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.