiting process, for new or replacement hires.  Inclusion of headcount in the current year budget is not an authorization to recruit and hire.  The ultimate decision to hire is dynamic, and each approval for hire will depend on current business conditions, investment prioritization, and optimal timing.   Owners should ask questions, such as what has changed since we put the budget together, or can we defer the position a month or two?   During the review of requisitions for new or replacement positions, the owner or CEO must filter the decision by matching against the top five ROI investments in the current year budget.   Pre-hire control processes are critical.   Once an employee is hired, a cascade of new expenses result such as taxes, fringe, bonuses, office space, paper clips, etc…

Post-hiring Controls

Segregation of duties is essential when controlling compensation costs for the existing workforce.  Controls take many forms, but implicit in most are owner involvement and review processes.  For example, the communication flow of all merits or raises should originate from the owner/CEO to human resources department or the payroll department.  Communication processes and procedures that are not clearly defined are an invitation for problems.

The process of controlling periodic payrolls must be well-defined.  If you are not outsourcing payroll, you probably should be.  However, outsourcing payroll is not enough.  Payroll registers should be reviewed by owner or her administrative assistant each month against a master salary list.  Payroll fraud is very common, can occur from inside the accounting department, and may very well occur without proper segregation of duties and owner oversight.

Variable compensation for salespersons requires control and oversight.  Written sales compensation plans should exist with quotas and commission rates that link into the annual operating plan.  The owner needs to know what the maximum payout percentage for each dollar of sales (including overrides), and such costs should be embedded in the operating plan.  Sales or sales managers should not be responsible for calculating sales commissions each period.  Accounting should prepare the sales compensation payouts, with appropriate review processes over these calculations.  If possible, a sales compensation calculation system should be used – spreadsheets often contain costly errors.

Fringe costs and taxes require controls also.  Health insurance is likely the largest component, but detailed discussions are beyond the scope of this article.  Payroll taxes and employee insurance program compliance require periodic reviews, especially if payroll is not outsourced.  Compliance checklists and calendars should be reviewed by the owner with appropriate personnel to ensure unemployment and workers compensation rates are reasonable, annual compliance is adhered to, and oversight over audits is proper.

The foundation for proper internal controls over compensation costs is a comprehensive set of employee policies and procedures, which an experienced CFO can lead in crafting.  While not an inclusive list, such policies should address general employment, business conduct, attendance and time off, employee benefits, travel and expense, performance review, electronic communications, and general employee programs.