Ask VeraSage: Is $250,000 per employee the max a CPA firm can achieve?

I received an incredibly thought-provoking email from Jonathan Iannacone, CPA, who blogs as well.

Ron,I hope this email is not too presumptuous but I consider you one of the rare thought leaders of public accounting. I subscribe to VeraSage (RSS) and am always happy with the thought provoking discussions that you create.First a disclaimer: I run a small CPA firm that specializes in outsource CFO services for growing businesses. I do not charge hourly (all FPAs) and I do not use timesheets. In short I am a raving Firm of The Future believer.I would like your thoughts on a question that continues to bother me regarding the K[ey] P[erformance] I[ndicator] we use at the firm, Revenue per Employee.Recently a list from Inside Public Accounting (IPA) came out listing the Best of the Best accounting firms for 2008 (top 25 and then next 25 honorable mentions). Using the data from that table, you can crunch the numbers to get partner/staff, rev/partner, and rev/employee results. For me, the Rev/Employee is most important since is let's me fact check my own firm goals.Looking at the numbers it made me questions a few things:

1. Is there a terminal velocity for Revenue/Employee for CPA firms? Data seems to suggest that whether your $6M or $600M, California or Arkansas, that $200K per employee is pretty much what the best firms do.
2. Timesheets or no timesheets? Does the admission of a terminal velocity render the argument meaningless because at the end of the day it is whatever the market will bear and this list pretty much tells us what that number is? In other words, are there "no timesheet" and "timesheet" firms side by side in this list that scale in the very same way and limit out at the same point?
3. How can we rethink the PKF to escape these constraints. Is there a way to "productize" and package it in a way that makes it infinitely more scalable (Turbo-tax and QuickBooks seem to point to yes).

I would love to have your input as to what the numbers are telling you and how you would then go about moving and addressing the questions that inevitably arise.Thanks in advance for any time and knowledge share.Sincerely,Jonathan

Jonathan attached an Excel spreadsheet that crunched the numbers from the IPA article, computing revenue per partner, revenue per team member, and revenue per all employees.The highest revenue per all team members was from Gerson Preston Robinson & Co., of Miami Beach, FL, at $250,685.The lowest was Novogradac & Company of San Francisco, CA, at $118,092.Jonathan asks difficult questions, ones we around VeraSage have discussed for years.The first issue you confront when looking at studies like this is to realize that these firms are pricing by the hour, which is a self-imposed ceiling on any organization's income potential.The Firm of the PastAs my colleague Tim Williams says—with a little exaggeration, but you get the point—if you sell time, and want to make a million more dollars, you have to charge a million more hours.Not a very effective lever for creating wealth. This is what we call The Firm of the Past, and it's theory is as follows:

Revenue = People Power x Efficiency x Hourly Rate

All of the firms in the IPA report have, in effect, the above theory as their talisman. I detail the problems with this theory in my recent Journal of Accountancy article.This is why we believe a new model is needed among Professional Knowledge Firms (PKFs) that leverages the real source of wealth in our knowledge economy: Intellectual Capital (IC).The Firm of the FutureHence, our New Practice Equation, or what we call The Firm of the Future:

Profitability = Intellectual Capital x Effectiveness x Value Price

This enables a PKF to leverage its IC in a myriad of ways, rather than relying on the head count of billable hours.Jonathan's second question is an excellent one. All of the firms in the IPA report use timesheets, and price by the hour. So we don't have a controlled experiment within those firms where we are able to study the differences in results.The best we can do is look at the firms we know that have trashed timesheets and implemented Value Pricing. These firms are, of course, much smaller than those in the IPA report.When you run those numbers, you find pretty much the same results—that is, not much over $200,000-$250,000 per employee.Though we do have some firms that top over $300,000 per employee, mostly sole proprietors, which tend to be the most profitable firms on the planet.Eventually, we will have Top 100 firms whose performance we'll be able to compare to timesheet firms, but I don't expect radically different results.Keep in mind that we are not advocating eliminating timesheets so that firms will be wildly more profitable. We are advocating their elimination because we think they are demoralizing to knowledge workers, along with measuring exactly the wrong the things.If they made no difference in the profitability of firms, wedd still rally for their elimination.To Jonathan's third question about re-thinking the PKF model to escape these constraints, that is exactly what our New Practice Equation is designed to do.I think you are right on about "productizing" PKFs intellectual capital so they can generate what we call "sleep revenue"—money you earn while in bed. You can't do that if you're selling hours.We have seen some innovative advertising agencies doing exactly this. They are creating their own portfolios of IC, thereby escaping the constraints of selling time.Among our CPA Trailblazers, what we are seeing is more investment into their "invisible balance sheet." O'Byrne & Kennedy (OBK), in Great Britain, for instance, has created a knowledge bank wherein it captures its IC so it can leverage it across more customers.In the long-run, this will make OBK more valuable, with a higher resale value, since it's not dependent on the IC in the heads of its owners.But this is a long-term strategy and it will not show up in the revenue per employee calculation anytime soon.Looking at these revenue per employee numbers also teaches that there are no economies of scale in a PKF. So firms that are merging as a source of growth are not getting any great gains in that area.PKFs are incredibly labor intensive, and until the business model changes from selling time to selling IC, I don't think you will see great movement in these numbers—regardless of whether timesheets are kept or trashed.One more point is worth mentioning. Value Pricing will, inevitably, help push up the revenue per employee numbers, while allowing the firms to do so with fewer customers.This is a change from economies of scale to economies of scope. Fewer customers equates to more profitability.But Value Pricing is limited to the value firms create. If all they want to do is play financial historians by offering attest and low-level compliance work, then unless they innovate new product and services to climb up the value curve, they are going to struggle to break the $300K barrier, let alone any higher.Another number I would love to see calculated for these firms is revenue per customer, which would shed some light on these firms' value propositions.In any event, this is not meant to be the final chapter on this topic. It's precisely this ceiling that inspired Paul Dunn and I to write The Firm of the Future.How long it takes for the New Practice Equation to diffuse throughout the profession, let alone impact on these calculations, is anyone's guess. Mine is past my lifetime.[I will have a future post on this very topic of the time it takes for new theories to diffuse within professions, in the form of a book review. The book I just finished has literally blown my mind, and has made me far more pessimistic regarding the ability of firms to change from selling time to selling IC. Stay tuned].As always, I welcome any and all comments from our Fellows, Trailblazers, and readers on this very thought-provoking analysis from Jonathan, and the questions he raises.