How Does Your CPA Firm Measure Profitability?

By: Michael Platt, publisher, INSIDE Public Accounting

FrontPageImageAs we wind down the 25th annual INSIDE Public Accounting National Benchmarking season, we wanted to dig a little deeper into the questions on everyone’s mind: How profitable is my firm? How do I compare against my peers? Seems like a pretty basic question, and given the fact that we are part of a community of CPAs, you would think that it would be a pretty simple answer.

But you would be wrong. After reviewing over 500 surveys, talking with managing partners around the country, and fielding questions on this for months, it is quite clear that “profit margin” means different things to different people.

If profit margin (net income as a percentage of net revenue) is the gold standard of measuring profitability, the fact remains that there are many variables that firms consider when coming up with their “number.”

View the 2015 Best of the Best

View the 2015 Best of the Best

The biggest variable comes in defining what net income consists of. Traditional measurements of net income assume that net income is measured before any compensation, draw, bonus or salary is paid to equity partners. INSIDE Public Accounting has used this measurement in its National Benchmarking Report for years. Why? Because there is little consistency among firms. Consider these various compensation strategies:

  • Pay a small livable wage as a draw and motivate partners by splitting up a larger piece of the profits at the end.
  • Assume that the firm will be doing well and pay partners a higher wage during the year.
  • Take profits and fund a deferred compensation program.
  • Reinvest in the firm by taking some profits off the table.
  • Distribute all profits to equity partners each year.

The flaw in the traditional measurement of net income is that it assumes the cost of partner labor is zero.

Leverage, therefore, plays a big role in defining profitability based on this approach. In firms with lower leverage, where partners are responsible for a larger share of the billable time, profitability will be significantly higher than in firms with greater leverage. Does that mean a low-leveraged firm is “doing better?” Maybe not.

By promoting a manager (where cost of labor is counted as an expense) to an equity partner (where cost of labor is not counted as an expense), profit margin will increase, and net income per equity partner will decrease (everything else being equal). Is the firm doing better or worse as a result? We need to find a way to level the playing field so that leverage does not skew comparisons inside firms and between firms.

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Many Ways To Calculate The Cost of Partner Labor

If partner labor is included as part of “cost of goods sold” in an accounting firm, it should give a clearer picture of true profitability. IPA’s National Benchmarking Report has used the traditional measurement of net income in determining profitability for years, but recently we began looking at this critical number in different ways.

Consider these three ways to measure a truer cost of partner labor:

Method 1 – Assign a flat rate per equity partner for a cost of their labor. If a senior manager costs the firm $150,000 a year, assign a flat rate for partner time of $200,000 per year as a cost of their labor. This is a simple, straightforward approach that approximates the cost of labor quickly and easily.

Method 2 – Calculate a cost to the firm of partner charge hours: For every charge hour billed by a partner, divide the billing rate by the selected billing multiple of the firm to determine the cost of labor for those billable hours, and only count the cost of billable time. For a partner charging $400 per hour, this would likely be around $100. The average equity partner may charge 1,000 hours, so the cost of that labor would be $100,000 per equity partner.

Method 3 – Calculate the cost to the firm of all partner hours: Presumably, non-charge hours are being spent productively and are of value to the firm, whether it is in relationship building, client acquisition, referral relationships, staff development and mentoring, etc. Take that same $100 and multiply it by total work hours of equity partners. For a firm with average partner work hours of 2,400, that would represent a cost of labor of $240,000 per equity partner. (Note: Often, partners wear their total work hours as a badge of honor, with some working 2,800 to 3,000 hours per year. The cost to the firm should reflect that total time commitment for a truer picture of partner labor, so $300,000 for those partners is not unreasonable.)

In my opinion, Method 1 is the simplest, and Method 3 is the most accurate. Method 2 discounts the value of non-charge hours and is not reflective of the value of labor provided by partners.

Adding this extra calculation to compare profitability from one year to the next internally, and in comparison to other peer firms, gives you a much clearer view of how well you are doing. It is well worth the extra time to get a much more accurate view of how profitable your firm is.

How IPA Can Help

The 2015 IPA National Benchmarking Report offers detailed information on CPA firm profitability, including a look at traditional profit margins as well as a measurement that includes a flat $200,000 labor cost to the firm per equity partner. The data comes from more than 500 firms across the nation and is presented by revenue band and by geographic region. Order the full report today or read the executive summary.