The Profitability Problem

This is my 100th blog post (Is that all?? Feels like a lot more than that!). As a milestone post, I decided this has to be an extra thoughtful one--I hope you'll forgive the length and find it thought-provoking.

What subject is of greater concern to firms than profitability?

I’ve read reports of high-profile consultants recently predicting record high compensation for partners in 2006 and beyond. I’m not sure on which data the forecasts are based, but I foresee the opposite. Here's why:

Employee costs are rising significantly. Firms are reacting, albeit slowly, to the continuing large numbers of non-partner professionals fleeing public accounting and law firms in search of less pressure, more stimulating work, and feeling valued by more enlightened employers. Promotions (some premature) and raises are used to keep key people when talent is at a premium.

For the past 5+ years, we’ve watched with amazement as law associate starting salaries skyrocket, now running between $100-145K/year and more in some top firms in top and even 2nd tier markets.

In return for those salaries, associates are agreeing to meet the demands of unhealthily high billable hour requirements. Many agree to these conditions because they begin their careers with average law school debt of $75K for top schools, and $45K for public universities. The associates hope they will be able to aggressively reduce this debt and pick up some valuable experience along the way.

The associates are probably unaware they walk into the firm already on the receiving end of some resentment from the senior partners who happen to know a few things:

• It wasn’t very long ago that they were making $150K
• These kids have it “a lot easier than we did” and they’re going to make them work hard for their money
• They’ll have a lot of trouble billing the new associate out at the standard mark-up hourly rate because clients won’t pay that much for the limited experience of a new associate. This means more write-offs, or less desire to use these expensive new associates (hmmm, think there will be even less delegation to these new associates when more experienced people can do the work more "efficiently"? That's a bad enough problem already! And how will they ever learn if they don't do the work -- see the catch 22?)
• There will be a lot less money left over for partners once they have raised the pay of all their other associates to get everybody back in-line, sometimes bringing their 4 or 5 year people up tens of thousands to put them appropriately above the new starting rates.

Smaller law firms – those nowhere near this pay amount – are not exempt from these problems. They face the exact same dilemma, just at lower dollar amounts. Proportionately, the impact to profitability is about the same.

CPA firms are some years behind law firms in dealing with this pay issue because new CPAs are nowhere near these starting salaries. But with the recent change in CPA exam requirements necessitating a fifth year in school, accounting grads are now presenting themselves with Masters Degrees meriting higher pay.

Fewer graduates mean everyone is fighting over those who are at all appealing. Rare, also, are qualified lateral hires since so many people are defecting public accounting, more often hired by clients of the firm than recruited by other firms. Headhunters are more brazen than ever.

As mid-sized law firms have been experiencing for years, CPAs are starting to feel the pinch to their profits of the domino effect that occurs when your new hires come in at the pay of your more experienced people. Raising everyone across the board is costly. Add to that the skyrocketing cost of health insurance and other fringes and incentives needed to compete for talent in the aggressive talent marketplace and, well, we have a big hit to the bottom line.

The business of predictions is a dangerous one. But I'm going on record as saying: the cost of the knowledge worker in CPA firms is going to continue to rise rapidly. I believe it is reasonable to expect salaries for mid- to high-level non-partners to double in the next 5 years. Someone receiving $50-60 now, would be commanding $100+. Say I'm wrong and they don't go up quite this much. They're still going to go up a lot.

Though salaries will never grow as much in smaller firms, firms will have to pay more in order to keep their CPAs. Remember, firms aren’t competing so much with each other for this talent pool as they are competing with private industry and other, more lucrative, professions, such as law, for instance.

That’s just the employee component. Then there is the growing cost of marketing and the new HR/marketing cost component for recruiting.

So, with all these costs going up, where is all this profitability – that these other consultants are projecting to turn into partner compensation – supposed to come from?

I don’t see it coming from significant new business development for two reasons:

1. firms won’t have the capacity to do tons of additional work—first, the talent pool is limited and, second, more capacity costs more money (people) so the net impact to profitability is not great (if measured by profit per person or profit per partner); and
2. the main reason I don’t see it coming from an influx of new business is that firms are not changing their business development behavior to make this sort of result likely.

In fact, as profitability becomes pinched, partners and associates, alike, are told what? They are told to BILL MORE HOURS. And the firm raises hourly billing rates.

It's widely accepted that hourly rate increases have minimal impact on overall profitability. They will increase write-offs, too, though, and reduce realization on jobs that are already price higher than the market will bear.

And what happens when people are grinding away to bill more hours? Every marketing person knows the answer to this one…they hear it all the time, “I don’t have time to market. My charge goal is too high.” 

This goal is counter-productive to increasing new business. I believe it further hurts marketing by decreasing morale which is reflected in service quality. Service quality directly relates to incoming referrals.

Decreased morale leads to loss of key employees--the very thing firms are spending big bucks to prevent. It's a terrible cycle that needs to be broken somehow.

So what *IS* the answer?

The first instinct of most organizations (right behind requiring more billable hours and raising hourly rates) is to cut costs. This, like increasing chargeable hour goals, has a very limited net potential impact. There are only so many hours in a day/month/year. There are only so many expenses that can be cut. Though some firms may choose to let go of some less valuable partners to save money, I don’t see this as a big fix across the board, either. It's potentially another capacity limiting move.

The single greatest factor that can improve profitability is price. It is time to look strategically at pricing and to recognize that the bill-by-the-hour model is flawed in it's lack of scalability and failure to take into account the high-end buyer is quite different from the low-end buyer.

Law or accounting firms that really want to increase profits in a tight and expensive employee market will want to look outside of the old way of pricing that undermines growth efforts by encouraging behaviors opposite of those needed for healthy growth.

Evaluating and controlling a firm’s capacity by knowledge level, specializing in a limited number of practice areas (service or product oriented) and pricing strategically are three practices that, when integrated, can lead to optimal profitability.

I'll offer specific suggestions in my next post.

Comments

[David Maister]

I think you are entirely correct in your analysis, Michelle. It makes all the senmse in the world.

I await your conclusions with bated breath. I worry that you "give in" too easily on the topic of delegation and leverage (partners just won't, you seem to imply.) It deserves a LOT more attention, as well as the price topic you are going to address. (I hope you will address desrving higher prices, not just playing with pricing schemes!)

[Thom Singer]

Michelle-

Congrats on the 100th post. Keep up the good work.

And you are right, times are changing for professional services firms, and someone will figure out a new business model. Once they succeed, all others will follow them. But there will be some pain associated with the changes for partners, associates, staff, etc...

[HART]

I think in the short-term the ones to suffer will be the upper level group of partners, stuck in their ways of spending money, with vacation properties, or summer houses, and keeping up with the 'Jones' with their partner drawing level .. (taking the draw to equalize because another partner needs the cash and is taking it). Soon there won't be enough cash to divvy up. You can't just keep doubling the rates to charge the clients.

The new associates and junior partners aren't yet used to the downsizing issues and they will not suffer too much, being that their school debt has been lowered. They will survive will lesser pay once their debt is lesser.

Yup .. Early retirement and bankruptcy is what I think will face a growing sector of the aging lawyers and accountants out there .. (i.m.o.). You're right - with this vacancy to come, rates will probably double for these entry level associates, who would now be gaining in their experience, and still be cheaper than the bunch they are replacing.

But how will that fare for the smaller businesses and individuals needing these services? A vicious cycle indeed.

PS: Has it only been 100 posts? Seems like a lot more! Good stuff.

[Nicholas golden]

Congrats on your 100th post, and and a thought provoking milestone at that. Hey,I think I smell dinner burning. Your loving husband.

[Michelle]

David, thanks so much for your kind remarks. Your point about leverage/delegation is a great one and it does deserve much more attention. As such, I will address it in yet another post on profitability. In the meantime, I hope you'll find the pricing post to have been worth the wait and not too superficial on "schemes." I'll look forward to your feedback whether you agree with my thoughts or not!

Thom, thanks for the congrats and for your readership. I think you are absolutely right. And the next business model is something I give much thought to. While some firms are experimenting with a more corporate model, the approach isn't without its pitfalls. I do think it's a step in a better direction, but there is an even better way out there...we all just haven't figured it out yet. Any ideas? :-)

Hart, I appreciate your post. Interesting thoughts, indeed. I hadn't actually thought of bankruptcy in firms, but I suppose it could happen. Seems like owners would much sooner sell or merge than file bankruptcy, though, wouldn't they? Well, either way, certainly the first steps would be pink-slipping excess people, partners and non...

Nick, you're funny! It's a good thing YOU are the chef in the family. If dinner's burning it's 'cause your spending too much time reading my blog!

[Christine Mefferd]

Michelle - I was listening to the Diane Rehm show yesterday and one of her guests was Tamara Draut, author of Strapped. She lends perspective to the 20- and 30-something’s financial situation. I wanted to pass along the link to you because I thought you’d find it interesting. Some of it leans towards the social/political side, but I think you’ll appreciate the commentary regarding the entry-level salaries/school loan debt/talent pool, etc. I personally like learning about generational differences, and I’m especially curious to see how these types of issues will affect business – A topic that is part of your bigger discussion here….

You can listen to it here:
http://wamu.org/programs/dr/06/02/07.php