CPA firms are simple and complex at the same time. Simple because they consist primarily of people – the clients and the professionals. Granted, firms also require workspace and technology to operate, grow and succeed, but people are the primary value drivers.
CPA firms are also complex for the same reason they are simple: because they consist mainly of people – each uniquely gifted and talented, each with selfish interest, diverse personalities and preferences, and each facing different challenges and seasons in life.
Whether CPA firms are viewed as simple or complex, most CPA firm professionals lack perspective and understanding of how their firms really “work,” and what is necessary to operate profitably and achieve sustainable growth. There is, however, a “high level” or “big picture” way to gain a better understanding, because similar to most processes, organizations and systems, CPA firms can be modeled with a mathematical formula.
In his book “Managing the Professional Service Firm,” David Maister, a widely acknowledged authority on the management of professional service firms, developed the following formula describing the 5 key “levers” that drive and influence “bottom line” net income per partner, or “NIPP.”.
- Leverage x Utilization x Billing Rate x Realization x Margin = NIPP
This formula is sometimes referred to by the acronym “LUBRM” – pronounced “Lubrum.” In this blog we will provide an overview of each of these 5 key levers, how they are defined or computed, how they relate to and impact one another, and how each should be prioritized short term vs. long term. Let’s start with leverage.
- Leverage is typically calculated as the number of billable professionals divided by the number of equity partners. We believe leverage is the most important of the five key levers. Without the right quantity and quality of people, CPA firms cannot grow and thrive. People are the #1 asset, not only for delivery of client service but for building and sustaining the CPA firm of the future. In the long term, higher leverage will lead to higher NIPP, but in the short term higher leverage will likely cause lower realization due to new staff “learning curve” and training time. CPA benchmarking surveys show leverage ranging from 2 professionals per equity partner for the smallest CPA firms to 11 for the largest firms, with leverage for mid-size firms averaging from 7 to 9.
Action Steps: CPA firms should focus both short term and long term on increasing leverage by continually recruiting new and experienced hires, creating effective new hire orientation programs, creating written role descriptions by performance level, developing people through both formal and informal learning programs, pushing work down through effective delegation, focusing on retention efforts, and developing succession plans.
- Utilization represents the level of “effort” put forth by billable professional resources. Higher utilization can be a “real time” indicator that a firm is on track financially, while a lower percentage may indicate excess capacity or too many people for the amount or “type” of work available. In the “LUBRM” formula, utilization is expressed in terms of average chargeable hours per billable professional, rather than as a percentage of chargeable hours to total work hours.
Action Steps: CPA firms must recognize that the there is a practical limit to staff utilization and that unrealistic expectations around utilization can lead to burn out, turnover and decline in client service quality. Recognize also that a focus on increasing utilization is “old school,” and that a “deliverables” based, work anywhere, anytime environment is the direction for the firm of the future. Reduce the focus on utilization as a management tool by making sure there is clarity on ownership of clients, engagements, and projects, efficient work flow and scheduling by service line, effective delegation, being clear on deliverables, by-when dates, and return and report procedures, and by teaching effective time management skills.
- Billing Rates provide an amazing lever that can drive profit to the bottom line without hiring another professional, adding another client or selling another engagement. According to David Maister increasing billing rates (“raising prices”) is the number one way to improve CPA firm profits. In addition, benchmarking surveys consistently show that firms with the highest partner and staff billing rates also have the highest profits and NIPP.
Action Steps: For most CPAs, increasing billing rates is outside their “comfort zone.” As with anything challenging and difficult, proceed incrementally and set a goal to increase billing rates over time. Start by reviewing billing rates by level as compared to other firm billing rates using one of several reputable benchmarking studies and identify which levels have room for increase. Next increase billing rates for all new clients going forward. Then perform a review of all current clients and determine the last time fees were increased. For the largest “A” clients, undergo strategic account planning to identify client needs and demonstrate the ability to increase “value added” services. More strategically, consider specializing in higher value services (like consulting) and/or speeding up the skills-building process in staff to enhance your ability to command higher fees.
- Realization is calculated as net fees billed divided by gross fees accrued. For example, if $10,000 in “gross” time charges are accrued and $8,500 is billed, realization is 85%. Realization is a measure of efficiency, indicating how well revenues are billed and collected compared to the gross time accrued on client engagements. High realization does not necessarily indicate higher profitability and more likely is an indicator that billing rates are too low. Likewise, low realization does not always indicate lower profitability and may instead result from investing in a strong team and “pipeline” of future firm leaders. Realization varies by service line and by firm size, with tax and consulting typically realizing higher than attest services. Benchmarking surveys have typical average realization rates across all services within firms in the 80% - 90% range.
Action Steps: There will always be “tension” between increasing leverage and realization, but realization rates can often be improved. When delegating assignments, be sure to establish “clarity of commitment” with detailed descriptions of deliverables, by-when dates, time budgets, a return and report process, and written email recaps. In planning client engagements, emphasize the importance of resetting expectations with clients and team members as soon as possible, to avoid and minimize budget and scope overruns. Finally, when reviewing firm financial performance, be sure to perform an “A-B-C” client ranking exercise to raise fees or eliminate low realization client work.
- Margin is calculated as net income divided by net revenue, for example, a firm with net income of $1,000,000 and revenue of $3,000,000 has a margin of 33%. While the first 4 levers focus on firm revenues, the concept of margin brings firm costs and expenses into account. Short term profits can be increased by expense reduction, but for long-term health, firms should not “control” costs by maintaining a low leverage ratio or “scrimping” on training, mentoring or superior technology. In current benchmarking surveys a margin of 30% is considered to be a good standard for most firms.
Action Steps: Margin should be computed for the firm as a whole and for each office, service line, and client engagement. Identify specifically where profits are being made and lost, and seek to improve profits on “losers” by increasing billing rates or “culling” underperforming clients or service lines. Do not lose sight of the strategic importance of investing in recruiting, training, mentoring and retaining people – the highest, most important “cost” in CPA firm business model. Also be patient with newer initiatives that need time to mature and grow in their profitability. Seek margin improvement through higher billing rates rather than lower people costs!
Better understanding of CPA firm economics must also come with a few warnings about “missteps” to avoid:
- Be careful about having too many economic metrics so people are unsure as to firm priorities, and, at the same time, don’t overemphasize one particular metric and drive unintended behavior or results
- Be careful to understand the things that influence various metrics, to avoid misinterpreting and taking incorrect actions, and the possibility manipulating measures aimed at “looking good” while not actually “doing good”
- Be careful not to forget about other “softer” but equally important measures, such as: Are you happy? Are you challenged and growing in your work? Are your people fulfilled? Are you making a difference for others each and every day?
We are committed to helping our CPA firm clients grow profitably by making sure all professionals from staff to partner understand CPA firm practice economics and the 5 Key Levers. If you, dear readers, have any ideas or experiences to share on this subject, please post them so others can benefit.