One of the biggest struggles for many public accounting firms is the conflict between realization and chargeable time. Each year management will ask staff for more chargeable hours but then at the end of the year complain about poor realization rates. The following year staff will eat their own time for the sake of healthy realization only to be scolded for lack of chargeable hours. This struggle stems from conflicting interest between management and staff; management compensation is based on realization per job while staff is compensated based on total chargeable hours. This struggle exist because many accounting firms still use billing rates per hour as a primary pricing mechanism. This blog post will dig deeper into this long existing conflict and ways to mitigate and even eliminate this problem.
What is Realization?
Realization is a metric used by accounting firms to calculate the profitability of accounting services. The formula for realization is calculated by taking the total number of hours invoiced to the client divided by the total number of hours charged on the job. For example, lets say a staff member with a billable rate of $200 an hour spends 5 hours to complete a tax return. The total amount charged to the job is $1,000 but the partner only wants to bill the client for $800 for this service. For this specific job the realization rate is 80% (4 hours/5 hours = 80% or $800/$1,000 = 80%).
What is Chargeable Time?
Chargeable time is the total number of hours it actually took to complete an accounting job. For example, if a staff member spent 10 hours imputing transactions into an accounting software for a client then the total number of chargeable hours is 10 hours. In theory, the more chargeable hours an accounting firm can produce the more revenue it can collect. For example, if staff members charged an additional 1,000 hours during a year at an average rate of $200 per hour than the accounting firm will have generated $200,000 more in potential revenue. Even if the realization on these jobs is 50%, that is still an additional $100,000 in the pockets of the partners.
Traditional Profitability Metrics and Performance Evaluations
Traditionally the way accounting firms make money is by buying and selling time; accounting firms pay salaried employees for their time and resell that time to clients in the form of accounting services at an hourly rate. Accounting firms can maximize profits by increasing the number of chargeable hours and increasing the realization per job.
By giving staff members incentives to produce more chargeable hours and giving management incentives to make the jobs more profitable you will suspect the accounting firm to increase revenue in direct relationship with these metrics. However, an obvious conflict arises due to competing interest between staff and management.
Performance evaluations for staff members, specifically new staff members, is more focused on total chargeable hours and less focused on realization rates. Although, it should be noted that realization rates that are significantly lower than the average will yield negative performance results. However, this aspect of an employees performance would have already been judged through missing deadlines, inability to learn new skills and inefficiencies when performing simple task.
As a staff members moves up the ranks and his billable rate increases he will be expected to reduce the time it takes to perform the same task. So in this aspect, realization rates should remain constant or increase even though the billable rate per hour is increasing. In essence, realization rates will not portray a complete picture of the staff members performance but will instead give a baseline metric for expected performance.
Managers, on the other hand, are graded on their realization per job. Managers are responsible for budgeting a job, ensuring the appropriate staff members are selected and making sure the job runs efficiently. If a manager has too much chargeable time on a job that was not ultimately billed to the client (low realization) then this will reflect poorly on their evaluations. This pressure to keep chargeable time low on a job is in direct conflict with staff members and staff members will be pressured to cut their time.
Why Realization Is A Poor Performance Evaluation Metric For Staff
Although it might seem prudent to evaluate staff member’s performance based on their profitability on a job, this type of evaluation leads to many unintended consequences. If a staff member’s compensation is based on their realization rates then there is an incentive to “cut” time, either by under reporting chargeable hours or cutting the actual time needed to perform the task effectively. This means staff members will take it upon themselves to decide if time should be charged to the client or left off the time sheets altogether. This reduction in chargeable hours means less potential revenue and overall less profits.
Even worse, staff members who feel pressured to reduce chargeable time on a job will skip necessary steps that are value added to the client. For example, a staff member will have no incentive to analyze their own work or spot check for mistakes. They will instead pass the work onto a manager who will be responsible for finding the mistakes and making the necessary corrections. In the process, the staff member will not be able to spot potential value added services for the client or ways to improve the quality or efficiency of the job itself.
Realization As A Health Metric
Instead of using realization as an indication of individual performance it should be looked at as a health indicator for the profitability of a job. Realization should be looked at in two ways: as a staffing tool and as a pricing tool.
Firstly, poor realization could be an indication that the job is not staffed properly. Either the staff members on the job have too high of a billable rate for the work being performed or the work is being done in an inefficient manner. Realization rates should not be a sign that the job was done poorly but instead as an indication that the job could be more efficient. The main distinction is the use of realization rates as an indication for change instead of a means of evaluation.
Secondly, if time is being cut from a job year after year then this is an indication that the price of the job is not being appropriately reflected in the billing. This has more to do with pricing then it has to do with efficiency. Poor realization on a job could likely mean that the ceiling on the job is too low and a conversation needs to be had with the client.
Alternative Methods Of Pricing To Align Incentives
Traditional billing for accounting services usually comes in the form of hourly billing. The work performed during the course of the engagement is charged to the job and at the end of the engagement the partner decides how much to bill the client. This is like taking your car to a mechanic and finding out how much you owe after the work is performed; not the best system for pricing.
The main drawback to this form of billing is the lack of consideration of the value of service provided to the client. Traditional pricing of accounting services focuses on inputs rather than outputs and charges based on the cost of time rather than the value of service. Instead, accounting firms should give clients pricing options for different levels of service instead of one flat billing rate.
If the price of accounting services are already determined ahead of time and the incentives of the engagement are structured around providing value to the client then management and staff will have the same motivations. Accounting firms should focus more on the price the client is willing to pay for a service and find ways to provide this service using the appropriate amount of capital. By aligning these incentives and rethinking the way accounting firms bill clients, accounting firms can increase both value to the client and profits to the partners.