There are dramatic differences between the way large and smaller CPA firms handle various areas of practice management, such as management and leadership; recruiting, development and retention of staff; training; diversity of services; specialization; and partner accountability.For now, let’s define “large” firms as Top 100 firms; No. 100 had annual fees of $29 million in 2007. Meanwhile, the “smaller” firms are those below the Top 100 threshold.

Though it’s tempting to generalize and say that large firms are strong at the above areas, whereas smaller firms are weak at them, there is absolutely no question that the vast majority of smaller accounting firms struggle mightily with these attributes. Therein lies the root of the differences in compensation systems between large and smaller firms.

LARGE MONEY, SMALL MONEY

To understand the root of these differences, one must examine the inter-relationship between three practices:

* Strategic planning. Small firms may prepare strategic plans, but implementation is sorely lacking. It would be highly unusual to see a smaller firm evaluate or compensate their partners on the extent that they help the firm achieve its strategic plan. At larger firms, the strategic plan and the core values drive the firm.

* Partner evaluation. Only 28 percent of firms under $10 million conduct partner evaluations. Large firms are in the 50 percent to 75 percent range. Of the smaller firms that do partner evaluations, very few use the evaluation results as a factor in allocating partner income. Evaluations at smaller firms tend to focus on traditional production metrics, such as originating business, billable hours, book of business, realization, etc., with very little emphasis on what the partners did to help the firm achieve its strategic planning objectives.

* Partner compensation. Smaller firms might have a strategic plan document sitting around somewhere. They might do partner evaluations. But when it comes to allocating partner income, neither strategic planning nor partner evaluations are used much.

It’s like there are two different worlds in a smaller firm:

The world that puts together a strategic plan with partner goals, and the world that essentially says: “I’m glad we have a plan and partner goals because that’s what they tell us at MAP conferences. But when it comes to allocating partner income, what’s most important is bringing in business, managing a large book and billable hours.”

The first graphic illustrates what I’m talking about (See “Worlds apart,” below). At most smaller firms, there is a huge disconnect between these three activities. But in larger firms, these practices are interconnected and very much integrated.

Large firms are driven by their commitment to achieving their strategic plan and living the firm’s core values. These firms are led by a management team whose job it is to mentor, assist and coach all firm personnel, including partners, to achieve their goals and fulfill their expectations. It’s only natural that this same management group would evaluate the partners’ performance and be a part of a group that determines the compensation of the partners.

It’s all integrated.

At smaller firms, because of the disconnect of the three circles, partners don’t know much about how other partners are performing — except in the traditional production metrics. As a result, many feel they have little choice but to adopt a formula compensation system based upon production metrics. Still other firms recognize that focusing on production and ignoring intangibles, such as firm management, mentoring of staff, etc., is a mistake, so they adopt the compensation committee approach to allocate income. They need to resort to a separate body to research the true performance of the partners.

OTHER DIFFERENCES

1. Selection of the compensation system. The formula system is clearly king at smaller firms, as shown in the accompanying table (see “Pay masters?” on page 32). Keep in mind as you look at it that roughly 95 percent of all U.S. multi-partner firms have fewer than 10 partners. There’s a virtually infinite array of formulas used by firms. Firms simply assign weights to the various production metrics to produce an algebraic formula that the partners agree on.

The table also shows that as the size of the firm moves beyond 10-12 partners, the compensation committee becomes the system of choice. Production metrics still play an important role. But compensation committees are increasingly putting less weight on two traditional stalwarts: book of business and billable hours.

* Book of business. As larger firms move to more of a team-oriented approach to managing client relationships and engagements, clients are team-sold and transferred between partners; partners work together on many projects. But this team approach won’t work well if the partners are worried about the size of their book of business. They reason that, despite all the emphasis on “team,” the compensation committee will still look at the size of each partner’s book.

So you can see why large firms are moving away from book of business as a key production metric. One managing partner of a Top 50 firm told me, “We don’t want our partners worrying about their numbers.”

* Billable hours. For quite some time, firms both large and small have come to understand that they don’t want their partners to have high levels of billable hours. What partners do with their non-billable time has become more important. Some firms even penalize partners for having billable hours higher than an agreed-upon threshold.

2. The role of intangibles. These are defined as management, mentoring of staff, developing new services and markets, teamwork, living and breathing the firm’s core values, etc. Smaller firms give very little recognition to intangibles. Large firms are just the opposite.

3. Role of the partners. I would guess that 10 percent or less of firms in the under-$10-million range have an effective formal, written, partner goal-setting system. When I ask partners if it is crystal clear what their role is in the firm and what their partners expect of them, almost all respond with, “No.”

Again, you can see why firms resort to formula systems — they feel that they have no other option. But the larger firms base a substantial amount of the compensation decisions on the following: Did the partner achieve their goals, and did the partner fulfill their role in the firm?

4. Living and breathing the firm’s core values. More than 90 percent of smaller firms don’t even have written core values. Of those that do, it’s merely wallpaper for their Web sites, firm brochures and lobbies. Large firms take their core values very seriously. When you ask a partner from a large firm why their firm is so successful, there is an excellent chance that they will reply, “Fanatical commitment to our values.” Smaller firms can’t even agree on what their core values are.

Perhaps the most-often-used quote I’ve heard at firms during the past five years comes from Jim Collin’s legendary Good to Great: “Before you begin strategic planning, make sure you have the right people on the bus and get the wrong people off the bus.” A managing partner of a large firm told me of one of their firm’s core values: “If you’re a jerk, you’re out.” At smaller firms, firing a partner is unheard of.

5. Staff. I’ve often lamented the practically non-existent role in partner compensation systems of developing and mentoring staff. With the severe shortage of staff that has plagued CPA firms in recent years, firms are finally waking up to the important role that partners need to play in retaining, developing, training and mentoring of staff. Finally, we are seeing this play a role in allocating income. But there’s a huge gap in the size of this role between larger and smaller firms.

6. Open vs. closed systems. In an open system, all partners know what each partner earns. Ninety-nine percent of all firms under $20 million have open systems. In a closed system, partners do not have access to the compensation of their fellow partners.

One of the best ways to explain why a firm would opt for a closed system is the following quote from Andrew Grove, former chairman of Intel: “If people are concerned about their absolute level of compensation, then they can be satisfied. However, if their focus is on relative standing, then they can never be satisfied.”

Another reason for having a closed system is to enable the compensation committee to allocate income in a manner that is as fair and honest as they can be. If the firm has an open system, then it is only natural that the members of the compensation committee may adjust their allocations to avoid “wars” with certain partners.

CONCLUSION

Many years ago, at a partner retreat I was facilitating, we had just concluded a two-hour session on the pros and cons of the firm’s present compensation system when one of the partners said: “You know, we all have to put our partner compensation system in the proper perspective. A partner compensation system is just a way to allocate income. It’s not meant to be the primary way to manage the firm.”

One of the main factors causing the differences in partner compensation systems between large and smaller firms is that, either directly or indirectly, smaller firms do use their compensation systems as the primary way to manage the firm, or at least to manage the partners. Until smaller firms adopt the management, leadership and accountability concepts mastered by the large firms, their compensation systems will out of necessity be different than those of large firms.

Marc Rosenberg, CPA, is a management and marketing consultant to CPA firms nationwide, president of The Rosenberg Associates in Wilmette, Ill., and publisher of the annual Rosenberg MAP Study. Reach him at (847) 251-7100 or marc@rosenbergassoc.com.

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