Many advisory firm owners have trouble with business accounting. This is often because different industries — and resources like industry surveys — use different terms for the same measurements.
For instance, some owners are confused by the term “gross profit.” It’s calculated by subtracting the cost of goods sold from total revenues.
In most accounting software, “revenues” are referred to as “income.” In some industry studies, “cost of goods sold” is somewhat related to “direct expense.”
While not meaning to oversimplify corporate finance, I believe there is good news: You don’t have to sort this all out to successfully run an independent advisory business.
Instead, you can greatly simplify your life by focusing on your “gross profit margin.” The GPM is defined as the total revenues (income) that your business brings in during a given period (quarterly, annually, etc.) minus the “cost of goods sold” divided by total income. In my years running advisory firms, this is the key measure of the efficiency of your business.
Unfortunately, GPM isn’t as simple as it should be due to varying definitions of the “cost of goods sold.”
Technically, cost of goods for an independent advisory business should only include the compensation of employees who contribute to providing and delivering services directly to the firm’s clients. These employees are your professional employees, such as lead advisors, associate advisors, etc.
Many industry surveys, though, exclude the costs of other employees (client- services support staff and management) in their cost of goods sold calculations. And technically, they are right, according to accounting methods.
Time to Recalculate
In reality, though, these same employees rarely perform just their stated professional function. Many do all sorts of other tasks in the business, including professional management.
These variations and dual roles cause confusion about what the gross profit margin should include. Most firms have talent that falls into overhead expense (a different category) and also falls partly into the cost of goods sold. This leaves firms owners confused on what to include in GPM.
To get accurate GPM figures, look at every job (and task) that every employee is doing, and then put a price on those staff members that contribute to the cost of goods sold and/or overhead.
This may seem like unnecessary and time-consuming work, and it may give some firm owners a complicated picture of their gross profit margin.
But consider this: When you do not have an accurate picture of your gross profit margin, your results probably look better than they really are, and you cannot efficiently run your small business.
With my clients, we put all compensation (unless there is over $10 million in income) into the costs of goods sold. This encompasses salaries and bonuses for all employees in your advisory business, including the owners. While this is not “technically” right from an accounting perspective, it helps you make better decisions.
Take the Challenge
With this exercise, I challenge my clients who fall below $1 billion in assets under management to increase their gross profit margin to 60%, without substantially growing their business or increasing their overhead. I want them to solve their efficiency problems using their brains, not their pocket books.
When tackling this challenge, most owners want to add people to solve problems. However, this shouldn’t be the first solution — it should be the last.
A far better approach is to get more productivity from your existing people and systems.
Advisors have a tendency to abandon the people, clients and systems they already have, in favor of new ones. But it’s almost always far more efficient to work on improving what you already have: train your employee, upgrade your systems and get more referrals from your clients.
When you improve what you have, you gain efficiency. What is the first step in recognizing efficiency for what it is? Seeing the logic of your gross profit margin. To management consultants like me, we call this the “efficient frontier.”
Using corporate finance creatively is often how firms can become much more efficient without sacrificing “profit margin.” And, profit margin is not the same as gross profit margin.