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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

Brilliant, simple.

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".

Yay profit.

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?

Not necessarily.

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.

Posted: Dec 06 2008, 07:16 PM by Krupo | with 6 comment(s)
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FMcKenna said:

Oh Krupo,  Such a complex subject....  I've written many posts on this, but let me try to explain it in a few sentences.

First of all, I can;t picture a "negative profit margin" but I do know you can have a "negative unbilled" situation.  That is explained here.www.retheauditors.com/.../making-money-chicago-way-early-and.html

Think of your internal timesheet and expense report process as contributing to the firms "cost accounting" process, not its calculation of "profit" as in profit that is taxable or that would be reported on financial statements to the public or a bank. Some firms are better at this cost accounting process than others and so they have more accurate information for planning, forecasting, pricing and evaluation of engagements/clients and partner's/manager's performance.  Some do not.

Your time is billed to clients at a rate which is artificial, but has a method ot its madness. It's usually developed by taking your salary costs plus benefits and adding various profit margins on top and adding/subtracting for comptetive factors.  

So, for example, say that your salary plus your benefits costs $75 per hour total.  Let's assume you work in IT Audit and the market for IT Audit in financial services companies is $150 per hour for someone at your level.  Every time you charge an hour on your timesheet, it is valued in the cost accounting system at $75 cost and $150 revenue going out.  

Now let's say that your engagement was sold with a total revenue figure based on a budgeted number of hours that equates to $160 per hour.  Your cost accounting system shows a "profit of $75 dollars an hour for each hour charged by you on the timesheet.  But depending on total number of hours charged (actual hours that go through the timesheets against that number budgeted) and the mix of hours actually charged versus priced into the revenue number by level of professional (This is where the leverage model comes in) the actual profit on the engagement is the amount you can bill the client (which may be not all the hours charged to timesheets or may be more or may be less) versus the amount charged through on timesheets.

Yes, it gets worse.  Suppose you have professionals told to eat hours - not charge hours to your engagement or to the actual charge number.  What's screwed up is the cost accounting information. Overall, as Krupo has pointed out, the firm gets in revenue a certain amount and pays out in expenses, salaries and other types another amount, no matter what you put on your timesheet (or maybe exactly what you do, if an engagement is billed on actual hours charged like a staffing firm.)  

The audit firms are partnerships, which throws another monkey wrench into the discussion.  Partners get paid as a profit distribution basis and this calculation is very focused on taxable income to them and to the firms. In the US it's not GAAP. It is also very short term focused, with firms not keeping as many reserves or holding onto cash for common goods as you would see in other types of companies.  As much as can be paid out in a year is paid out.  A partners chance to earn under this  model is limited and varies from year to year.  It's very much a cash flow type of calculation.

So enough for one comment.  I am sure you can take this further and extrapolate to many other kinds of issues, like overtime, paid or not, and what happens when overtime is worked and does not ever get paid.  How do price engagements when you don't know how long they will really take (such as in new things like Sarbanes-Oxley) ?  How do you manage budgets when you have a deadline and some folks get paid overtime?  And then there is billable and non billable travel time and expense....

Ok, I'm tired. My brain hurts.

# December 6, 2008 10:37 PM

bdirenfeld said:


Yeah definitely didn't factor in other costs.  It does make a lot of sense that these need to be considered when determining bill out rates.  I just find it difficult to reconcile engagement profit with firm profit from a conceptual standpoint.


"But depending on total number of hours charged (actual hours that go through the timesheets against that number budgeted) and the mix of hours actually charged versus priced into the revenue number by level of professional (This is where the leverage model comes in) the actual profit on the engagement is the amount you can bill the client (which may be not all the hours charged to timesheets or may be more or may be less) versus the amount charged through on timesheets."

Definitely didn't think about staff-level and corresponding variances in bill-out rates.  So much still to learn.  Not sure if this makes sense, but can you think of uncharged time as an opportunity cost?

# December 7, 2008 4:52 PM

Krupo said:

Thank you for the gritty details Francine - some excellent points there. I remember during the UFE process being taught my our instructors that the companies we work for don't report their OWN financials using GAAP. You could hear some peoples' brains imploding at that point. The topic of "time" will be discussed tomorrow at a high level.

The fun part about these "brain hurting" discussions is that you always have additional interesting things to discuss.

BD - for opportunity cost, that would be time you could spend working on client XYZ instead of client ABC, if you only have enough staff to work on one instead of the other...

# December 7, 2008 5:13 PM

michaelk said:

You're absolutely right about the firm revolutionizing process... I've been tasked with bringing in control testing, as well as implementing and maintaining an IT infrastructure (email servers, backup servers, VPN, etc) and I've been loving the task, but I've been rushing to implement it without learning about the personalities I'm dealing with. I'll definitely take that advice to heart.

# December 30, 2008 12:23 AM

Krupo said:

Whenever you have the chance to get to know the people you're working with before you dive headfirst into the details, that's a recipe for 'win'.

# December 30, 2008 11:00 PM

Krupo said:

If anyone's looking for the math behind how to more precisely calculate a profit margin against say, a markup, this article offers good reading: www.buildingtrade.org.uk/.../markup_or_margin.html

# December 31, 2008 1:32 AM