From the May 2003 issue of Investment Advisor • Subscribe!

Profit Is Not A Dirty Word

Over the years, I've seen way too many advisors avoid thinking about their practices as businesses, apparently under the misperception that such prurient matters would detract from their professionalism. However, the simple truth is that the best advice in the world isn't worth much if you don't stay in business to deliver it. In fact, as we've seen time and again, better-run practices provide the time and resources for advisors to serve their clients better. The bottom line is, after all, the bottom line.

The first step in building a profitable practice is to find out how profitable you are now. That requires running what we call a profitability analysis. The process isn't complicated, particularly for someone with a financial background. But it can be time-consuming, since to truly get a handle on your business you need to look at the profitability of your company as a whole and then look at the profitability of each client, of each professional, and of each working team, where appropriate.

Let's start with some definitions. There are really two measures of profitability: the gross profit margin (GPM) and the operating profit margin (OPM). Gross profit is simply gross revenues (which would include all fees, commissions, and gross income related to the business) minus direct expenses (all fair compensation to professional staff including the owner(s), which is also known as the return for labor).

To calculate the gross profit margin, just divide the gross profit by the gross revenues. In the 2002 Financial Performance Study of Financial Advisory Practices that Moss Adams produced for the Financial Planning Association, the median gross profit margins ranged from 79.8% for the upper quartile of participating firms to 42.9% for the lower quartile.

To calculate operating profit, subtract your overhead expenses (all other costs related to running the business including administrative salaries, rent, office supplies, and travel) from the gross profit number. And to get the operating profit margin (OPM), divide the operating profit by gross revenues. In the 2002 Study, median operating profit margins ranged from 33.8% for the upper quartile to 0.6% for the lower quartile.

To evaluate the profitability of your firm, look at an analysis over at least three consecutive years. By comparing changes in the GPM and the OPM from one year to the next, you can see where you are experiencing creeper costs, i.e., expenses gradually inching up that are eroding the profitability of your firm.

Next, compare the GPM and OPM to a benchmark (refer to the FPA study, or compare it to your own best year). The 2002 Study, for instance, has median operational ratios of all firms by quartile, by size, by business model, by the number of principles, by revenue mix, and by strategic differentiator. Once you've chosen the appropriate benchmark, if there is a negative variance from that yardstick, take the difference and multiply it by your gross revenue. This will show you the financial impact, or, put another way, the size of your problem.

For example, if your OPM benchmark is 25% but your current OPM is 10%, the size of your problem is 15%. If your annual revenues are $1 million, this would tell you that you are $150,000 below where profitability should be. In other words, every percent counts: Even a 1% variance is $10,000, which could cover the cost of a couple of computers, could be used for a marketing campaign, or could even buy you a few nice days off.

Putting the Numbers to Work

So how do you use this information? By seeing the magnitude of the problem, you now can go back to your analysis and focus on what causes this "low profitability." If you have a declining operating profit margin, or one that is below your benchmark, there are three possible causes: poor cost control, insufficient revenue volume to support your overhead structure, or a low gross profit margin.

The most immediate way to attack low profitability is to examine which costs you can eliminate. This may mean subletting space in your office, imposing a purchase control program, laying off staff, or taking a variety of other actions. Such measures are often difficult for advisors to accept because of the perception that any cuts would seriously damage the flow of revenues into the business.

But put the problem into perspective: If you are not making what the average practitioner is making in their business, then you already have begun to damage your business. What steps are you willing to take to fix it? Is it easier to cut costs, or increase revenues? When it's a $150,000 problem in a $1 million practice, it's probably a combination of both.

Increasing revenue volume basically means to sell more. The question is whether you have a culture of business development and the ability to attract new clients. Refer back to your practice's history to see if you can learn from your past successes. Seek new referrals from your contacts, explore the potential for deeper penetration into the portfolios of your existing clients, and examine what other steps you should take to attract and keep clients who fit your sweet spot.

Finding, Then Fixing, the Problem(s)

If at the end of your analysis you find that your gross profit margin is out of whack with your benchmark, there could be four major reasons:

  • Poor pricing If you have control over AUM or planning fees for example, this is where you can get hurt.
  • Poor productivity One example of this is not managing enough profitable client relationships, or generating enough revenue per client.
  • Poor product or service mix This can happen when small practices are too diversified and therefore never create a strong market impact.
  • Poor client mix You may have too many clients on the low end of your spectrum, and many of them may not be able to afford you.

There are some fundamental steps you can take to improve your GPM. Raising prices for existing services such as for managing or supervising assets, developing new revenue generators such as writing financial or estate plans, or instituting a new hourly consulting fee is always a challenge, especially in a grizzly market like the one we've had for the past three years. Moreover, raising prices for existing clients could have a dampening effect on increasing revenue.

On the other hand, if this approach forces you to be more selective about which clients you take, it could be a positive development. Is there anything wrong with working less and making more? Chances are you have not touched your pricing, especially for planning and consulting services, in a long time. Do you know what the value of your time is? Or the value of your staff's time? Are you getting paid adequately for that time? A profitability analysis will help answer these questions.

Evaluate the productivity of each professional staff member, or each team, to determine who is generating a "contribution margin" (their cost divided by the revenues they bring in) consistent with the rest of the firm. For those who are not generating that margin, consider coaching them up or coaching them out. Impress upon your professionals the importance of boosting the bottom line, show them the numbers that support your judgment that they are not contributing, and tell them how they can do better. Seeing a problem in black and white can be a powerful motivating factor.

Forget the 80/20 Rule

Finally, evaluate your relationship with clients: Can you afford to keep all of them, or are some not yielding enough revenue for the effort you put into the relationship? One of the great myths in the financial advisory profession is the relevance of "Pareto's Constant." Vilfredo Pareto was an Italian economist and sociologist who in 1906 determined that 80% of a nation's wealth was held by 20% of the population. Later in the 20th century, business managers began applying permutations of this concept. What is known as the 80/20 rule has become an accepted axiom in the advisory business, too: 80% of an advisor's business comes from 20% of his clients.

Strategically, acceptance of this rule doesn't make sense. Why would one tolerate having 20% of his business subsidize the activities of 80% of his client base, or accept building a business that serves so many clients who do not fit his sweet spot? While it may be difficult to fit all your clients into an optimal client profile, it should still be the goal. At a minimum, the rule should be reversed to where 80% of one's clients fit within the optimal profile.

Cutting the Cord

From a financial management perspective, there are a number of ways in which to evaluate the productivity of client relationships: revenue per client, GPM per client, and OPM per client. However, there is a point at which it does not make economic sense to serve certain clients. Individual advisors must make decisions for their own altruistic or relationship reasons to accept clients below a minimum threshold, but that should be the exception, not the rule. In order to be effective in delivering services to your core client base, those core relationships must be profitable and productive.

Taken together, running a GPM and OPM analysis on your firm, your professional staff, and your clients will give you a unique perspective on your practice. It will help you to see your practice as a business, and create a better platform for serving your clients. As one advisor who has gone through this process told me recently: "Running a profitability analysis will change forever the way you look at your practice."

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