Profit Margins: How they work, for accountants and others
A profit margin for a large factory can be reduced to a simple formula. You sell your product for X, and it cost you Y to make it. That makes Z your profit.
X - Y = Z
A young accountant can be forgiven for following into the following trap:
Here’s the thing that confuse me the most. Profit per file should be
fees, less the the prorated salaries of the employees doing the work.
But, under a billable hours system profit margin is the difference
between the final fee and billable hours. So you can have a negative
“profit” margin - i.e. go over budget - while still making a profit
from the firms perspective.
It's a clever idea, if you're thinking like an economist: Marginal Revenue which exceeds Marginal Cost is considered a Good Thing, if you're keeping things simple.
The problem is that the above idea, while attractive, doesn't capture true costs. It might come close, but there's other factors at play.
If you work with your friends you may just try and add up your cost "Y", and subtract it from the money you earn, "X".
As your business gets bigger and more complicated, however, what gets included in the costs, "Y", increases, dragging down your profit margin.
Those mega-parties aren't cheap, you know.
If "Y" is simply the amount of money you pay yourself, your friends, and whatever taxes you owe the government, then the above theory works.
But larger companies need to pay for their many employees, their perks, plus expenses like marketing, insurance, rent, legal fees, training - the list could take all night to write.
So if your accounting firm is earning more in fees than your employees are paid, are you making a profit?
The bigger you are, the more complicated, and expensive, things get. You need to earn enough money to not only pay your staff, but also all your fixed and variable costs, plus enough so you have a decent profit margin for the owners.
You start learning about costs in your first accounting class so I'm not going to rehash that topic. And only an anarcho-syndicalist would argue that owners don't deserve to earn some profit if they manage their investment wisely.
All this means is that using the benchmark of how much your staff 'seem' to cost would lead to a loss situation in most cases.
Accountants, of all business people, should know when to accept work and when it's actually going to lead to a loss. The math used to arrive at these conclusions is in theory simple, but it often gets increasingly complex.
Over time you'll be exposed to your company's way of tracking the "economics" of your work - where you learn the secrets behind how decisions are made to assign staff to projects. While you're a fresh out of school or just done the UFE you will be fired up to revolutionize your company - which is a Good Thing - but you have to give yourself time to learn about any company - yours, or a client's - before you can really make deep suggestions.
If it's practical, it's a good idea to spend time with people who are more involved in managing your company's costs; you'll learn a lot from them in a faster period of time, shortening the time you spend on the learning curve.
Next time I'll discuss another dilemma raised by Last Year's File: how to deal with the uncertainty of "time" when you're out on a never-ending audit.