From the June 2012 issue of Investment Advisor • Subscribe!

May 22, 2012

Growth and Austerity

Balancing growth and austerity requires discipline

Despite all of the quick-fix rhetoric, there is no magic pill that can restore health instantly. Despite all of the quick-fix rhetoric, there is no magic pill that can restore health instantly.

The economic story unfolding in Europe raises questions for all business leaders. Should we attack our deficits or should we fund our growth? While well-intentioned people can argue “yes” to either question, those in charge know that it is easier to write the slogans than it is to create the business plans to fix what ails us.

Despite all of the quick-fix rhetoric, there is no magic pill that can restore health instantly. This is true for governments. This is true for people. And it is true for businesses.

In our simplest minds, the choice seems obvious. Austerity causes pain. Revenues create pleasure. Why on earth would anyone choose to suffer if there is an alternative course? Thinking more deeply, however, our complex minds know that each action has a consequence, and no solution is entirely black and white.

Some combination of growing revenues, limiting financial leverage and managing expenses allows leaders to correct their missteps and steer in a new, successful direction. But the magnitude of the problem and our control over the levers dictate how decisively we can act. As much as we wish for new revenues, higher margin relationships and to grow without costs, the management of each of these levers requires discipline.

The average cost of running an advisory firm is rising faster than revenues. This is because of a pent-up demand for people, their need for higher compensation, rising regulatory costs and lower productivity.

In “Mission Possible III,” a recent independent study commissioned by Pershing Advisor Solutions LLC and developed by independent consulting firm FA Insight, we observed that the median overhead expense per client has been ticking up at a rate of 5.2% for the last several years (see Figure 1, left). Meanwhile the average overhead expense as a percentage of revenue is hovering around 40%. Of course, many firms are above average, which is not where you want to be.

Especially compelling, this analysis revealed where the expense dollars are going (see Figure 2, left). Thirty-five percent of total overhead goes to administrative staff, management, technical specialists and support staff. Other staff costs such as taxes and benefits consume 17% of the overhead budget, and office expenses take up another 20%. The rest is shared among IT costs, business-development-related expenses and a general catch-all called “other.”

These numbers affirm that we are very much a people business, no matter how many computers and smartphones we buy. Second, they affirm that with salaries, taxes and benefits consuming almost 50% of the operating outflow, advisors must continue to find new ways to squeeze out greater productivity. Bear in mind that these numbers do not include compensation and benefit-related costs for professional staff, which is counted in a category called “direct expense.” (More details on financial accounting within an advisory firm can be found in “Practice Made (More) Perfect.”)

Overhead is perceived as a necessary evil within advisory firms; they cannot grow without competent staff and an investment in infrastructure. But each addition to overhead necessitates more clients and more revenue, which beget the need for more staff and infrastructure to support your growth. It seems impossible to jump off the spinning wheel onto stable ground.

There is hope for long-time sufferers of the overhead dilemma. The top performing firms, according to this study, showed an overhead expense ratio 10% below the average. For a $5 million practice, that’s a $500,000 variance.

How do they accomplish such an improvement?

First, they get to scale. Again, there’s no magic pill. As long as each hire and each purchase takes up a separate line on your income statement, it is difficult to get overhead expenses down to 35% of revenue or better. Scale depends a lot on the cost of your location, meaning that San Francisco costs a lot more than San Antonio. But generally somewhere between $4 million and $5 million of annual revenue should begin showing a lower expense ratio if the business is managed effectively.

Second, they create scalable solutions even if they are not yet at the right size. This means examining their work flows, systematizing that which occurs regularly and eliminating steps or processes that don’t add value. It also means delegating down so that the most expensive people are not consumed with teachable tasks.

Third, they actively manage to profitability. Every business suffers from creeper costs, those costs that get together at night and conspire to cut your throat. Using a technique called common-sizing, managers are able to observe trends in individual line items to see what is rising with revenue and what is not. They may also calculate what it will take to break even on an expenditure so that they can build a plan around paying for it out of future revenues.

Fourth, they begin to sharpen their focus on their optimal client and invest in processes, procedures and solutions that align with that optimal client. Most advisors find that by focusing resources, instead of over-diversifying, they can create a better outcome for their clients and create a more profitable, sustainable business.

Growing revenue and practicing austerity are not mutually exclusive exercises. Both cause pain and both create pleasure: When balanced in a careful plan, advisory firm leaders may build a stable and profitable enterprise. There is no one magic pill that cures all ills. Success requires disciplined, active management of firm expenses.

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