From long experience, I’ve learned that profitability is anathema to most financial advisors. Sure, they want to make a living, but they don’t want to think about their practice as a business or consider their profitability. They tend to look askance at advisors who do focus on such pecuniary matters.
Maybe it’s middle class morality. Maybe it’s innate guilt from our Baby Boomer generational affluence. Or maybe it’s an aversion to the big-producer, identify-the-prospect, close-the-sale world that most independent advisors left to better serve their clients. My guess is the last, and most of the advisors I know could indeed make more money with fewer headaches pushing product as stockbrokers or insurance agents.
But as much as I applaud this professional, client-oriented approach that most advisors take, I’m here to tell you that profitability, and its measure–profit margins–do matter. Here’s why: Most financial planning practices today don’t work, because most advisors don’t listen to what their profit margins are telling them. What follows is a simplistic example that hopefully will help you to see this as clearly as I do.
When thinking about your practice, it’s important to keep in mind that you, as the owner, are being paid (or should be paid) for two things: the work you do as an advisor, and the risk you take as a business owner. Keeping these two sources of compensation separate in your mind will not only help you to understand what really is happening in your business, it will also make you feel better about making substantially more money than your employees. (I suspect that in these successful times, guilt about their compensation is another reason that advisors avoid thinking about the business end of their practices.) As probably the most senior, most experienced, and best-trained advisor in your firm, you warrant a high level of compensation. And as owner of the business, you’re also entitled to a fair return on the investment you’ve made, and continue to make, in capital, time, and liability exposure.
Healthy, but Not Wealthy?
To see how to quantify separating your working and ownership compensation, consider a practice that brings in gross revenues of $1 million each year. Out of that, you might pay your professional staff (including yourself) a total of $400,000 in salaries and bonuses, and spend another $350,000 on overhead, including rent, technology, and support staff. That leaves $250,000 to be counted as profit, and the 25% of revenues it represents is a healthy, but certainly not exorbitant, profit margin.
- Your profit and loss statement then would look like this:
Direct Expense:400,000 40%
Gross Profit:600,000 60%
Overhead Expense:350,000 35%
Operating Profit:250,000 25%
Now, to see why this is important (and why your practice is probably dysfunctional) consider the impact of hiring another support employee, for say, $40,000 a year in salary and benefits.
Most advisors, and many other small business owners as well, would probably decide whether to make such an addition to their staff this way: All our lives will be made easier with the extra help, and if we can just generate another $40,000 in revenues to offset the additional expense, we’ll break even. If they’re sophisticated, they might also consider that since the firm averages $4,000 in revenues per client each year, they’d only have to add an additional 10 clients to reach breakeven. If they are very sophisticated, they might calculate that they’d only have to add 13 new clients to not only break even, but to maintain their 25% profit margin. So it almost sounds like a no-brainer, doesn’t it?
And that, ladies and gentlemen, is why you’re working longer hours, on more clients, and having more management headaches, with more staff dissension, for what seems to be about the same money. To put it another way, that’s why your firm is dysfunctional.
In a nutshell, none of these tabletop analyses have considered the impact of the extra workload for the professional staff or on you as the owner that is required to get to breakeven. What you’re really doing is taking on more work in order to pay for the additional help (or computers, or office space. The analysis for additional overhead is all the same).
- Here’s how your new P&L would reflect your eroding compensation and profit margin and growing overhead:
Direct Expense:400,000 38%
Gross Profit:640,000 62%
Overhead Expense:390,000 38%
Operating Profit:250,000 24%
That’s only a drop of 1% in the profit margin, but it was only an additional $40,000. That means by these usual calculations, for every $40,000 in new expenses, your $1 million firm’s margin will erode by 1%. It won’t be long before you’re working much harder for a single-digit return on your investment. On the other hand, here’s how a business analyst would provide five steps to help you quantify hiring that $40,000 staffer and solve your problem
Step 1. To determine your current breakeven revenue level, divide your total overhead expenses by the gross profit margin ($350,000 ? 0.60 = $583,000). Obviously, based on its cost structure, this practice breaks even at a level well below its current revenue.