From the July 2009 issue of Investment Advisor • Subscribe!

July 1, 2009

Formulas for Success: Physician, Heal Thy Business

Six management levers you can use to restore bottom-line health

Advisors without a healthy practice and mindset of their own run the risk of being too distressed or distracted to consistently make good decisions--for the firm and for their clients. After so many months focusing on restoring clients' peace of mind, now is the time for advisors to attend to their own financial health. The business often represents the biggest source of income and value for advisors, so a proper diagnosis should be the first step.

To accomplish this, measure your practice against reasonable standards. While the updated results from past benchmarking studies should be interesting if not helpful, managers of advisory firms must act with even greater urgency to address business challenges they independently face, regardless of what the rest of the industry is doing.

So set some benchmarks of your own by looking at your best year or at historical averages. For example, if your gross profit margin has typically been in the 55% range (gross profit ? total revenues = gross profit margin), analyze how you can get to this same level of profitability based on your current run rate. It is often helpful to translate the negative variance into dollars so that you can judge the magnitude of the problem. Let's assume your current revenues are $1 million, and your gross profit margin is 50%. That would be a negative variance of 5%. Multiplied by the $1 million revenue, the negative variance equals a $50,000 shortfall from your benchmark target. So what can you do in your business to restore $50,000 of gross profit?

Other key ratios to calculate include operating profit margin (operating profit ? total revenue), revenue per staff, revenue per professional staff, revenue per client, and client per staff.

Isolating the Problem

It may be small consolation that virtually every advisory firm is experiencing lower profitability than they had in the last two years. The freefall in portfolio values alone caused the greatest decline, though other factors contributed to lower margins. From a management standpoint, isolate the costs and profits among Direct and Overhead Expenses, Gross Profit and Operating Profit, so that you can focus your remediation on the right problems.

Gross Profit is the amount left over after fair market compensation to the professional staff, including owners (what it would take to replace you with someone of comparable credentials, experience, and client responsibility). Operating Profit is what remains after Overhead Expenses are deducted from the Gross Profit. Overhead includes such things as administrative staff compensation, marketing costs, rent, utilities, technology, and benefits.

Compare these numbers over a period of three to five years to observe any trends. Isolated numbers provide a snapshot of where you are, but not much insight into what is happening and why. One of the biggest errors that managers make is to regard the firm's performance against benchmarks as a score--meaning you're better or worse than your peers--rather than using benchmarking as a tool for gaining insight into your business.

Follow a linear process for translating your finding into management actions:

1) observe the actual numbers compared to a previous period

2) convert the numbers into ratios or Key Performance Indicators

3) examine the ratio trends over a series of periods

4) compare the ratios to a benchmark, whether developed individually or by using industry standards and

5) calculate the financial impact of any negative variance.

Profit Drivers

Every advisory business runs on six drivers of profitability. A low Gross Profit Margin could be caused by poor pricing, poor productivity, poor product or service mix, or poor client mix. A lagging Operating Profit Margin could be caused by either poor expense control or insufficient revenue to cover your overhead costs.

Understand these six drivers so that you don't overcorrect in one area only to create negative consequences for another. It is a common and instinctive mistake, for example, to cut staff costs when profits are down. While expense control improves the bottom line, the biggest cuts here would likely be in the area of compensation. As a result, it's possible that an elimination of staff could adversely impact the productivity of advisors. Approach any decision by looking at all the moving parts and determining which combination of adjustments will result in better profitability without worsening your condition.

Let's examine the questions you should consider as you conduct this analysis:

Poor Pricing. Will clients expect us to reduce our charges in a low return environment or as a result of portfolio losses? If so, should we accede to their requests? What is an appropriate dollar amount we should charge to deliver the services the way we do? Should we charge more and separately for non-asset management functions such as financial planning, special needs analysis or charitable strategies? Are we in tune with the costs to deliver our services, the market for comparable services, and what our clients perceive as "value"? Are there any clients who are costing us money? Are there any clients for whom we should or could raise prices?

Poor Productivity. Are we managing enough relationships to justify the compensation costs of our professional staff? Are all staff performing their work on a timely basis and are their efforts focused on the right things? Are we leveraging our technology, our custodian, or broker/dealer, and our outsourced solutions adequately to keep our fixed costs in line?

Poor Product or Service Mix. Have we ventured into areas that are not scalable? Are we performing any "one-off" services for specific clients we do not intend to invest in further? Is this costing us money or is it critical for the retention of the specific client? Are we customizing too much?

Poor Client Mix. Are we suffering from the 80/20 syndrome in which too many of our clients fall outside our sweet spot? Do we have a clear idea of who our optimal client is and what the client experience should be for them, including what we charge? Would cutting a group of low-margin clients allow us to eliminate any staff positions? Would reducing these low margin clients or reducing the level of service we provide them positively impact our productivity? Does everybody in the practice know how a sub-optimal client negatively impacts our business?

Poor Expense Control. Are there any specific categories of expenses that have increased faster than revenues have increased? When will those expense increases get normalized and how? Are we spending money on things that do not add value to our client service or improve the quality of our practice? Are we adequately leveraging our custodian or broker/dealer to achieve greater efficiencies?

Insufficient Revenue. What is our specific action plan for increasing new business opportunities and for converting prospects into clients? Who is accountable? Should we change our compensation model to reinforce new sales behavior? Is our market positioning clear? Are we losing clients for reasons within our control? If so, why and how do we fix this?

Act With Alacrity

Like most business owners, advisors are not trained to act in crisis. We are told how to increase things, improve things, advance things--but rarely how to manage things when the business goes sour.

As the market and bad economic news become less jolting, clients and staff have gotten their initial panic under control. Owners of advisory firms have a little breathing room to make clear-headed decisions. But not a lot of time.

It is likely that the business will experience economic distress for a number of months and it's going to take a couple of years to get back to the same financial position enjoyed before the economy began its swoon. Decisions that owners and managers make now to address low profitability will produce better returns once the market experiences a permanent recovery. But just thinking short term, these decisions will also help to ensure the viability of the enterprise should the recession extend for years, not just months.

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