drive your profits with only four metrics

accounting firm econ. 101, including a sample income statement.

by marc rosenberg
the rosenberg practice management library

all businesses have economic structures unique to their industries:

• grocery stores are high volume, low-profit margin.
• real estate ventures use accelerated depreciation and other tax angles to generate cash flow and healthy rois.
• professional sports teams focus on increasing the value of the franchise so it can eventually be sold for a gigantic profit.

more: a crash course in the business of public accounting | how to get promoted to manager | how to create a path to partner | making partner: what managers need to know | the 17 rules for making partner at a cpa firm | who shouldn’t be a partner? | nine reasons people are promoted to partner | how to make partner?
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the typical cpa firm is a low-volume, high-priced business, with a relatively high-profit margin (generally 30-45 percent of revenue).

• the supply of cpas relative to the demand for them is fairly low. this is because of the high level of technical knowledge required to become a cpa and a longtime decline in the popularity of a career in accounting. most young people do not perceive the accounting profession as exciting. the result is a shortage of labor. this has led to firms operating at lower volumes than they would prefer, but it puts them in a position of charging strong prices.
• cpa firms enjoy their high-profit margin because of a few interrelated factors. first, because of a shortage of staff at the senior and manager levels, partners are forced to perform more billable client work than they would like to or should do. second, many cpa firm partners enjoy doing work that other firms would delegate to staff, which partly accounts for their lofty billable hours (often 1,200 to 1,400). third, many cpa firm partners feel that a good way to increase their compensation is to work harder themselves and employ fewer staff.

one of the main purposes of this post is to provide future cpa firm leaders with an understanding of how their firm operates as a business, including how it makes money and what holds back profitability. with this knowledge, team members will make better decisions about how they spend their time and perform their work.

the vast majority of a cpa firm’s revenue is considered an “annuity” business. clients of cpa firms typically remain with their firms for five to 10 years or more, thereby providing a relatively safe revenue stream that continues every year, primarily for compliance projects such as audits, reviews, compilations, bookkeeping, and tax returns.

most expenses are fixed. even though staff labor is theoretically a variable cost, with the exception of major recessions the headcount at firms stays relatively constant despite fluctuations in revenue. most firms can absorb a healthy number of new clients without increasing their personnel headcount.

also, because of the shortage of labor, most cpa firms are continuously in a hiring mode: if a firm is fortunate enough to come across someone who has a good resume and is available, the person will generally be hired immediately, even if the firm’s revenue volume does not appear to justify increasing head count.

low overhead expenses. cpa firms have low overheads compared to law firms and other businesses. despite earning substantial profits, the vast majority of cpa firms are not big spenders. many have very nice offices but would never be considered lavish. a very small percentage of a cpa firm’s expenses are discretionary.

cpa firms are top-line-driven. in the pursuit of increased profitability, many businesses must either increase revenues or decrease expenses. but cpa firms rarely focus on controlling expenses because there is little excess to trim. instead, virtually all the focus is on increasing revenues.

cpa firms increase revenues by

• bringing in new business and clients
• increasing billing rates
• increasing realization, billing a higher percentage of time spent on client work
• increasing productivity, getting personnel to bill more hours and work more efficiently

increases in revenue drop directly to the bottom line (profits) because these revenue increases rarely cause the firm’s expenses to rise much.

leverage is king. the vast majority of the work performed by a cpa firm is done by staff instead of partners. therefore, one of the top operating strategies of firms is to maximize the amount of client work that each partner can create for non-partners to perform, under their supervision. achieving this high leverage frees up partners’ time to devote to developing business, nurturing relationships with clients and referral sources, and helping staff learn and grow.

bigger is better. any analysis of cpa firm profitability will consistently and conclusively show that the higher a firm’s revenues, the higher its profits will be. this is because the bigger the firm, the more it can afford to invest in sophisticated marketing programs, develop specialties and niches, aggressively pursue mergers, create better training programs and hire high-level professionals in the administrative, marketing, hr, and it areas. all of these tactics attract larger clients (who pay higher fees), more talented staff, and smaller firms looking to merge in.

why should employees care how the firm makes money?

the cynics among you might ask this question. after all, the profits that the firm earns from the staff’s great work go directly into the partners’ pockets, right?

what incentive do staff have to contribute to firm profitability? what’s in it for them? here are four good reasons:

1. some of the profits flow directly to the staff in the form of higher salaries and bonuses. high levels of compensation enable the firm to retain its best people.
2. more money is available for career-enhancing training programs, updated technology, top-notch marketing and other niceties such as modern (not lavish) offices.
3. capital is available to merge in smaller firms and attract larger and more sophisticated clients, creating new client opportunities for everyone, including the staff.
4. when a company’s revenues and profits are increasing, a funny thing happens to office morale: everyone is happier! firm personnel are more fun to be with, more helpful and more willing to work together. bosses are more patient and smile more often.

the opposite of all those things happens when companies struggle. ask anyone who has had the misfortune of working for a stagnant organization that struggles with profitability. it can be miserable.

key definitions

charge hours or billable hours: a cpa firm’s widgets (units of production) are hours. the vast majority of a firm’s revenue is billed directly or indirectly by the hour, so cpa firms pay a lot of attention to the billable hours worked by their personnel.

non-charge or nonbillable hours: all work time that is not worked on client projects. this includes training, firm meetings, business development, vacation, holiday, and sick time.

billing rate: all personnel, from partner to staff, are assigned standard hourly billing rates. these rates, when multiplied by the hours worked on client work, result in a number called gross fees or billable time, which eventually is billed to clients.

timesheet: all charge and non-charge hours are recorded on timesheets. these charge hours are entered into the firm’s billing system and accumulate in the firm’s work-in-process, which is the starting point for generating client invoices.

work-in-process (wip): wip is a receptacle in the time and billing system where all time and expenses are accumulated by client. when clients are billed part or all of the accumulated wip, these billings reduce the wip balances, leaving a net unbilled amount for each client. these amounts are either carried forward to subsequent months to be billed at a later date or written off.

write-offs: cpa firms (law firms, too) are rarely able to bill for 100 percent of their actual time spent on client work. the amount of client work that is not billed to clients is written off. the vast majority of firms write off 10-20 percent of their client time.

there are many reasons for write-offs, including:

• project inefficiencies that cannot be passed on to clients
• discounts given to clients to procure the engagement
• on-the-job training. experienced personnel often use client engagements to teach less experienced staff how to perform their work. this training often cannot be billed to clients.

realization percentage: the percentage of all client work that is billed to clients. the realization percentage for most cpa firms is in the 80-90 percent range.

billings are the actual amount of billable time that is invoiced to clients. the difference between gross fees (the value of all time worked on client projects) and billings (sometimes called net fees or net revenues) is write-offs.

leverage: this term is used in many industries and has a different meaning in each of them. in cpa firms, there are two interrelated ways to define leverage:

• a partner delegating client work to a staff person. the more staff that each partner can keep busy with client work, the more the firm is considered leveraged.
• leverage is measured as follows: if a firm has five equity partners and 25 professional staff (administrative staff are not included in the leverage computation), the staff-partner ratio is 5:1. the staff-partner ratio is a principal way that cpa firms measure leverage.

income per partner: the total earnings of all equity partners divided by the total number of equity partners. ipp is the primary measure of a cpa firm’s profitability.

the four most important metrics used to manage profits

these four metrics are key to any analysis of cpa firm profitability.

1. fees per equity partner. the firm’s billings divided by the number of equity partners. this is one of the ways we measure leverage. the more billings each partner can manage, the higher the firm’s profit margin. on average, partners do 10-15 percent of all work performed for clients; the remaining 85-90 percent is performed by staff under the partners’ supervision. the higher the percentage of client work the partners perform, the harder it is for them to find the time to build their client base and help the firm achieve a high fees-per-partner ratio. to manage a large client base properly, partners need to delegate as much of the client work as possible to staff.
2. fees per person. this is another leverage metric. the “person” part of the calculation is every employee in the firm, including administrative people. firm headcount is measured in full-time equivalents (ftes). someone who works 1,000 hours a year is considered a 0.5 fte. one who works 1,200 hours a year is a 0.6 fte. no one can ever be more than a 1.0 fte, regardless of how many overtime hours they work.
3. staff-partner ratio. this leverage metric is the number of professional staff (all client service staff who are not equity partners) divided by the number of equity partners.
4. billing rates. the rates assigned to each person in the firm that are multiplied by charge hours to arrive at billings.

many years ago, a great and very successful managing partner told me that the key to cpa firm profitability is “leverage and rates,” epitomized by these four metrics.

a typical cpa firm income statement

	amount	percentage of net fees
gross fees	$5,000,000
write-offs	500,000
net fees or billings	4,500,000	100.0%
expenses: staff salaries and benefits overhead expenses* total expenses	2,000,000 1,000,000 3,000,000	44.4% 22.2% 66.6%
total income to the equity partners	$1,500,000	33.4%

 

* rent, office supplies, marketing, insurance, training, it costs, etc.

 

examples of how various actions impact a cpa firm’s profits

assume a firm with eight partners and 28 professional staff.

1. everyone in the firm records only one extra billable hour per week. notice i said “records,” not “works” an extra hour. both partners and staff perform hundreds, if not thousands, of hours on client work that are recorded as nonbillable time instead of billable time. why? it could be sloppiness in keeping track of time. or perhaps someone feels guilty about spending too much time on a task. maybe a manager spends a couple of hours training a staff person on a client engagement and makes a unilateral judgment that the time shouldn’t be billed to the client. in many cases, this extra time can be billed to the client. but if the time never makes it to the billings records, it will never be billed.

• • one hour x 48 weeks per year, x 36 people = 1,728 hours
  • @ blended billing rate of $130, additional revenue=$225,000
  • @90% realization, $203,000 of additional profits
  • no additional expenses should be incurred

2. 18 people each bring in a $5,000 client. assume that half of the 36 client service personnel were able to bring in just one $5,000 client per year.

• • 18 people x $5,000 each = $90,000 of new revenue
  • at 35% incremental profit, that equals $59,000 per year

if the client averages a 10-year tenure with the firm, the present value at 5 percent per year of bringing in this revenue is $300,000.

3. 18 people each lose a $5,000 client. the reverse of #2. if half of the client service personnel in the firm provided such poor service to a client that the client left the firm, the cost to the firm over 10 years would be $300,000.
4. the firm invests time in staff training. assume that managers and partners make the effort to spend more time training staff so that each staff person, on average, becomes able to bill one additional hour per week.

• • one hour x 48 weeks x 28 staff x $100 per hour = $134,000
  • @ 90% realization = $121,000.
  • if training time cost $25,000, incremental profit = $96,000

5. partners push down work to staff and use the freed-up time to bring in new clients. assume the eight partners delegate 100 billable hours each, per year, to staff. further assume that the 800 hours of freed-up time is used for business development and that the result of those efforts adds $400,000 of revenues.
   

if the partners’ billing rate is $250 and the staff’s blended rate is $110, that’s a difference of $140 per hour. if 800 hours of work previously billed by partners is now billed by staff, revenue will be reduced by $112,000.

• • new business: $400,000
  • reduced partner hours: 112,000
  • profit increase: $288,000

it’s important to note that the firm should not reduce billings to clients simply because work formerly done by partners is now being done by staff at a lower billing rate.

6. the staff is not very productive. assume that the firm’s 28 staff average a disappointingly low 1,400 billable hours per year. if the firm can improve the staff’s productivity by increasing the average from 1,400 billable hours to 1,600, a very realistic goal, the firm can make do with 24 staff instead of 28.

• saving the cost of four people at $80,000 each (includes benefits) = $320,000

benchmarking norms for cpa firms

annual fees	fees per partner	fees per person	staff-ptnr ratio	ptr billing rate	income per partner	bill hours ptnrs	bill hours staff
$2-5m 2019 2018 2017	$1,136,669 $1,031,407 $1,045,286	$184,842 $179,102 $172,986	4.4 4.0 4.1	303 295 289	$345,537 $332,717 $334,615	1,163 1,137 1,149	1,448 1,409 1,445
$5-10m 2019 2018 2017	$1,535,836 $1,527,333 $1,491,828	$190,269 $178,746 $178,533	6.0 6.2 6.3	329 318 311	$477,941 $445,604 $422,073	1,148 1,156 1,159	1,472 1,510 1,497
$10-20m 2019 2018 2017	$1,895,655 $1,813,824 $1,773,257	$192,214 $183,906 $176,069	7.4 7.3 7.5	355 343 339	$506,375 $479,451 $473,320	1,043 1,028 1,022	1,493 1,486 1,480
> $20m 2019 2018 2017	$2,543,042 $2,339,067 $2,123,735	$204,616 $200,610 $199,390	9.3 8.7 7.9	406 405 403	$674,711 $643,170 $634,949	1,031 1,034 1,056	1,474 1,448 1,469

source: the 2020 rosenberg map survey. data is for 2019.

 

the term “partner” here denotes “equity” partner.

the main takeaway from this chart is that generally speaking, the larger the firm, the stronger the performance, especially in profits, as indicated by the income per partner metric.

 

to download the cpa firm income statement in google sheets, click here.

 

posted on july 1, 2021