Matters Column

Engagement letters are vital part of doing business

November 9, 2018
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What is an hour of someone’s time worth? Most small business owners are not paid an hourly wage. Their pay is the profits of the business. In other words, their pay is commensurate with their skills and effort. Sounds fair to me. There is much that can be unfair in paying for hours that have been measured only by the time clock.

I grew up in Flint. One of the downfalls of the American auto industry was its inability to control its labor cost and effectiveness. There were people paid by the hour and people who did what was called piecework. The hourly worker was paid for the time they were on the clock. People on piecework were compensated for what they produced. Who do you think worked harder?

Accounting classifies labor as direct or indirect. Direct labor is the amount that is paid for wages to actually make the product. Indirect labor is everybody else. This is a very important distinction. Direct labor as a component of cost of goods affects break-even analysis, planning, taxes and many other important calculations. Cost accounting is an important function in finance.

Indirect labor is judged by the quality of the function that the employee is responsible for. A receptionist is expected to make a good impression and make sure phone messages are delivered to the correct person. If those functions are being handled properly, the employee is doing their job and their pay will be determined by what the market is for that function.

Direct labor is a function of measuring production. You are not paying for time, you are paying for what that person produced in that hour. If they produced nothing, that is what they should be paid.

Pay for creative people can be tricky. You have to measure an intangible. That then becomes a negotiated compensation. What is an artist, athlete, radio or television personality worth? Whatever it is, it’s too high in management’s eyes and too low in employees’ eyes.

Now, let’s look at outside services for which hourly rates are the norm. Whenever you are dealing with professionals, absolutely positively do not do business without an engagement letter that spells out cost, goals, rates, etc.

Jokes are funny due to some absurdity. So, an attorney dies and approaches St. Peter at the pearly gates. St. Peter looks perplexed. He looks at the attorney and says there is a problem. His birth certificate says he is 65. When the angels added up his timesheets, he had to be 130. You could use the same story using an accountant or any other professional, except that nobody thinks accountants are funny. Jokes are a product of real situations made funny in part due to some base in reality.

My office picked up an excellent client years ago. The reason they were leaving the previous firm was that the previous accountant had made a mistake on their financials. Errors happen, but that wasn’t the problem. They received a bill for the time to correct the financial statements. When the client asked for an explanation, the answer to the question was who else could we bill for the time?

People in professional firms are graded by their billable hours. An attorney told me that he had a target number of billable hours per day. So, my natural question was what if you don’t have enough work? The answer he gave was a wink and a smile.

Mack McClain, a friend of mine from Flint who l have known since I was 5, is one of my favorite people in accounting. He was in town recently and described a situation to me. He was working on an audit, and the bookkeeper asked him to find an error worth a few pennies in the bank reconciliation. He demurred explaining to the bookkeeper that the cost of finding her error would not be worth what he would have to charge to help her. That is the kind thinking you are looking for in professionals. The proper level of expertise and cost should be used commensurate to the expertise required. Having a $300 per hour expert working on a task that a $20 per hour staff member could do is obviously illogical and a waste of money.

I want to emphasize the use of engagement letters when hiring professional services. Dealing with high per hour cost professionals without an agreement on fees and goals of the engagement is like leaving a signed check without an amount on it in a public place. I recently had an 1880s vintage farmhouse in northern Michigan resided due to an insurance issue about asbestos in the old siding. The cost was around $30,000.

That house now will be usable 100 years or more into the future. I witnessed at one time a professional bill in excess of that amount that accomplished nothing. If you don’t have an agreement, you are at risk for uncontrollable expense. Friendship, family relationship, reputation of the firm, length of relationship all should not cause you to hesitate to require an engagement letter. Bitterness or resentment have no place in business. Do business the right way and those emotions will be avoided.

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