you’d think accountants could agree on a common definition. nope.
by marc rosenberg
the rosenberg practice management library
if you asked the president of a fortune 500 company or the owner of a restaurant to define profitability, they would be able to give a quick, definitive answer. not so with cpas.
surely, you’ve heard the story, perhaps apocryphal, of the company that was interviewing for a new cpa firm. only one question was asked of each candidate: “how much is two plus two?” the firm that won the bid gave the answer, “how much would you like it to be?”
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the same can be true of cpa firm profitability. how do we measure it? you would think that the uncontested champions of measuring financial data, cpas, would have this down to a science. but such is not the case.
the two most common measures are income per partner and partner income as a percent of fees. income as a percent of fees tends to range from 30 percent to 35 percent, with the most profitable firms earning beyond 40 percent of fees. but each measure has some significant flaws, all relating to the standards used for making someone a partner. some firms have very high standards for making people partner, while other firms are quite generous in bestowing the title of partner. because the computation of these two measures of profitability depends upon the number of partners in a firm, and the standards for who is invited to be a partner vary widely from firm to firm, it can be difficult to compare ipp or income as a percentage of fees from firm to firm.
i’ve read some articles citing a number of more scientific methods for measuring profitability. many suggest that the income statement of the typical cpa firm fails to consider the owners’ labor and capital. therefore, these expenses need to be imputed. for example, the cost of an owner’s labor might be imputed by multiplying his/her billing rate by the firm’s billing rate multiple. after imputing these costs, a typical firm’s net income as a percent of fees might be 10 percent to 12 percent instead of 30 percent to 40 percent under the more traditional methods.
although this approach seems inherently logical, there are serious flaws in it. firms with high billing rates – which i have consistently found to be one of the best correlates of financial success in cpa firms – will show higher imputed salaries for the partners and, thus, lower net income. this makes no sense. also, firms that require partners to maintain significant levels of capital will have higher interest expense imputed, which results in lower net income. this also distorts the picture.
the best definition of profitability is a blend of the following:
1. what the firm’s budgeted profits are. some firms – not many, in my experience – actually do for themselves what they do for their clients: they estimate expenses and revenues, and the difference between the two is the budgeted profit. very simple. if the budget calls for the partners to each earn $300,000, and the firm actually earns $400,000 per partner, then they are “profitable.”
2. what the partners want to earn. everyone has different standards. i know some partners who earn $150,000 a year and don’t know what to do with their money. i know other partners who earn over $300,000 a year and seem to live paycheck to paycheck. to some, quality of life is paramount, and they aren’t willing to sacrifice their personal lives to make a few more bucks. to others, making more money is the driving force in their lives. they can never make enough.
this definition may not be as satisfying as some of the more traditional measures. and i certainly am not suggesting that firms ignore the traditional measures used in map surveys. but a blend of what your budget is with how much you want to earn is probably the best measure of firm profitability.