FORMULAS FOR SUCCESS- Why You Need to Run the Numbers

Overhead Expense:390,000 38%

Operating Profit:250,000 24%

That's only a drop of 1% in the profit margin, but it was only an additional $40,000. That means by these usual calculations, for every $40,000 in new expenses, your $1 million firm's margin will erode by 1%. It won't be long before you're working much harder for a single-digit return on your investment. On the other hand, here's how a business analyst would provide five steps to help you quantify hiring that $40,000 staffer and solve your problem

Step 1. To determine your current breakeven revenue level, divide your total overhead expenses by the gross profit margin ($350,000 ? 0.60 = $583,000). Obviously, based on its cost structure, this practice breaks even at a level well below its current revenue.

Step 2. To determine breakeven revenue with the addition of the new hire, divide your total overhead expense plus the cost of the new hire by the gross profit margin [($350,000 + $40,000) ? 0.60 = $650,000].

As you can see, in order to cover the added $40,000 in costs, you need to generate $67,000 more in revenue. How could this be? Because in this example, you have 40% of your revenue going to professional staff, including yourself, and you only have 60 cents of every dollar left over to cover your fixed costs.

Step 3. With the addition of this new hire, how achievable is it to increase your revenue by $67,000 or more? Taking your average revenue per client of $4,000, this means, rounding up, you'll need to add 17 more clients to cover the new hire ($67,000 ? 4,000 = 16.75). Notice we're already up considerably from the 10 clients we thought we'd need to break even.

Now we need to add a profit goal to this calculation, since if you can't increase your operating leverage and financial return with the addition of new people, then you shouldn't do it (unless your goal is to operate a charity to increase the national employment level). In this example, the advisor was dropping 25% of revenue to the bottom line. Let's assume that she wants to make 25% on every dollar of investment in staff. That's an additional $10,000 in this case ($40,000 x 0.25 = $10,000).

Step 4. To determine your breakeven revenue level with the added $40,000 cost, plus the $10,000 additional profit, divide total overhead plus new hire and the profit goal by the gross profit margin [($350,000 + $40,000 + $10,000) ? 0.60 = $666,666]. Subtract the original breakeven revenue level of $583,000, and you've raised your firm's breakeven point by $83,000. The result in this example is oddly Satanic, but the point of the exercise is to get you thinking that profit is a fixed cost just like rent, utilities, and other administrative costs. When you keep this in mind when paying staff, it will help you to understand that staff is an investment on which to generate a return, rather than an expense to control.

Step 5. To determine the breakeven revenue level at which to maintain an operating profit margin of 25%, divide the total overhead plus new hire by the overhead expense margin [($350,000 + $40,000) ? 0.35 = $1,114,286]. In other words, you would need to sell $114,286 of new business (or add the equivalent of 29 clients) to hire the staff person and maintain your margins, by paying yourself and your professional staff $55,714 more compensation to attract and work with those 29 new clients, and yourself $28,578 more profit.

• Here's what a more accurate P&L would look like:

Revenue$1,114,286 100%

Direct Expense455,714 40%

Gross Profit668,572 60%

Overhead Expense390,000 35%

Operating Profit278,572 25%

Unfortunately, most advisors don't consider the increased workload that the existing staff must take on to pay for any new additions in personnel, technology, marketing, office space, or any other expense. The result is that even if you do reach the breakeven numbers you've projected, you and your staff are working harder and longer for the same money (which represents a decreasing piece of the revenue pie). Consequently, you see your firm growing, but feel like you're not getting anywhere, or even moving backwards, while your staff is increasingly unhappy at working harder for the same compensation.

In essence, you've all become slaves to your growing overhead expenses. It's a vicious cycle that can only be broken by monitoring your profit and overhead margins. That doesn't mean you're a profit- monger, enriching yourself at the cost of your helpless clients. But it will save you and your professional staff from the creeping tyranny of your overhead expenses, and enable you to look at overhead as an investment that must boost the bottom line rather than a cost that merely erodes it.

A leveraged practice will allow you to continually push work down to the lowest levels, thereby allowing you and other capable members of your team to focus on where they make the greatest impact, such as getting business or providing sophisticated advice to your clients. The trap for many advisors is the presumption that cutting costs will lead to greater profitability. In reality, if you invest in staff (or technology, or processes) in a way that allows you to leverage better, the net profit dollars will provide you with a return on your investment commensurate with your risk.

Mark Tibergien is a nationally recognized specialist in practice management for financial services firms, and partner-in-charge of the Securities & Insurance Niche for Moss Adams LLP, the 10th largest CPA firm in the U.S. You can reach him at [email protected].