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  • Writer's pictureMarcus Williamson

What is your salary cap?

Does your business operate under the salary cap model? For most people, that question produces a fuzzy look and the thought “well no, I am not an NFL owner.” Bear with me and see what the salary cap model means for you and your business. I will contend operating with a salary cap mindset when it comes to hiring workers makes the process much more efficient.

To begin, let’s discuss the bottom line - you want to make money. The question is how much? Breaking even will not cut it and even 3-5% margins leave you one bad month away from failure. At a minimum, you need to shoot for a 10% margin. The salary cap is one way to help keep you there. Achieving 10% margins may seem insurmountable (and will be discussed in a subsequent post) but for now, let’s assume you can and will (and potentially already are) operate at a 10% pretax profit.

We will further assume you are a new and growing business that has ramped up to $1,000,000 in top-line revenue for the year. Round numbers make things easier. Using our 10% pretax profit metric, we see that at year-end we should be left with $100,000. Not a bad year. However, many things went into earning the $100,000 of profit. We can divide these costs into our personnel expenses and everything else. The everything else bucket is pretty easy to define - it is all expenses that are not, directly and indirectly, paying your people. This will be rent, office supplies, insurance, products, internet, utilities, and so on. If you are a product-based business, your costs of good would fall into this bucket. When calculating your everything els bucket, you have to remember that in a product-based business, your cost of goods will increase as your revenue increases. As long as you have a good product costing calculator, your total costs for the year should be fairly easy to predict. Now that we know what all gets thrown in the everything else bucket, let’s assume that number totaled to $350,000.

The Equation

Now it is time for the amazing accounting equation to figure out where to set the salary cap.

Salary cap = Revenue - pre-tax profit - everything else

In our example this calculation would be:

Salary cap = $1,000,000 - $100,000 - $350,000 = $550,000

And here we have arrived at last to our magic number - $550,000. It does not matter if you spend it on full-time or part-time, salaried or hourly, incentive pay, or anything else - this is the cap. At the end of the day, The number in Box 1 on your W3 at the end of the year cannot exceed this amount. While there may not be a luxury tax imposed o your business for exceeding the cap, there is a hard knocks tax that will be due one day. Exceeding the cap cuts into your real pre-tax profit, driving it below 10% and inching your business closer to financial troubles.

What Now?

Now you may be wondering - “how I increase my business’s salary cap? My workers need raises!” And that answer is fairly easy to compute if you refer back to the accounting equation. To make the salary cap larger you can:

  1. Increase your revenue (remember to account for the additional cost of goods if applicable to your business)

  2. Decrease your everything else bucket (since some of these are more than likely fixed costs, this could be hard to achieve)

Another way of looking at how much you can increase your salary cap is to rearrange the equation to see how your actual pretax profit is performing:

Pre-tax profit = Revenue - Personnel Costs - Everything Else

If that number begins rising above your 10% target, congratulations! Now you can make the decision to either increase the salary cap and hopefully drive additional growth in your business or accept the higher profitability. Every business is different and every owner has different goals so there is no truly correct answer. However, there is a caveat to always keep in mind: your people drive your business. Treat them accordingly.

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