Successful management of assurance and advisory (A&A) services practices require a firm to meticulously track and measure profitability factors. The factors that contribute to profitability: productivity, realization, leverage, overhead, and compensation can be observed as interior angles of a pentagon—the center being profit per partner.
The performance pentagon is a framework that graphically represents the profitability factors and is used to supplement monthly financial statements and budgets to actual comparisons. In addition, it allows the firm to juxtapose the current relationships between the factors and the partners’ profitability. Any A&A firm, or its individual practice offerings, can use the pentagon to set targets for the factors and monitor progress in achieving them. A&A practices that offer various niche services, such as healthcare, business valuation, or strategic planning, can also adopt the performance pentagon to review the profitability of the niche service. The performance pentagon can establish key metrics when projecting a particular service’s expected profitability.
At the top of the performance pentagon lies productivity, which represents the amount of partner (whether equity or non-equity) and staff activity that can be billed to clients. An A&A services firm’s productivity rate can be quantified by multiplying the number of partners and staff by forty hours (to determine total available hours), then dividing that number by total hours actually billed
For example, ten partners and staff at forty hours per week have 400 potential billable hours—if 240 hours are actually billed, the productivity rate would equal 60 percent.
The productivity rate represents the average of all partners and staff that provide A&A services, meaning, total available hours must include hours of all professional staff, not just partners and principals. Often times, partners will have less billable hours due to other responsibilities. In a recent survey, the billable hours for partners in various CPA firms was 2,450 . This number is significant when considering the standard 40-hour work week is only 2080 hours annually. This translates to a productivity rate of 118 percent.
To maximize profit-per-partner, a productivity rate of over 60 percent is recommended. Huron Consulting, a global Healthcare management consulting firm, reported an operating income increase of 51.3 percent in 2013 ($31.1 million in 2013, from $20.6 million in 2012). Its growth was attributed to an 11 percent increase in average billable staff hours over the past year and a productivity rate of 73.9 percentii. The firm earns more profit if the partners and staff are highly billableiii. To achieve high productivity rates, the firm should minimize the number of hours not billed to clients. Many mid-tier CPA firms average 1450-1,525 billable hours.
One caveat to mention here is that 2080 hours per year may not be the standard against which to judge productivity. Firms should take into account holidays, staff training days, sick days, personal days, and any other non-working days that staff is allowed to arrive at a standard number of hours expected to be billed. For example, if there are 10 holidays during the year, staff are expected to engage in 40 hours per year of continuing professional education, and staff are allowed three sick days and two personal days per year, the total number of potentially billable hours is reduced to 1920. This is the standard against which productivity must be compared. (Some firms include overtime, sick days, vacation and holidays in their total hours for the year. In either instance, there should be a consistency of how total hours are calculated, so comparisons can be made from year to year and across practices. We are not advocating one method over another, just choose a method and use it consistently.)
The formula for calculating productivity rates can also be used on specific engagements or for individuals. Hours actually worked on engagements should be recorded regardless of budget or a client’s willingness to pay. This will avoid potential underbidding on similar engagements and avoid mistakenly assuming that the hours billed on the previous engagement included all required hours. Whether those hours are actually billed to the client depends on the engagement partner and the relationship with the client and the proposed bid for the engagement. In other words, staff should not be encouraged to “eat hours.”
Some individuals will not necessarily have high productivity rates because of their responsibilities for business development and administration. Productivity for individuals who spend time on business development and/or administration should be included in the performance evaluation process for promotion, raises and bonuses. Individual and engagement productivity rates will vary depending on staff level. For example, newly hired staff would be expected to work most of their hours on engagements. As they move up in the organization, responsibilities for administration of other staff would reduce their potential billable hours. Partners and principals have significant responsibilities for administration and generating new clients, and therefore the expectation of billable hours would be significantly less.
In case both employers and employees facing a lose-lose situation, it seems to be possible for firms to move on without the “billable hour”: firms could evaluate the performance metrics for CFOs, controllers, accounting mangers and managing partners based on how well they are doing on the accurate information generated by the finance department, the position they would stand for, the smooth status of cash flow, the quality of updated assigned work, the visibility of the engagement and the contribution they made.
The next point, realization, is measured by dividing the dollars per hour billed on each project by the weighted average of all standard rates established for staff. If $120 is an employee’s standard billing rate, but the firm only bills the client $40, the realization rate is 33 1/3 percent. However, if the firm bills the client at $60, the realization rises to 50 percent. Full realization of rates is desirable; though, the ideal rate should be over 50 percent. If the rate falls below 50 percent, it is possible that the firm set its initial standard rate too high. Other possibilities include poor scheduling, poor training, weak supervision, poor delegation, reducing rates just to get jobs, and/or high volume of low realization engagements. The firm should then determine the minimum acceptable combination of productivity and realization rates for each individual. To compensate for a lower productivity rate, the realization rate must be higher.
In value billing, a method for pricing services based on the value added rather than the amount of hours it takes to complete the engagement, the standard realization rates may be significantly higher despite having infrequent billing opportunities.
In information technology engagements, particularly ones that involve basic coding or forms design, many new hires will be working in the back office. In these cases, productivity rates will be higher because the associates will focus on the required tasks rather than interacting with clients. Consequently, realization rates may be low because many competitors are likely to provide similar services at lower rates.
Between the high leverage services and the low leverage services are such services as strategic planning, financial consulting services, and human resources development. The productivity for these services increases, but realization rates decrease.
The bottom left angle of the performance pentagon is leverage. Leverage represents the ratio of professional staff assigned to a particular engagement to partners. Typically, the ratio should be as high as possible in regard to the type of work performed. For example, five staff working with one partner on an engagement (5:1) will yield more billable hours than a lower leverage ratio and thus, higher profits per partner. The firm, however, should be aware that partners working extensive hours do not have the opportunity to bring in more business through their marketing efforts. This may be good for profits in the short run, but a balance of billable hours and marketing hours is necessary. The average engagement team size at McKinsey & Company consists of one partner, one engagement manager, and two to three associates (5:1)iv. Leverage ratios at most consulting firms can range from a high of 10:1, to a low of 1:1. However there is a recent trend towards lower leverage ratios – clients are expecting more experienced consultants on engagements.
Despite this trend, the ratio is dependent in large part on the services provided. If the partners of the consulting firm are staffed exclusively on high level management engagements such as strategic planning or leadership development, productivity rates will be low. There are not as many of these types of engagements as reviews or basic tax preparation. As mentioned earlier, offsetting the rates with as much realization as possible compensates for low productivity rates. In order to maximize profit-per- partner, the firm should assign the most experienced partners who can command premium rates that will boost realization for these particular engagements.
Across from realization is the compensation factor. Taking the total salary and fringe benefits and dividing by earned services will yield the salary rate. Earned services is the total dollar amount that the firm bills to clients, not necessarily what it collects from them. Compensation, as a percentage of earned services, should be as reasonable as possible. Most firms typically base standard rates for billing clients on employees’ salaries and fringe benefits. Especially for CPA firms who desire to generate revenues and keep clients and repeat major projects each year, performance-based compensation will help them avoid situations of clients’ reluctance or partners’ low financial incentive.
For example an associate consultant (recent hire) at Bain & Company earns $70,000 and has fringe benefits (profit sharing and bonus) of 24 percent of salary, in effect is being paid $86,500 annuallyv. Based on 2080 hours per year, this $86,500 computes to about $42 an hour total cost. Multiplying the cost by three to five is usual in determining standard rates. If Bain & Company uses three
times the hourly cost, it would bill the associate out at a standard rate of $126 an hour. As the service performed by the associate becomes more specialized, the factor used in determine the standard billing rate will increase.
Another example is if a managing partner spends a significant period of time in managing the firm and takes in a $775-800K book of business, the expected income would be $240,000 when this person owns 26%, which is almost the same as the other partners in the firm. Thus, if the compensation is performance-based, this MP will be to available to make the $25-50K on MP duties based on the compensation at $265-290K.
Three types of partners’ performance due to the non-performance-based systems would be:
1) Game-takers: Self-motivated partners who always devote themselves in higher performance without external incentives; 2) Leftovers: Low-motivated partners who performance poorly when competing with talented colleagues; 3) Coasters:
Career-successful partners who reach their performance peak and are hard to motivate.
The last point in the pentagon, overhead, brings in all other costs of doing business. The overhead rate is calculated by dividing total direct and indirect overhead charges by earned services. What percentage is desirable? Obviously, overhead should be as low as possible, but it will vary according to the firm’s size and location. Multi-partner firms typically experience overhead rates in the 20-25% range.
Using the Performance Pentagon to monitor profitability
To use the performance pentagon to monitor profitability, firm management can use a graph to plot points that represent the current rates, target rates, and the minimum acceptable rates for each factor.
In essence, firm management would plot the existing performance pentagon in relation to the minimum and target rates and compare the results on a specific timetable (month by month). By comparing the different pentagons, management is able to answer these questions: Are we in control here? Are we within the bounds set for the minimums and the targets? Should we make any adjustments at this time?
If, for example, realization is outside the acceptable minimum, the firm would need to control it by adjusting standard rates, or by meticulously examining its engagement bidding practices. If the current performance pentagon is inside the pentagon that represents the target rates, the firm would be exceeding its best estimates. For example, if the firm set the range for leverage as 2:1 minimum and 5:1 target, and it achieved 6.5:1 then that point would be inside the target performance pentagon.
The performance pentagon is a graphical representation of the major factors and is an adjunct to financial statements; it can assist partners in managing the firm, its practices, and its engagements. The concept of the iron pentagon is applicable to accounting, auditing, and tax practices. However, the unique nature of many A&A engagements requires techniques and frameworks like the performance pentagon to help manage the firm better. To move forward in managing a profitable firm, the firm should be constantly assessing operating boundaries and making the adjustments necessary to reach its targets.
Dick Savich is President of ABKO Consulting, a business knowledge organization. Savich would like to thankMarc Rosenberg, The Rosenberg Associates Ltd.; Mengfei Zhang, a graduate of the A. Gary Anderson Graduate School of Management; and Kevin Wu, a graduate of the School of Business, University of California Riverside, for contributions to this article. Savich can be reached at email@example.com.