Is Gross Margin Percentage a Reliable Indicator of Firm Profitability?

Not always.

You can’t blame a CPA for measuring profitability with gross margin percentage.  It’s the most basic term we learn in Cost Accounting 101.  But paradoxically, it’s not always a reliable measure in CPA firms to measure profitability.

For the reasons stated below, we don’t like using gross margin analysis at CPA firms.  Instead, we advise firms to look at a group of key metrics including realization by partner on his/her client base, realization by staff person and by engagement and overall billable hours of each staff person – all compared to national norms as well as internal budgets.

First, some definitions:

• Gross margin percentage:  The profit after direct expenses, divided by gross fees.
• Gross fees are billable time before WIP write-downs.
• Direct expenses include WIP write-downs plus the labor cost of client service personnel working on client engagements.
• The cost of a client service person is his/her annual compensation divided by the annual number of billable hours that person works.  Billable hours are reduced by time written off.

Each of the following factors can distort the firm’s gross margins:

Gross margin calculations usually do not include the cost of partner labor.  Therefore, partners who are “working partners” (those who perform high amounts of staff-level work themselves instead of delegating it to staff) will report artificially higher gross margins than partners who push down work to staff, simply because the working partners’ costs don’t include the cost of their own labor.  Though partners perform roughly 14% of the total billable hours under their control (per the latest Rosenberg MAP Survey) this figure varies widely by partner.  We have seen many partners (usually at firms under $10M) perform as much as 30-50% of the work they manage.

Gross margins exclude partner labor because it is very difficult to calculate the true cost of an hour of partner labor.  The main complexity is that the true cost of an hour of partner labor has two components that are nearly impossible to separate: a partner’s true labor cost and his/her share of the firm’s profits.  Theoretically, firms can impute the cost per hour of a partner, but this is a tricky calculation; we rarely see gross margin reports that include cost factors for partner billable hours.

Firms frequently are unable to assign the correct level staff person to engagements due to the industry’s widespread shortage of labor.  Rare is the firm that has the desired or healthy mix of managers, seniors and lower-level staff.  As a result, it is quite common for firm personnel, including partners, to perform beneath their competence level because the firm has no one for them to delegate the work to.  When higher level personnel do the work of lower level staff, the cost of labor increases, thus reducing the gross margin percentage.

Staff at firms have widely varying levels of productivity.  A firm’s best staff are in high demand by managers and partners, so these stars’ cost per hour is brought down as a result of the high number of billable hours they achieve in a year as well as the lower amount of their time that is written off.

Newer partners have difficulty getting the “good staff” on their jobs because they are committed to the senior partners.  Conversely, senior partners tend to get the better staff assigned to their engagements. Both scenarios skew the gross margin percentage.

Marginal staff sometimes struggle to find work.  Managers and partners often avoid under-performing staff because they are a drain on overall efficiency and profitability.  The billable hours of these people are low because it’s difficult to find work for them.  They are branded “marginal” because (1) a higher percentage of their work has to be written off compared to other staff and (2) they work slower than the better staff.  The low productivity and high write-offs raises their cost per hour, bringing down the firm’s gross margin percentages.

Conclusion:  There are better ways to measure profitability than gross margin percentage.