Kitces: The ratios that determine advisory firm success

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As an advisory firm grows, it’s crucial to both measure and manage productivity. This is typically accomplished in two ways and at two levels: by evaluating the time it takes employees to complete various key tasks, and through key revenue ratios that become key performance indicators for the firm as a whole.

By tracking and analyzing these KPIs, firms can potentially learn some surprising truths. For example, some firms may realize they wouldn’t benefit from growing larger and gaining economies of scale. That's because firms that pursue this path tend to attract more affluent clients who generally demand additional services — which offsets any scale-based efficiencies.

If there’s one great determinant of a business’s success, it’s the amount of revenue it can generate from a customer. If that customer doesn’t generate enough revenue to cover the costs of providing the product or delivering the service, the business simply doesn’t work.

In fact, the whole point of so-called cost-plus pricing is to determine the raw cost of a product or service — including the overhead to create, deliver and service it, along with what it takes to market and sell it — and then add a little markup for the profit opportunity of the business. That exercise sets the price.

In the context of advisors though, not every client will buy the exact same service at the exact same cost. Instead, the amount of revenue generated from each client will vary based on the size of each transaction for a commission-based model; the size of each portfolio for an AUM model; or, the complexity and depth of each plan for a fee-for-service model. So while in a typical cost-plus pricing exercise, the price of a product is set at a level that will make it both profitable to the seller and attractive to the consumer, advisors know all too well that not every client will be equally profitable.

Granted, this is less of an issue with a fee-for-service model, where pricing is tied most directly to time the advisor spends on the client. That’s because services are either billed directly by the hour or at least are priced based on the estimated number of hours required to deliver the advice. But in a commission-based or AUM model, the amount of revenue generated per client can vary substantially, even as the cost to service each client — the latter being driven primarily by the staff time it takes to service the client — is relatively consistent.

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This in turn explains why it’s so common to segment clients in an advisory firm by the revenue they generate. Indeed, adding services or other forms of value effectively reinvests a portion of the proceeds of an otherwise highly profitable client, in the hopes of increasing the retention of a client who’s slightly less profitable.

Calculating average revenue per client makes it possible to both identify clients who are materially above the average — i.e., those who are either most profitable and perhaps deserve some additional services to justify the firm’s fees — and/or who should be terminated or graduated to another advisor for whom they’re a better fit. And given the typical advisor can only handle about 100 real planning relationships, understanding the average revenue per client also provides an indication of the maximum revenue an advisor can ever earn — e.g., $3,000 per client every year means a maximum of $300,000 per year in revenue for the practice — beyond which growth is only possible through hiring another advisor or finding more affluent clientele.

In fact, industry benchmarking data shows that increasing average revenue per client is key to growing the size of an advisory firm, as firms that grow tend to move upmarket, attracting more affluent individuals who generate higher revenue. Furthermore, those higher levels allow the firm to provide more and deeper services that attract an even more affluent clientele.

While individual advisors are primarily constrained by the amount of revenue per client they can collect, the second key metric becomes the amount of revenue managed per advisor. In essence, revenue per advisor is the core measure of advisor productivity, literally quantifying the amount of revenue that the typical advisor is responsible for generating and managing.

Nonetheless, the overall capacity of advisors to service a certain number of clients is remarkably consistent once advisory firms grow and scale to a certain size. Any other mid- to-large-size advisory firm can use this knowledge to assess its own teams to determine whether they are more or less productive than the average.

Advisor productivity as measured by revenue per advisor also functions as an indirect measure of the advisor’s knowledge capital. More educated, trained and skilled advisors are generally capable of working with more affluent clients and/or generating a higher level of revenue on the time they work in the business. The value of measuring and tracking revenue per advisor is that it helps clarify whether the firm may ultimately be over- or under-servicing its clients relative to the competition. For instance, firms that can only generate $300,000 to $400,000 of revenue per client are, by definition, supporting fewer clients and/or less revenue with each advisor.

Nonetheless, if an advisory firm working with less affluent clients generates less revenue per advisor, it literally means that the firm may be over-servicing its clients — i.e., offering a greater depth of service than it can really afford to deliver.

Conversely, a firm with materially higher average revenue per advisor might need to question whether the advisor is under-servicing clients — i.e., not providing enough value or not adequately maintaining the relationship, such that the client base may be at risk if the advisor were to depart or there was a market decline.

The bottom line is simply to recognize that measuring revenue per advisor is an incredibly important measure of advisor productivity in managing client relationships, especially for firms above roughly $3 million of revenue that have also achieved the basic infrastructure economies of scale.

For the largest advisory firms, the last key revenue ratio to measure is total revenue per employee. This is the ultimate measure of how efficient the firm is in delivering its service offering to its clientele. The revenue per employee metric is also notable because it can actually be used to compare planning firms to other industries and their productivity. In this regard, advisory firms don’t actually stack up very well, due to the fact that they are labor-intensive service businesses.

In fact, the average revenue per employee of even the largest advisory firms — i.e., greater than $15 million of annual revenue — pales in comparison to the revenue per employee of any of the 10 sectors of the S&P 500, based on Craft’s analysis of revenue per employee across industry sectors. On the other hand, relative to other service industries, advisory firms are actually rather productive. Law firms, for example, typically generate only $150,000 of revenue per employee, and public accounting firms fair only slightly better.

But at the most basic level, evaluating revenue per employee allows advisory firms to compare themselves to other businesses, which in turn can help them understand whether they may be more staff- or overhead-heavy than their competitors. Conversely, it may reveal whether employees are more productive in the amount of aggregate work being done for clients, relative to what their clients generate or pay in revenue.

Regardless of firm size, working to understand the various revenue ratios is obviously time well spent. The starting point, however, is to ensure you’re setting and tracking KPIs in the first place.

This article originally appeared in Michael Kitces
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Revenue and expenses Independent advisors RIAs Revenue streams Employee relations Fee-based compensation AUM Practice structure Client acquisition