The Limits of Efficiency - Business Management for Financial Advisers

For the solo model, the major problem is profitability: The more clients the firm acquires, the more it needs to add administrative staff to support them.

When a firm adds administrative staff (this includes management, support staff, and others involved behind the scenes), the cost is charged to overhead expense. In other words, the addition of administrative staff adds nothing to productive capacity.

Broader and Deeper Client Relationships

Broader and Deeper Client Relationships

Overhead costs go up while the firm is at a physical limit in terms of how much new business it can take on, because the owner-adviser can manage only a finite number of relationships.

It’s becoming more apparent that at least in terms of cost, the level of volume that must be generated in an advisory practice is redefining “critical mass.” Critical mass in this context is the point at which a firm is achieving optimal efficiency in its cost structure, optimal profitability based on its client-service model, and optimal effectiveness in the number of clients it can serve well.

In terms of effectiveness, the less time an adviser spends dealing with clients, the more sluggish the business becomes and the less valued it is by the clients themselves. In terms of efficiency, advisory firms would ideally keep their overhead costs as a percentage of revenue below 35 percent.

we observe the costs as a percentage of revenue as practices grow larger. The data from a study we did of financial-advisory practices for the Financial Planning Association in 2004 shows that expenses as a percentage of revenue actually increased as the firms generated more revenue, peaking at an expense ratio of 44 percent when practices hit $1 million in revenue.

The expense ratio declined after that point, as practices became more efficient and added more productive capacity in the form of professional staff. But it isn’t until practices hit $5 million of annual revenue that they consistently achieve the optimal expense ratio of 35 percent.

Economies of Scale

Economies of Scale

Part of this assessment is obviously theoretical—and, in fact, a flight of fancy for many advisory firms that will never achieve or aspire to a practice this size. But at one time, $1 million of revenue and $100 million of assets under management were considered the ultimate achievement. Now it appears that $5 million is the new level of critical mass for an advisory firm. The challenge is to determine how many clients, generating how much in fees, served by how many advisers will a firm need to achieve critical mass by this definition?

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