Read David Maister’s Managing The Professional Service Firm.
This is the first piece of advice I give to new managing partners and aspiring consultants. Maister retired in 2009, but is considered the country’s most respected and go-to source EVER on managing professional service firms.
With that build-up, I’m now going to be sacrilegious and dispute a concept of his that continues to be abused by surveys and journal articles presenting their flawed interpretations. It’s called LUBRM (sometimes referred to as LUBRUM). It’s a formula for computing income per (equity) partner (IPP), the CPA profession’s measure of profitability:
Leverage x Utilization x Billing Rate x Realization x Margin = IPP
Maister didn’t intend for his formula to actually be computed, he was merely identifying the 5 most important ways to increase profitability. But that hasn’t stopped practice management surveys and other consultants from making the LUBRM calculation, and it pains me to see it.
The following definitions, which interestingly are not from Maister but others interpreting Maister, are fairly reasonable:
- Leverage is measured by the ratio of professional staff to equity partners. Non-equity partners are included in the staff headcount.
- Utilization is measured by calculating the average annual billable hours by professional staff. This is not the proper definition of utilization, but I won’t quibble.
- Billing rate is computed firmwide. Divide the firm’s revenue by the firm’s overall billable hours.
- Realization is the percentage of total firmwide billable hours worked that is actually billed.
- Margin is the total equity partner income divided by the firm’s revenue.
Why the LUBRM calculation is misleading
The Rosenberg Survey, now in its 20th year, is the country’s most authoritative MAP survey for small and medium-size firms. It provides us with a unique “test laboratory” of CPA firm data. We selected a sample of 25 firms and computed IPP, using LUBRM. On average, the LUBRM IPP was 29% lower than the actual IPP. Similar results occurred when we examined data from a private MAP survey we have access to.
One other point: Various publications make the flawed assumption that each of the five factors is weighted evenly. Maister didn’t even provide us with a key for measuring the five factors, so he certainly didn’t suggest a weighting. If he did, I feel the brilliant Maister certainly would not weigh them evenly.
So, the LUBRM formula doesn’t work. Maister never intended for his formula to actually be computed; he was merely identifying the most important factors that determine profitability.
Math nerds will find this unsettling: NO formula exists that accurately computes CPA firm profitability. Trust me. I’ve tried to find it for 20 years and have given up.
What Really Makes CPA Firms Profitable? addresses►the essence of CPA firm profitability ►benchmarking ►marketing and the bottom line ►strong management and leadership: the most reliable path to profitability ►25 best practices that move firms from good to great ►what does not seem to be important to firm profitability ►40 great ways to improve CPA firm profitability.
The 4 most important factors in profitability- per Rosenberg Survey research
No other metrics are close to these four for correlation to IPP:
- Revenue per (equity) partner- It’s actually one of two major forms of leverage. Staff to partner ratio is the other. This metric is omitted from the LUBRM formula. Here are some of the ways firms boost revenue per partner: Partners always push work down to staff; Develop and train staff to perform the work delegated to them; Have a higher bar for who makes partner, Making better use of the non-equity partner position; Firm growth is focused on, with an emphasis on acquiring larger business clients, which enables partners to manage a larger client base.
- Revenue per person. It’s a measure of the firm’s efficiency; how many people, from partner down to file clerk, does it take to get the client work out? This is omitted from the LUBRM formula. Here are some of the ways firms boost revenue per person: World class training and mentoring; Efficient staff scheduling system; Admin is performed by skilled professionals (firm administrator, directors of HR, marketing and IT) instead of partners; Proper supervision and monitoring of staff on client projects.
- Billing rate. Maister includes this in his formula.
- Staff to partner ratio. Also included in Maister’s formula.
We like to refer to these as the Big 4 profitability metrics.
Some LUBRM factors are really not that important. Caveat: The points made below apply to the vast majority of firms, not outliers. You’ll see what we mean as you read.
Realization. Realization does not correlate very highly with IPP in our surveys. Not because it’s unimportant. But because the vast majority of firms’ realization falls within a fairly narrow band – 80-95%. Firms can usually expect a huge variation in profitability if there realization is 92% vs. 50%. But since most firms do a fair decent job of staying within the 80-95% band, realization doesn’t impact IPP as much as the Big 4 metrics. I would remiss if I didn’t mention this truism about realization: To grade an “A” in realization, your firm’s percentage should never be higher than 90-95%. High realization rates indicate your billing rates are low. Better to have lower realization and higher revenue (boosted by higher rates) than the opposite.
Utilization. Measured by average annual billable hours of professional staff. Similar argument as realization: The vast majority of firms’ staff charge hours fall within a narrow band – 1,400-1,600. We are not saying that high staff productivity is unimportant. We are simply saying that most firms get somewhat similar charge hour rates (albeit low ones) from their staff, so the correlation of this metric to IPP is not as high as the Big 4 metrics. The real problems here are (a) firms lack of efficiency in scheduling work, keeping staff busy and keeping partners away from doing staff-level work and (b) firms’ reluctance to ask for reasonable levels of charge hours (at least 1,600) for fear of infringing on staff’s work-life balance.
Margin. Partner profits as a percent of revenue is one of the most misunderstood and incorrectly analyzed metrics in our profession. When staff-partner ratio goes up – a good thing – it brings down profit percentage. That’s the way the math works. You can’t take profit percentage to the bank, but you CAN take profit dollars to the bank. Who cares what the profit percentage is as long as IPP is high. In the LUBRM formula, highly profitable firms are actually penalized for having relatively low margins, say below 30%.
One more point: Cost control, except for outliers, is rarely a meaningful issue with CPA firm profitability. 90% of all multi-partner CPA firms’ overhead expenses (all expenses less partner comp, staff comp and benefits) are 20-25% of revenue, a narrow range. CPA firms are not big spenders.
So you might want to think twice about using the LUBRM formula. Amazing as it seems, it was not devised as a formula to be calculated. Instead, the intent is to focus firms on the keys to profitability. My recommendation is to look at actual income per equity partner (total equity partner income divided by the number of equity partners), revenue per equity partner, revenue per person, ratio of professional staff to equity partner and equity partner billing rates. CPA profitability is all about leverage and billing rates – keep telling this to yourself over and over.