From the February 2008 issue of Investment Advisor • Subscribe!

February 1, 2008

More Than Keeping Score

Using benchmarking to help make critical management decisions

An accepted principle in portfolio management is rebalancing--the process of restoring your portfolio to its original mix that was designed to meet a specific investing goal. Rebalancing is primarily about managing risk or reducing dependency on a particular investment. When parts of the portfolio have grown out of proportion to the benchmarks you set, you pare back those that have grown and direct investments to areas that have not.

The same principle applies to managing your business. Each facet of your enterprise--sales, service, human capital, technology, operations--requires an investment of time, money, management, and energy.

You periodically assess your operating performance, but do you apply this same rigor to your management decisions? For most business owners, it is difficult to have all elements of the business consistently performing at the optimal level, year in and year out. Some things go well and some things need work. Do you keep investing in that which is hitting on all cylinders, or do you reallocate to areas that need help?

I was struck by this recently when meeting with an advisor who had engaged a consultant to assess his people practices. One area of assessment was the comparison of what the owner thought was important and what the staff thought was important. The evaluation showed that this was a culture in which meeting client needs and new business development were the paramount values. However, the assessment also rated how the firm was doing in terms of developing and motivating others, fostering open communication, using financial data to make decisions, and thinking creatively. In these areas, the staff did not think the owner was living up to promises; the owner conceded these weaknesses.

But as the owner wrestled with the results of this process, he expressed concern over diverting attention to dealing with the aspects of his business that have been neglected. He was worried that the areas in which the firm was performing well--sales and client service--would suffer. "If I invest time and money in people development," he said, "I will have to give up on something else." That is a little like saying that if an investment class grew faster than the rest, it would make sense to continue investing in that segment rather than bulking up in areas that will help your overall return long-term.

Every business has finite resources, so the challenge is to deploy them in a way that moves you closer to your ultimate goal. Sometimes specific needs require big investments, and sometimes specific needs require incremental attention.

The notion that if you concentrate resources in one place it will cause another part of your practice to under-perform is an emotional flashback to the beginning phase of your business when survival was your overriding goal. However, for the typical advisory business with consistent, predictable income and a history of success, when something is working well it is likely that the enterprise is strong enough to endure a diversion of resources into areas that demand meaningful attention. Further, it is probably critical that resources be diverted where help is needed--or failure will become a self-fulfilling prophecy.

Benchmarking as a Management Tool

For owners and managers of advisory firms, it is critical to have a framework for making management decisions, for knowing when to rebalance the investment. Some use a concept called "best practices" as their measuring stick, which is a good starting point. But advisors should also use medians, averages, and their own best year as a baseline for evaluating operating performance. The key word is evaluating. The temptation, however, is to compare your business to this data as a means of keeping score. Instead of interpreting the trends and comparisons and using the information to determine areas for improvement, many will use the benchmarks for bragging rights. While we're always pleased to meet the high performers, we have more comfort in the management decisions of those who stay humble and recognize they are not infallible.

Stuff happens in business. If being on top compared to your peers ensured superior performance in perpetuity, then GM would not be losing ground to Toyota, Sears would not be overshadowed by Wal-Mart, and the New York Yankees might translate their record-setting payroll into winning the Series, or at a minimum, the American League pennant.

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What to Measure

Benchmarking provides business owners with both lagging and leading indicators. On the one hand, it's good to know where you've been; on the other, it's great to know where you are going. Almost anything you do in managing an advisory firm can be benchmarked--from client service and staff development to managing risk and measuring operating performance.

For the latter, the data provided in Moss Adams's Studies of Financial Performance of Financial Advisory Practices is one good place to get benchmarks, but advisors should seek as many data points as possible to provide a framework for making sound decisions. (Disclosure: Moss Adams was my previous employer.) To evaluate operating performance, owners and managers of advisory firms should evaluate the following metrics (at a minimum):

  • Gross Profit Margin
  • Operating Profit Margin
  • Revenue/Total Staff
  • Revenue/Active Client
  • Active Clients/Staff

These measures will provide insight into pricing, productivity, client mix, service mix, and expense control.

In addition, advisors should observe trends in operating expenses as a percentage of revenue, not just in aggregate, but line-by-line. This is a process called "common-sizing," where every key category of expense is divided into total revenue and expressed as a percentage. When observed over a period of years, you can determine where the "creeper" costs are (those costs that get together at night and conspire to cut your throat).

The process of using benchmark data is linear:

Step 1: Observe the actual numbers-- revenues, expenses, profit;

Step 2: Convert the numbers into ratios or financial relationships;

Step 3: Observe the trend by comparing the ratios over a period of 3 to 5 years;

Step 4: Compare the ratios to relevant benchmarks, including your own best year;

Step 5: Calculate the financial impact of any negative variance to measure the degree of the problem.

For example, Moneypenny Financial Advisor is a 10-year-old financial planning and investment advisory firm with three principals, three associate advisors, two paraplanners, and five administrative staff. In the year just past, the firm showed revenue of $2,540,000, gross profit of $1,422,000, and operating profit (after compensation to principals and staff) of $304,000. The business serves 360 active clients and manages $370 million of assets. Revenue and assets are both up from the previous year. When top-line numbers are heading in the right direction, the first inclination is to rejoice. But when compared to a benchmark, Moneypenny will develop a different insight.

The first observation is that the dollars, for the most part, are heading in the right direction, at least at the top line. Gross profit dollars are also increasing, but the operating margin is declining. This is the result of one of two factors--either Moneypenny is not managing expenses well, or the revenue is not sufficient to cover the overhead. When you see this trend in dollars, it's important to discover what is driving the result before slashing costs. If Moneypenny is investing in infrastructure, this is an anomaly that will soon resolve itself.

The second observation is that the profit margins are declining as a percentage of revenue and are below the benchmarks for its peers. At a time when revenue is going up, this is a very disconcerting trend. A decline in operating profit margin could be rationalized during a growth cycle because often firms invest ahead of the curve, and in smaller firms, every dollar of expense shows up more visibly. But when the gross profit margin declines in a growing firm, there is a legitimate reason for alarm. A gross profit margin below the benchmark or heading in the wrong direction is usually a signal that the business is struggling with pricing, productivity, service mix, or client mix.

Digging deeper into the other operating relationships, it is evident that such deterioration is in fact occurring. The revenue per active client is declining, as is the average pricing in basis points. A pricing decline might be logical if there was a material increase in the average client where breakpoints kick in, but that is not the case for Moneypenny. More disconcerting is the relationship of revenue per active client.

In many firms, discretion on pricing is left to the lead advisor. Without a framework, it's possible that certain advisors are discounting in order to add clients and assets. It's not uncommon for this to occur when advisors are paid based on top-line results. Volume, rather than margin, becomes their driver.

After reviewing the numbers, ratios, trends, and benchmarks, it is helpful to compute the financial impact of the negative variances. As an example, Moneypenny could conclude that her current gross margin of 55.98% is within the range of the benchmark at 59.3%, so there is no cause for alarm. But when you multiply the difference of 3.32% (.0332) by total revenue of $2,540,000, you discover that the financial impact is $84,328. In other words, the size of her problem is considerable. This now frames the issue for discussion with her staff--what steps can we take to increase our gross margin by $84,000? Are we encouraging the wrong kind of client or fee negotiations with clients? Each percentage point variance in gross margin has a profound impact on the bottom line. The result is less money to pay in bonuses and fewer dollars to invest in infrastructure.

Narrowing Your Focus

The business of financial advice has many moving parts. For most owners and managers, the data can be overwhelming. To transform benchmarking data into a meaningful management tool, it's best to decide which key performance indicators to monitor on a regular basis so that you know when to dig deeper into an issue.

In the end, the measures are not about keeping score, but about knowing which direction your business is heading. This is one of the few investments over which an advisor has direct control, so the challenge will be to apply the same discipline to evaluating performance and rebalancing priority as you do in managing client assets.

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