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ADVICE: An initial look at firm profitability

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In this, the first of a series of two articles, we look at the pressures on an accounting firm’s profitability

There was a time when accountancy business owners were seemingly guaranteed high profit emanating from a business model that was often characterised as the 1/3, 1/3, 1/3 model. That model is also known as the cost-price model whereby the hourly charge rate was based on a 3−4 times multiple of salary. This model still exists to some extent, but it is no longer delivering those same margins. The reasons are evident, and they include:

  • Salary costs in real terms are greater than ever before.
  • Training costs have increased.
  • Social security costs have increased.
  • Time out for holidays has increased.
  • Funding for retirement has become compulsory (in some countries).
  • Technology might have driven down costs for the accountancy business, but it has now reinvented itself as a competitor.
  • Clients are more cost conscious than ever before and are prepared to resist fees at current levels let alone fee increases.
  • Time managing the requirements of regulators such as IRBA and SARS absorb time for which the client sees no value.

KEY PERFORMANCE INDICATORS (KPIs)

You will know most of what there is to know about numbers. But maybe when it comes to viewing numbers there is too much emphasis on those in the profit and loss account.

KPIs should focus on the numbers that drive the numbers in the profit and loss account and balance sheet in the desired direction.

There are three numbers that you should calculate:

1 Revenue per billable hour

Do not focus on either your charge rate per billable hour, or the realisation rate. One is a number that you feel represents your value and is undoubtedly calculated by reference to a person’s salary and firm status. The other is a result of the maximum you feel you can bill compared to the accumulated time cost.

How to calculate? Divide the total number of charge hours and then divide this into the total fee revenues.

What does the trend reveal? Recently, a partner in a Top 15 UK firm came to me and said that his executive committee was alarmed at the trend and even more alarmed to find that the forward projections reveal a 7% −  yes, a 7% − reduction in margin.

2 Revenue per client

You will need to decide how to calculate this. I recommend you identify the revenue per business client.

This is an important number to manage. While there remains a focus on compliance services there are perhaps lost opportunities to super-serve the client with services that create greater value for the client.

3  Staff costs as a percentage of fee revenues

First of all, let’s look at one approach to calculating staff costs.

Include all chargeable staff salaries and direct on cost (social security, pension costs etc). Therefore you can, if you so wish, exclude costs of admin, reception and support staff.

Include a fair market salary for all partners whose cost is not captured above.

Owners should be managing these KPIs and doing everything possible to ensure these KPIs over time are all moving in the right direction.

How? That is a good question. Remember the old adage that says, ‘If you keep on doing what you’ve been doing you will keep on getting what you have been getting’ – and that is not what you wish to happen – right?

Improving job profitability

I started to explore how to improve profitability when I was managing my own accounting business. That journey has continued and is now a specialist area that my clients and seminar attendees always find of interest. I trust you find some new ideas together with creative solutions to an old but now a must-solve problem.

When your top line is not the top line

On one occasion I was working with a £7 million seven-partner firm. One of the partners was underperforming significantly. During our coaching sessions he told me he felt that he could make no real difference to the firm’s results as a result of the size of the firm. I considered that a very lame excuse.

In order to coach him out of this mind-set, I showed him how the firm was grossing not £7 million but £10 million. He was somewhat bemused to say the least. I explained to him that it was a shortcoming of the double entry bookkeeping system.

£3 million is a huge number and yet it was not that unrealistic.

You see, the point is that there is real potential for profit improvement if we focus on this £3 million gap. Remember that we ‘manage that which is monitored’.

Your firm’s profit and loss account is a document that all accountants go to first. That’s natural, it’s a core component of our outputs. But that statement can only reflect cash/bank payments adjusted by journals and accruals and prepayments. But, if you were to journal in the three core variances then I suspect that more time would be spent on addressing the objective of reducing these debits. It is these three variances that account for the £3 million gap.

So, back to my client. We looked at the time he was not charging, the write-downs on his jobs and the discounts he was allowing, and he came face-to-face with the reality that improving his performance would make a real difference.

There are three key variances between the real top line as I see it and the reported top line according to your financials.

1 CHARGEABLE TIME

Make sure you set chargeable hour targets each year with a good measure of S T R E T C H for each staff member (including all firm owners) and then monitor actual against budget … monthly. I did this in my accountancy business by producing a weekly staff member league table – not the most popular monitoring system I introduced but one that had those in the bottom half trying to up their performance. Then report in your profit and loss account (not in an attached supporting schedule) this variance and ask, ‘What can we all do to increase chargeable time?’

Key point: Watch firm owners and managers chargeable time in particular.

Write-downs – an introduction

Imagine this scene in the manager’s team meetings when they discuss the issue of write-downs: ‘Do you know the reason why we have write-downs in this place is that the partners don’t have the courage to bill what the job is worth.’

At the same time, the partners are meeting, and they are also discussing the same issue. Here is what can be heard: ‘Do you know the reason why we have so many write-downs is because the staff aren’t being managed efficiently or effectively by the managers. There are too many errors creeping in and staff are taking far too long.’ This is the black hole of job management – managers hold partners responsible while partners hold staff responsible.

There are two very different types of write-downs and they need to be managed differently:

Manager John prepares a budget for R25 000 and goes along to the partner Sue who looks at it carefully and after a short discussion says, ‘I can’t possibly the client that fee – the maximum we can charge is R22 000.’

This R3 000 write-down is a sales variance.

With job complete John ventures into Sue’s office ready for partner review and sign off, only to tell Sue: ‘Sue, we have completed all our work, but we have also gone a little over budget. The total cost is looking more like R28 000.’

This R3 000 write-down is a productivity variance.

Time reporting systems rarely distinguish between these two variances.

Let’s look at these write-downs in more detail.

2  SALES VARIANCES

Firm owners are usually responsible for agreeing the price for the assignment. Managers for producing a proper and full budget for the work. To the extent that the price for the work is less than the budget you have a sales variance.

Your objective should be to target a sales variance of not less than 95%.

3  PRODUCTIVITY VARIANCES

Remember the manager has produced the budget and good managers prepare good budgets. They should be on the look-out for client-caused problems and, like the car service manager, ensure that these are brought to the client’s attention – with a price to fix the problem.

So, partners are responsible for sales variances and managers/staff to manage productivity variances and then ensure that they are reported on monthly with everyone focused on seeking to reduce the quantum of these variances.

Key point: On this basis what is your firm’s true top line?

Next month we will explore in more depth key strategies for improving your job profitability.

[Author]

Mark Lloydbottom is the founder of a number of leading edge publishing companies serving the UK accountancy firm marketplace. He is a leading consultant to accounting firms. Mark lectures for SAICA and has consulted with many South African firms. He is the author of Double Your Income available from SAICA