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.
Step 2. To determine breakeven revenue with the addition of the new hire, divide your total overhead expense plus the cost of the new hire by the gross profit margin [($350,000 + $40,000) ? 0.60 = $650,000].
As you can see, in order to cover the added $40,000 in costs, you need to generate $67,000 more in revenue. How could this be? Because in this example, you have 40% of your revenue going to professional staff, including yourself, and you only have 60 cents of every dollar left over to cover your fixed costs.
Step 3. With the addition of this new hire, how achievable is it to increase your revenue by $67,000 or more? Taking your average revenue per client of $4,000, this means, rounding up, you’ll need to add 17 more clients to cover the new hire ($67,000 ? 4,000 = 16.75). Notice we’re already up considerably from the 10 clients we thought we’d need to break even.
Now we need to add a profit goal to this calculation, since if you can’t increase your operating leverage and financial return with the addition of new people, then you shouldn’t do it (unless your goal is to operate a charity to increase the national employment level). In this example, the advisor was dropping 25% of revenue to the bottom line. Let’s assume that she wants to make 25% on every dollar of investment in staff. That’s an additional $10,000 in this case ($40,000 x 0.25 = $10,000).
Step 4. To determine your breakeven revenue level with the added $40,000 cost, plus the $10,000 additional profit, divide total overhead plus new hire and the profit goal by the gross profit margin [($350,000 + $40,000 + $10,000) ? 0.60 = $666,666]. Subtract the original breakeven revenue level of $583,000, and you’ve raised your firm’s breakeven point by $83,000. The result in this example is oddly Satanic, but the point of the exercise is to get you thinking that profit is a fixed cost just like rent, utilities, and other administrative costs. When you keep this in mind when paying staff, it will help you to understand that staff is an investment on which to generate a return, rather than an expense to control.
Step 5. To determine the breakeven revenue level at which to maintain an operating profit margin of 25%, divide the total overhead plus new hire by the overhead expense margin [($350,000 + $40,000) ? 0.35 = $1,114,286]. In other words, you would need to sell $114,286 of new business (or add the equivalent of 29 clients) to hire the staff person and maintain your margins, by paying yourself and your professional staff $55,714 more compensation to attract and work with those 29 new clients, and yourself $28,578 more profit.
- Here’s what a more accurate P&L would look like:
Direct Expense455,714 40%
Gross Profit668,572 60%
Overhead Expense390,000 35%
Operating Profit278,572 25%
Unfortunately, most advisors don’t consider the increased workload that the existing staff must take on to pay for any new additions in personnel, technology, marketing, office space, or any other expense. The result is that even if you do reach the breakeven numbers you’ve projected, you and your staff are working harder and longer for the same money (which represents a decreasing piece of the revenue pie). Consequently, you see your firm growing, but feel like you’re not getting anywhere, or even moving backwards, while your staff is increasingly unhappy at working harder for the same compensation.
In essence, you’ve all become slaves to your growing overhead expenses. It’s a vicious cycle that can only be broken by monitoring your profit and overhead margins. That doesn’t mean you’re a profit- monger, enriching yourself at the cost of your helpless clients. But it will save you and your professional staff from the creeping tyranny of your overhead expenses, and enable you to look at overhead as an investment that must boost the bottom line rather than a cost that merely erodes it.
A leveraged practice will allow you to continually push work down to the lowest levels, thereby allowing you and other capable members of your team to focus on where they make the greatest impact, such as getting business or providing sophisticated advice to your clients. The trap for many advisors is the presumption that cutting costs will lead to greater profitability. In reality, if you invest in staff (or technology, or processes) in a way that allows you to leverage better, the net profit dollars will provide you with a return on your investment commensurate with your risk.
Mark Tibergien is a nationally recognized specialist in practice management for financial services firms, and partner-in-charge of the Securities & Insurance Niche for Moss Adams LLP, the 10th largest CPA firm in the U.S. You can reach him at email@example.com.