Sixty Questions to Address Before Expanding a Business Practice
More than a ‘Swashbuckler’ Approach Is Needed

By Michael Kraten

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JANUARY 2008 - An assault on a new market segment can be exhilarating. Indeed, what CPA would pass up an opportunity to swoop into a sea of competitors and plunder their clients?

Such passion, however, can lead to catastrophe if a firm doesn’t soberly assess its chances of success before launching a new practice venture. Many promising new initiatives have failed, not because a firm’s lust for competition was found to be wanting, but rather because some fundamental detail of business planning was overlooked or poorly implemented.

The purpose of this article is not to discourage “swashbuckler” accounting firms from launching assaults on new markets. Rather, its purpose is to present operational questions that can help pinpoint hidden dangers so business planners can be prepared.

Prospective swashbucklers may blanch at the prospect of methodically poring over volume estimates, cost analyses, and return-on- investment calculations. Nevertheless, if such mundane activities reveal a single “nuts and bolts” problem that can disrupt an initiative, that time may prove to be a wise investment.

The Business Model

Objective 1A. Identify key competitive advantages.

1. Will the firm be able to retain an ideal mix of client service professionals?
2. Can the firm give its professionals what they need to perform effectively?
3. Will the professionals’ work lead to increased client activity and satisfaction?
4. Will the increased client activity and satisfaction help the firm achieve its fiscal goals?

Accounting firms must be very specific in defining the requirements of each of its professional positions. Valuation specialists, for instance, may simply need to maintain their requisite credentials. Eldercare advisors, however, may need the right temperament to interact effectively with seniors and their family members.

Firms should also think carefully about matching the business model with their business goals. A valuation practice specializing in divorce cases, for instance, may do less to attract entrepreneurial clients to a middle-market CPA firm than a personal financial planning practice. On the other hand, a personal financial planning practice may do less to support the growth of audit division revenues than an information systems consulting practice.

Objective 1B. Present statistical evidence that supports the firm’s business model.

5. What is the firm’s primary fiscal goal?
6. What specific competitive advantages will the firm rely on to achieve that goal?
7. What statistical evidence supports the firm’s competitive advantages?
8. Has the firm placed appropriate emphasis on these advantages in its business model?

A firm might establish its primary fiscal goal to be “reducing audit client defections by 50% by providing value-added consulting services.” If, however, statistical evidence indicates that continuous contact with clients throughout the year discourages client defections, then the fiscal goal might be easily achieved by simply interacting with client employees frequently at conferences and community events. In other words, consulting services may neither be required nor desired by clients.

Such statistical evidence may also reveal fatal conflicts of interest that could doom the venture. If an important referral source perceives the new service as a competitive threat, or if a number of audit clients are concerned that the growth of consulting services would distract the firm from focusing on its core assurance function, survey data—or perhaps just simple feedback—from such sources may convince the firm to find some other path to growth.

Objective 1C. Confirm that these advantages will yield profits at various levels of volume.

9. What are the firm’s plausible low, moderate, and high levels of engagement volume?
10. If the low-volume scenario yields a loss, can the firm afford it? For how long?
11. If the moderate-volume scenario yields a profit, is it sufficient to offset the risk of a loss?
12. Considering the costs of rapid growth, is the high-volume scenario truly achievable?

Most conventional business plans present profit projections for a single “most likely” volume scenario. A good risk manager prefers to review projections across multiple scenarios; for practice expansion initiatives, a minimum of three scenarios is often advisable.

Many consulting services generate significant fixed costs due to professional liability insurance, membership fees, marketing expenses, and other business requirements. Thus, the firm must assess the profits it expects at moderate volumes in comparison to the losses expected at low volumes, considering the risk that such moderate volumes may never in fact be achieved.

Furthermore, some practice expansion initiatives do not grow to high levels of volume without expending additional resources to take business away from deeper-pocketed competitors. Accounting firms should assess whether such high volumes of business can ever be achieved and maintained profitably.

Volume

Objective 2A. Determine the firm’s maximum capacity of client service volume.

13. What “inventories” must be available in order to conduct business?
14. How much inventory does the firm need to meet its engagement sales target?
15. What constraints will prevent the firm from maintaining these levels?
16. Considering these constraints, what is the firm’s maximum service capacity?

For an example of what “inventory” means in this context, a litigation-support practice may need to maintain a roster of specialists who can travel to client sites on short notice; their contracts may be treated as “direct material inventories” if the firm must prepay for service hours to secure their availability.

Similarly, a firm planning to enter the eldercare business may need a roster of social workers to interact with clients. With three such advisors under contract, a CPA firm might be able to address the clinical needs of up to 600 eldercare clients. If only two advisors are available, the maximum client roster might be reduced to 400.

Many accounting firms track their staff utilization levels in a “pipeline” format of engagements that are “works in progress” or “finished goods.” Such inventories should also be considered at this stage of the planning process.

Objective 2B. Determine the potential market demand for the firm’s services.

17. How much demand already exists within the firm’s current client base?
18. How much additional demand can the firm generate from its current marketing activities?
19. How much additional demand can the firm generate from new marketing activities?
20. Considering these marketing activities, what is the likely total level of client demand?

Accounting firms can survey current clients to establish a base level of demand for new services. In addition, by exploiting advertising opportunities in firm publications, sponsored community events, and other current marketing activities, firms should be able to identify new client opportunities. New practice ventures also introduce a firm to new trade associations, conferences, and publications. Firms should investigate these opportunities thoroughly when assessing market demand, given that unexplored sources of business may be available.

Objective 2C. Reconcile capacity with demand while maintaining service quality.

21. Does the firm’s maximum service capacity fall short of client demand? By how much?
22. Can the firm increase its maximum service capacity safely and effectively?
23. What quality management practices can the firm implement to address liability risk?
24. What is the firm’s single best estimate of likely service volume?

If a firm is reluctant to dedicate significant resources to a new practice initiative until client demand is self-evident, it might consider contingency plans. For instance, it can use temporary employees, outsourcing arrangements, and other short-term solutions to raise service capacity to the level of market demand.

Such practices, though, may necessitate strengthening internal oversight functions in order to ensure service quality. Total quality management (TQM) principles have been applied to practice monitoring functions for years. TQM refers to specific practices that can help prevent problems, test for technical errors, and ameliorate in-house and client-based service failures. These functions may be costly to implement, but nevertheless necessary to an expanded support service capacity.

A firm that fails to increase capacity safely to meet client demand may become a victim of its own success. Even if a firm generates a lot of new business, a single failure to serve a client because of staffing shortages or poor oversight practices can destroy the relationship.

Cost

Objective 3A. Compute costs per period by matching them against revenues.

25. How much will the firm spend on direct client-service functions per period?
26. How much of these expenditures will be accrued for completed engagements?
27. How much of these expenditures will be accrued for billed engagements?
28. After matching these expenditures with revenues, what profits will be earned per period?

A standard pipeline of consulting activity involves the application of staff resources to client engagements before engagements can be completed, and the presentation of engagement deliverables before completed engagements can be billed. Accounting firms rely on staff-utilization data to monitor the first function, and on client cost-sheet data to monitor the second function.

Consulting projects often feature unusual terms for “completion” and “billing.” For example, certain projects may call for retainer-style billing, in which case services may be billed before they are performed and completed. Other projects may require reports to be approved by the board before bills can be issued, in which case services may not be billed until well after engagements are completed.

Objective 3B. Establish special policies for costly client or project niches.

29. Are certain services more costly to produce and distribute than others?
30. Are certain clients more costly to serve than others?
31. What cost drivers most influence these differences?
32. Can these differences be minimized, absorbed, or passed along?

A financial advisory practice may find it far more costly to analyze complex hedge-fund derivative investments than direct equity investments. Similarly, an eldercare practice may find it far more costly to provide care-oversight functions for Alzheimer’s seniors than for physically frail seniors.

A firm should identify and assess the cost drivers that produce such differences from a risk-management perspective. For example, if a lack of qualified staff is driving such cost differences, then staff-sharing joint ventures with other firms may be worth consideration. On the other hand, if a lack of qualified staff can be addressed only through reliance on costly independent contractors, the benefits of the new line of business may not outweigh the risks.

Cost differences alone should not deter a firm from entering new lines of business. They can be managed via oversight activities, justified by ancillary service revenues, ameliorated through flexible progress billing practices, or passed along within higher fee structures.

Objective 3C. Establish risk management systems for exceptionally risky cost drivers.

33. Which of the firm’s cost drivers may be the most unpredictable?
34. From a cost perspective, what is the worst-case scenario for these items?
35. If this scenario ever occurs, will the firm be aware of the causes?
36. If this scenario ever occurs, will the firm be prepared to implement risk response activities?

Risk managers may be justified in dropping an attractive practice expansion opportunity if the probability of incurring a significant loss is high, or if the cost of a relatively improbable loss is potentially catastrophic.

For example, an actuarial advisory practice may be unduly risky if losing clients because of a shortage of qualified staff at some time in the future is highly probable. Likewise, a tax-shelter practice may be too risky if even the low probability of being targeted by investigators for tax fraud would threaten the firm’s existence.

Furthermore, if a professional liability company believes that a new service is unreasonably risky, it may increase premiums to the extent of making the new service unprofitable. If an insurer opts to carve out the service from coverage instead (e.g., when daycare oversight activities are carved out from eldercare policies), then a firm must consider self-insuring against potential risks.

A good risk manager should identify specific cost drivers, assess the attendant risks of loss, then consider risk response and internal control systems that can mitigate those losses. These elements should all be incorporated into the practice expansion plan.

Revenue

Objective 4A. Consider a discount-off-standard fee strategy.

37. What will be the firm’s revenues, variable and fixed costs, and operating margins?
38. How many clients will the firm need to serve to produce its target profit?
39. Will the firm’s volume growth lead to sufficient earnings growth?
40. Will the firm be able to use price discounts to attract new clients?

After computing margins on a standard-fee basis, a firm should consider a variety of short-term, growth-oriented discounting options. For example, an absorption-cost discounting strategy would involve establishing a discounted fee structure that would generate sufficient revenues to cover staffing and overhead costs but would not generate profits. A more aggressive, variable-cost discounting strategy would involve a fee structure that would generate sufficient revenues to cover staffing costs but would not cover overhead or generate profits.

In highly competitive markets, some firms decide to set fees very aggressively when starting up operations, but shift to more profitable fee levels as volume builds toward the target profit level. Before implementing such price increases, however, a firm should consider how clients would react.

Objective 4B. Consider the competitive implications of a fee strategy.

41. Do competitors price their services rationally?
42. How might competitors react if the firm implements an aggressive discounting strategy?
43. Is a destructive price war with competitors avoidable?
44. Should the firm charge standard fees for some services, and discounted fees for others?

Some firms may respond emotionally, perhaps even irrationally, when faced with the prospect of losing clients to a new, fee-slashing competitor. Accounting firms should identify these competitors, then consider their likely behavior when planning a new venture. Because timing is everything, a firm may wish to consider introducing discounts at a time when its chief competitors are least prepared to respond to them.

Certain competitors may not be accounting firms. For example, law firms may compete for tax-advisory clients, whereas software companies may compete for information technology clients. Because these businesses have very different pricing models than accounting firms, responding to their challenges may require developing creative discounting models.

Objective 4C. Consider offering extremely deep discounts to specific clients.

45. Do any prospective clients already have special relationships with the firm?
46. Will the firm benefit from developing special relationships with new clients?
47. Do legal issues affect the fee strategy?
48. Do tax issues affect the fee strategy?

A new litigation-consulting practice may need to offer discounted fees to law firms that are partnering with the organization’s existing mergers-and-acquisitions practice. Likewise, a new actuarial-consulting practice may need to offer discounts to longstanding audit clients.

When sales taxes and franchise fees are imposed in certain markets, accounting firms may need to offer deep discounts to clients in those markets. Such discounts can be risky if clients in different markets discreetly compare notes on their consulting fees. Without such discounts, however, the effective cost of the accounting firm’s services may exceed their perceived benefits.

In certain markets, regulatory constraints may also require consideration. If a firm is considering expansion into a state that bans CPA firms from accepting certain forms of sales commissions, or restricts their ability to hire attorneys, investment advisors, or other professionals, then the firm may need to increase its fee levels for permitted services to adjust for these opportunity costs. In such circumstances, significant premiums (as opposed to deep discounts) may need to be imposed.

Investment Value

Objective 5A. Assess the impact of cash flows on value.

49. Will cash balances remain at acceptable levels throughout the start-up period?
50. Will operating, financing, and investing cash flows be balanced?
51. Will profits be earned on an accrual basis as well as on a cash basis?
52. Are these conclusions highly sensitive to changes in future assumptions?

In a typical start-up scenario, accrual-basis income, operating cash flows, and investing cash flows are all negative in the early stages of growth, while financing cash flows are positive. Then, after the breakeven point is achieved, income and operating cash flows turn positive, while financing cash flows turn negative.

Timing considerations can make or break a business plan from a cash-flow valuation perspective. If there is a risk that financiers may need to be repaid before the breakeven point is reached, the new initiative may fail. Similarly, the initiative may fail if there is a risk that the breakeven point may be reached in terms of income while operating cash flows remain negative.

Many new lines of business muddle through years of mediocre performance, draining funds, and managerial attention from more worthwhile activities. To avoid such scenarios, accounting firms should not hesitate to drop such ventures when they fail to achieve minimum standards of success.

Objective 5B. Design a risk-management system that optimizes value.

53. How will the professional evaluation function reflect residual-income standards?
54. How will the performance incentive plan reflect economic value-added standards?
55. How will the firm’s growth plans reflect return-on-equity standards?
56. Will the firm’s risk-management system protect these standards?

Arithmetically, residual income (RI) equals the difference between actual income and minimum required income; furthermore, minimum required income equals the minimum required return on investment (ROI) times the capital required for start-up purposes. Thus, conceptually, RI represents the extent to which profits actually exceed minimum requirements. If a new practice slips into negative RI, its managing partners may be placed on probation, replaced, or dismissed.

Such steps cannot be taken lightly. The dismissal of a partner because of failure in a poorly conceived venture inevitably drains a firm of valuable talent. The reassignment of a partner from an existing line of service to a new one likewise deprives existing clients of that partner’s expertise. Thus, the minimum requirements that define the RI standards must not be set too low; rather, they must be established at a level that compensates for these prospective or actual losses.

Economic value added (EVA) is similar to residual income, but it employs an average return statistic (usually the weighted average cost of capital) in place of a minimum return statistic, and it employs net assets in place of capital. Thus, conceptually, EVA represents the extent to which actual profits exceed average expected profits. When a new practice generates positive EVA, its managing partners should be rewarded.

Mathematically, return on equity (ROE) equals profits divided by equity; it can be disaggregated into three components: asset growth (assets divided by equity) times sales growth (billing revenue divided by assets) times profitability growth (profits divided by billing revenue). When developing a new practice, accounting firms often focus on asset growth initially, then sales growth later, and finally profitability growth.

An accounting firm should design its employee and operations management systems, including professional review, compensation, oversight, and internal control systems, with an emphasis on these fiscal performance outcome measurement standards. Furthermore, risk-management systems should be designed with an emphasis on maintaining a consistently high set of RI, EVA, and ROE measurements.

Objective 5C. Develop a continuous quality improvement system that maintains value.

57. Has the firm’s original business model survived the planning process?
58. How will the firm measure each relationship within the firm’s business model?
59. How will the firm analyze and report these key measurement indicators?
60. How will the firm ensure the continuous improvement of its new initiative?

A firm must think broadly about any inherent contradictions between the five sections of this business-planning model that may lead to failure. For instance, if a CPA firm is planning to introduce a financial advisory practice for elderly clients with significant investment assets (as defined under “Business Model”), its communication processes (as described under “Volume” and “Cost”) should not emphasize Internet modalities if these clients are technologically unsophisticated.

A firm should develop quantitative and qualitative performance indicators to manage each key relationship of the business model. In addition, the managing partner should review all indicators; employee indicators should be shared with the director of human resources; infrastructural indicators should be shared with the director of information systems; and client indicators should be shared with the director of marketing.

Finally, remember that new ventures must find a home within the existing family of products and services that are maintained by accounting firms. Although certain events may be beyond the control of new practice partners, understanding how such events could impact the value of the firm is very important. For example, even though a financial investment advisory practice may enjoy initial success by recommending successful investments to its clients, the firm’s overall value may diminish if those investments unexpectedly sour and the clients lose faith in all of the firm’s business recommendations.

Why Bother?

This five-section question-and-answer format is designed to reflect the rational line of thought that accountants follow when thinking through business plans. Certain topics covered by this approach are not included in the planning guidelines published by the Big Four and other professional organizations, yet are fundamental tools of management planning and accounting.

For example, when planning new initiatives, accountants should ask the following:

  • How will the new practice actually operate and succeed on a day-to-day basis? This is addressed under “Business Model.”
  • Is the managing partner prepared to deal with inevitable, but hopefully infrequent, service glitches and staffing shortages? This is addressed under “Volume.”
  • Are engagement partners prepared to deal with unexpected, but perhaps inevitable, variations in labor costs by modifying their recruitment and retention plans? This is addressed under “Cost.”
  • Are engagement partners willing and able to slash fees in order to respond to the aggressive actions of competitors? This is addressed under “Revenue.”
  • Will client service and administrative support professionals at every level of the firm support its commitment to quality? This issue is addressed under “Investment Value.”

The model above produces answers to management questions that accountants will likely need to ask while contemplating new growth opportunities. Any individuals developing a practice expansion plan should ask themselves the questions above during the planning process.

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Michael Kraten, PhD, CPA, is founder and president of Enterprise Management Corporation, Milford, Conn., and an assistant professor at Suffolk University, Boston, Mass.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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