If you don’t know what it costs to deliver your service, you don’t know your business… Johnny Grohovaz
Most advisory businesses are quite content, as long as the amount of commissions and fees coming in exceed expenses and salaries going out. But is it really?
Understanding costs is Business 101. Most businesses know how to cost their products and services. This is essential as it leads to an understanding of profit. Why should the financial advice business be any different? Going forward, it will become increasingly important as regulations change and consumers become more cost conscious.
A Budget for your Practice
The starting point for costing is the practice budget. The total budget amount needs to be allocated across the different services. For this exercise, a budget of R 2,383m is assumed.
Direct Costs
The first step in allocating costs is to work out the “direct” cost of each service.
An indication of the amount and what types of services have been covered in a previous article embed link to article # 3. The ongoing services mentioned in that article are alongside.
For each service, direct costs are based on “time and materials” of the service components. For example, the cost table of the retiree service below shows how the direct cost of R 1 351 is determined.
As there are 200 retirees in this example business, their direct cost is 200 x R 1 351 = R 270 200. Repeating this process for each service allows for the calculation of total practice direct costs. Assume all the direct costs for the different services are R 1,8m. This means R 2,383m minus R 1,8m = R 583 000 will be the “indirect” costs.
Indirect Costs
A practice can spend money on rent, interest, furniture, internet connections etc. It is difficult to allocate these types of expenses to specific services. Hence, for these indirect costs, a different method of allocation is required.
One method is to take the unallocated amount and simple divide it by the number of existing clients. This headcount approach can be inappropriate in certain circumstances. Compare the family service mentioned above with direct cost of R 285 to the wealth management service with direct costs of R 4 854. If all the indirect costs were divided by the client numbers (675), this would result in a headcount cost of R 863. This would quadruple the family service cost whereas, for the wealth management service, the increase would only be 18%.
Another way to allocate indirect costs (or on-costs) is a proportional allocation. It is also possible to use a combination of both of the above methods. See table below:
The process above provides key business insights into the cost of each service. If a client on that service produces more revenue than the cost, then the practice is at least making money on that client.
The next step is to add a reasonable profit margin.
In the coming articles in this series, more information around adding profit margins will be provided.
*My apologies to the author for changing the title. Some of our more senior subscribers may recall this as the title of a Crosby, Stills and Nash song which I think sums up what Fees for Service can lead to.
