Are you drawing a market salary from your building company either weekly or monthly?
If you are not, then your financial reports will not give a true reflection of your building company's performance.
And that’s a real problem for business owners who are planning and budgeting for the year ahead!
If you have been told by your accountant to avoid drawing a salary because, “We will sort that out for you at year-end, tax effectively,” then your margins will end up becoming compromised.
Leaving the accountant to manage the salary of a business owner in a tax efficient manner at the end of the financial year is fine from a tax perspective, however it causes major problems in terms of budgeting and financial reporting throughout that year.
A business that does not reflect the owners’ salaries at market rates month by month typically operates on lower margins than a business that includes the owners’ salaries at market rates.
This may sound nonsensical and illogical, but that's because as humans our decision making process is flawed.
According to the Harvard Business Review, the way the human brain works can sabotage the choices we make.
Our Business Decisions Are Psychological
In an article first published in 1998, eight psychological traps that can affect the way we make business decisions were examined.
The anchoring trap leads us to give disproportionate weight to the first information we receive.
The status quo trap biases us toward maintaining the current situation, even when better alternatives exist.
The sunk-cost trap inclines us to perpetuate the mistakes from the past.
The confirming-evidence trap leads us to seek out information supporting an existing predilection and to discount opposing information.
The framing trap occurs when we miss-state a problem, undermining the entire decision-making process.
The overconfidence trap makes us overestimate the accuracy of our forecasts.
The prudence trap leads us to be overcautious when we make estimates about uncertain events.
And the recall-ability trap prompts us to give undue weight to recent, dramatic events.
The best way to avoid all the traps is a combination of awareness, because forewarned is forearmed.
Better Information Leads To Better Decisions
And, working on the most accurate information available, because better information leads to better decisions.
Some builders we speak to dismiss the idea of taking a market salary and strongly believe that it's easier, and probably more tax efficient just to leave it to their accountant.
It’s totally understandable, because that is exactly what I used to do myself!
I would budget for the staff and all the other fixed expenses for the company, but for me, it was a case of, let’s see how much the company makes and I’ll take a cut of that.
However, as the year progressed, each time I looked at the bottom line in the monthly reports, all I saw was how much money I was making rather than the company, and that had a deep psychological effect of my perception of the amount of disposable income I had available to me and the type of lifestyle I could afford, or even, deserved!
And from a business perspective there was very little left over in the way of retained net profit that would increase the company’s reserves over time.
As a consequence I ended up running on fumes and relying on cash flow to fund a lifestyle I couldn't really afford.
It all came to an abrupt halt one day when a new bank manager took over at my local branch of the HSBC and after taking one look at my company’s balance sheet and comparing the retained equity to the overdraft being provided by his bank, he told me in no uncertain terms, “We’re not here to fund your lifestyle.”
And he was dead right. There was no equity and no substance to the business. It was a huge risk to the bank.
Something had to change and fortunately that new bank manager forced me to look at my business in a different way.
He insisted that my salary was reflected in both the budget and the actuals for the fixed expenses.
And he made me agree that I would not draw a penny more out of the company than had been agreed, not in the form of salary or bonuses without his written approval!
He explained to me that I effectively had two roles in the company.
As Business Owners We Have Two Options...
One was the director, and the other was the shareholder or owner of the business.
As a director, the salary he had just nominated for me was all that a company of this size could realistically afford, so if I wanted to make more money there were two options.
I could draw a dividend at the end of the year from the retained profit, or I could leave the profit in the company, scale it, and draw a bigger salary as revenues increased.
And that second option meant that any future dividends were also likely to increase over time.
But I now realise, he was the suit that not only saved my business, he also taught me a valuable business lesson that has served me well ever since.
So, that evening I sat down with all my financial budgets and started adjusting them to include the previously agreed gross salary that I was now going to be drawing each month.
What that did, was it allowed me to look at the accounts for the company from a different perspective.
The wage I was on was not what I was used to, so changes to my lifestyle would have to be made in the short term.
And the only way my lifestyle was ever going to improve was by growing the company.
And when I looked at the revised forecast I’d just produced, that was simply not going to happen fast enough!
Even though my salary was pretty average given how hard I was working in the business.
This was a pivotal moment for me, and I've had so many builders experience the same light bulb moment themselves whenever I’ve repeated this exercise with them.
We all know our value, or at least we all have a perception of what we feel we are worth in terms of annual income.
And we all know when we are not being paid what we are worth!
So, let me ask you… are you happy with your current salary?
Not including net retained profit that is left in the company, or even any dividends you may be drawing as a shareholder of the company, just the salary that remunerates you for your time, is it fair?
Is it worth the amount or time you invest into your building company, and the sacrifices you make?
Poor Information Leads To Poor Outcomes
If it’s not, then it's time to get angry and make some changes. Because if you do not value your own time, then no one else will.
If you are not including your salary at market rates then the net profit that is displayed in your financial reports is meaningless.
And poor information leads to poor outcomes.
However, when you have an accurate budget for your fixed expenses for the year ahead, that allows you to plan for success!
Now, when you mention to your accountant that you want to start paying yourself a market salary each week, it’s quite possible they may object and persuade you not to do it.
And their reasoning for this may be perfectly logical.
Maybe you have other income sources, or you need to allocate income to a non-working spouse for tax purposes.
Or maybe you have a complex trust structure in place that only the accountant can figure out what goes where at year-end!
Whatever it may be, these are all valid reasons for why you would not want to include your salary in the weekly payroll along with the rest of your staff.
However, you don’t need to include yourself in the payroll or even draw the cash out of the business each month in order to make this work.
All you need to do is get your bookkeeper to set up a very simple monthly or weekly journal entry that adds a debit entry to your fixed expenses and a credit entry to your accruals.
This one thing will correct your accounts all the way through the entire financial year and it can then be easily reversed by your accountant at year-end allowing them to optimise your income for tax.
When you do this your monthly fixed expenses will increase to include your salary, which means you now have a true net profit and your balance sheet will also reflect the end of year liability that has not yet materialised.
Giving you a perfect insight into the health of your building company.
Remember, when you are using journal entries you're not pulling any cash out of the company.
So make sure you leave those journals in place in order to reflect how much the company ‘owes you’ even when cash flow becomes challenging.
You’ll decide at year-end the best way to deal with this ‘debt’ from a tax perspective, but in the meantime, you will always have a true reflection of the company's performance rather than a manufactured artificial impression.
Pay Yourself A Market Wage That Reflects Your Role
And always pay yourself a market wage that reflects your role.
Check out the different apps available online that can give you a typical salary for your role in your location and avoid underpaying or overpaying.
If you underpay, you will over-inflate your net profit, which always leads to leaving money on the table in price negotiations with potential and existing clients.
And if you overpay, then your company will appear far less appealing to you or anyone else which could hamper you in multiple ways at some point in the future.
So, you have two choices, you can artificially lower your fixed expenses by not including a market wage for the owners of your company that also work in the business, or you can build a company that produces true net profit and has real value by drawing market salaries, or at least, making a journal entry in your accounts that reflects salaries at market rates.
If you’d like to follow the APB step-by-step process to get an accurate picture of your building company’s true financial position, then click on the link below and take a look behind the curtain in order to see the templates and tools we are providing to our members.
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