How Realization Negatively Impacts CPA Firms

IN BRIEF

Despite claims to the contrary, the billable hour is still the most common billing method, and realization the most common profitability metric used by CPA firms. Even with the emergence of other billing protocols such as value billing and fixed pricing, most firms have not progressed beyond these traditional methods and metrics. The authors suggest that, when used as a performance indicator, realization may actually decrease profitability and create a negative work culture leading to increased employee turnover. The alternative, gross profit margin method, promises to be a more accurate means of measuring performance that can increase profitability, provide for more accurate fee proposals, and create a more positive workplace culture.

Realization, calculated as the total amount invoiced divided by the total labor charged for a job, is the most common performance measure used by public accounting firms to calculate the profitability of client engagements. Total labor is determined by multiplying the number of hours worked on a job by a predetermined standard hourly billing rate. These rates vary by position and range, on average, from $75.50 to $322.50 in large firms ($10 million or more in client fees) (AICPA, "National Management of an Accounting Practice (MAP) Survey," https://bit.ly/2JtIyEK, 2018). To illustrate: if a staff member with a standard hourly billing rate of $100 spends 10 hours on a client tax engagement, the manager or partner responsible for billing that engagement would see $1,000 of work in process (WIP) on their billing report. The partner determines that, based upon the scope of work performed, they are only able to bill the client $850 for these services. In this case, the realization rate for this specific client engagement would be 85% ($850/$1,000)-which happens to be the average firm realization percentage for large firms, according to the AICPA 2018 National MAP Survey.

In the remainder of this article, the authors will describe the various problems inherent in utilizing realization as an indicator of staff and firm performance, and its negative effect on firm revenues, profits, and staffing. A simpler and more meaningful way to measure performance-gross profit-may increase profitability, lead to more accurate fee proposals, and reduce employee turnover.

The Issues with Realization as a Performance Measure

The first problem with realization is that "standard hourly rates" simply are not real. Not that they aren't "realistic"; they aren't real in the sense that they only represent arbitrary numbers that the firm seeks to earn for each hour spent, or essentially "sold" to clients, for the work performed. When measuring labor in terms of standard hourly billing rates, accounting firms are essentially using a fictitious revenue driver in hopes of recouping as close to 100% of the hourly rate as possible. Although these standard hourly rates are based upon valid factors, such as compensation that increases with experience, they still are simply hourly revenue goals, not reality.

A second and seemingly larger problem with realization is its potential to create unnecessary conflict between staff and management. Each year, partners generally try to increase the chargeable hours worked by their staff, while also increasing realization on the jobs they are responsible for. As staff feel pressure to work more chargeable hours, they may spend more time than necessary on a specific job or, even worse, improperly report hours spent on engagements in order to hit chargeable-hour goals, thus ultimately decreasing realization. The following year, when staff feel pressure to increase realization, they may choose not to report all the time spent on an engagement. By underreporting

total hours spent on the job, they need to work even more to meet chargeable-hour goals. This spiral of pressure to perform usually culminates during the already overwhelming tax season, when chargeable-hour goals, and stress, are typically highest. Goals set by management to increase performance and profitability can backfire if staff underreport hours on certain jobs to increase realization, and pad hours on other jobs to meet billable-hour goals. Costly errors can result if staff members skip vital steps or hurry through engagements in order to meet hours budgets or realization goals set by management. With partner compensation and goals often tied to performance or client realization rates, asking more of staff who are already overwhelmed causes unnecessary stress and conflict, creates an undesirable work culture, and most certainly contributes to employee turnover.

"Change the Way You Look at Things and the Things You Look at Change"

How can a change in performance measures actually improve performance? First, firms need to forget past practice and get back to basics. Very simply, accounting firms are in the business of buying and selling time. Firms buy time from employees with salaries and benefits and resell that time to clients. The sale price should be based on cost plus a desired profit margin. However, most client fees are based upon an estimate of billable hours spent on those engagements. While some have argued against, and in one case even written an obituary for, the billable hour (T. Williams, "An Obituary for the Billable Hour," 2016; https://bit.ly/3mttupd), it is still very much alive and well.

In 2018, firms with client fees greater than $10 million reported that about 62.5% of their billings were hourly based. This percentage is even higher for firms with net client fees between $1.5 and $5 million (80%) and $5 and $10 million (75%). Firms also reported using other billing protocols, such as value pricing and value billing, fixed pricing, and per-form tax fees, but to a much lesser degree. In effect, the profession must address the problems brought about by focusing on realization as the main performance measure utilized by accounting firms, while understanding that the billable hour continues to play a crucial role in the majority of firms today. The solution: Simply change the performance measure used.

As providers of service for fees, public accounting firms are no different than other service entities seeking to measure performance. How do most of those entities measure financial performance? Gross profit-as presented above, the standard hourly rate accounting firms utilize is essentially a fictitious revenue driver representing a goal that firms seek to charge for each hour of service, while employee cost is a driver that is real and can be easily determined. The authors propose that firms use employee cost as the firm's "cost of goods sold."

Using data from the 2018 AICPA National MAP Survey for firms with greater than $10 million in net client fees, one can see how this methodology would essentially work. The approach is the same for firms of any size. According to the survey, salary expenses are 40.3%, retirement plan costs are 1.1%, and payroll taxes and other employment expenses are 6.8% (combined 48.2%) of total firm income. If these are considered the firm's "cost of goods sold," the average gross profit margin for these firms would be 51.8%. Recall that the average realization rate for these firms is 85%. These figures are all very similar to and substantiated by the 2018 Rosenberg Survey, which lists realization as 85.1% and staff salaries/benefits as a percentage of total fees as 48.7% for firms with revenues between $10 and $20 million ("The State of the Profession. Analyzing the Results of the 2018 Practice Management Survey," https://bit.ly/36qjM1a).

The following example shows how a shift in thinking away from realization to gross profit might benefit a firm's profitability, provide more accurate proposal quotes, and improve relations between staff and management. On average, a senior associate with four to five years of experience receives annual compensation of $68,265. Based on 2,080 total hours worked annually, the associate's cost per compensated hour is $32.82. Using the more relevant cost per chargeable hour as the basis for our measure, with an average of 1,500 chargeable hours per year, the cost per chargeable hour for a senior associate would be $45.51 per hour. Adding an additional 20% (slightly higher than average), or $9.10 per hour, for benefits brings the total hourly cost per chargeable hour to $54.61. Compare this to the average standard hourly billing rate for a senior associate of $161. In this example, consider a client engagement that takes a senior associate 10 hours to complete. Assume the partner determines that the maximum they can charge for this engagement is $1,200. At a standard hourly cost rate of $54.61 per hour, and 10 hours spent on the engagement, a total of $546.10 would be reflected in work in progress (WIP) at cost. Marking this cost up to achieve the average gross profit margin of 51.8% would result in an invoice of $1,133; therefore, the actual invoice of $1,200 would provide an above-average gross profit margin of 54.5%.

Using the realization method for the same example, total WIP of $1,610 would be calculated ($161 standard hourly billing rate x 10 hours) representing a realization rate of only 74.5% ($1,200 total amount invoiced ^ $1,610 total amount incurred), more than 10% below the average 85% rate the firm likely desires. The partner then may admonish the associate for spending too much time on the job, thus lowering that partner's realization numbers and ultimately affecting their compensation. If the associates feel as though they must then underreport chargeable hours and therefore work more in order to make up any chargeable hours goal deficit, this may lead to an unsatisfactory work/life balance, one of the most commonly cited reasons for employees to leave public accounting. Utilizing realization as the performance measure in our example, the firm believe it fell short of its goal by more than 10%; whereas utilizing the gross profit margin approach, the firm would be happy to come in almost 3% over its target. Realization as a metric might lead to negative performance evaluations, while gross profit margin might result in positive performance feedback.

It is important to remember that, under either measure, the hypothetical firm's profits are exactly the same- but the satisfaction of both partner and staff are much different when looked at through the gross profit margin lens.

Creating a Positive Culture

A change in perception of profitability and job performance would undoubtedly lead to a more positive work culture overall. Such positive cultures have been shown to actually make employees more productive and firms more profitable. Research shows that high-pressure workplaces, such as at public accounting firms during tax season, experience 50% greater healthcare expenditures, and thus generally higher health insurance rates than other organizations, with more than 80% of doctor visits due to stress. Stress in the workplace has been specifically linked to a wide variety of health problems including cardiovascular disease. In addition, poor workplace culture leads to costly employee disengagement: 60% more errors and defects, 18% lower productivity, and 16% lower profitability (E. Seppälä and K. Cameron, "Proof That Positive Work Cultures Are More Productive," Harvard Business Review, 2015; retrieved from https://hbr. org/2015/12/proof-that-positive-work-cultures-are-more-productive). Finally, a negative work culture leads to increased costs due to turnover. Research has proven that workplace stress leads to almost 50% of voluntary turnover. The estimated cost of recruiting and training a single employee varies widely; however, most studies place the cost of replacing an employee at six to nine months' salary on average (C. Merhar, "Employee Retention-The Real Cost of Losing an Employee," 2016; https://bit.ly/36s7jtE). While turnover rate has decreased in recent years-down to 10.70% nationally for public accounting firms as of 2018- it is still almost twice the national average compared with professional service firms overall. (BLS, "Job Openings and Labor Turnover - June 2019," https://bit.ly/2VCqCdT, 2019).

Using gross profit margin analysis when responding to requests for proposals (RFP) may help increase both close rates and overall profits. Consider the same example discussed above. In determining an estimated fee quote to respond to the RFP, the partner would most likely try to achieve the minimum average realization rate of 85%; in that case, the proposed client fee would be $1,368.50. Keeping with the assumption that the maximum fee acceptable to the client is $1,200, the firm would most likely not be awarded the work. If, however, the partner bid on the job to achieve the average gross profit target of 51.8%, the proposal would be $1,133, thereby falling within the client's acceptable range and providing the firm with a much better chance of being awarded profitable work. The difference in measure comes from nothing more than utilizing actual cost drivers (cost per hour) to determine job profitability, as opposed to somewhat arbitrary revenue drivers (standard hourly rate). Increasing profitability and productivity, creating a more positive work culture, and reducing voluntary turnover can be as simple as removing a misguided performance measure. *

at the State University of New York at Fredonia, and operates Mark A. Nickerson CPA PLLC, in Buffalo, N. Y. Linda Hall, PhD, CPA, CMA, CGMA, is a professor of accounting and interim director of the school of business at the State University of New York at Fredonia.