Over the years I have noticed that expenses are not always what they appear to be. For some reason it is easy to find out what the revenue was but not so easy to discover what all the expenses were. The reasons for this range from ego to just not recording some expenses. The revenue is almost always recorded because it becomes a deposit into an account somewhere. The ego part is, most are very proud to announce what they earned. I visited a firm when an attorney was proudly announcing that she had a million dollar settlement. A grand achievement indeed, but at what cost. It is rare that anyone can tell me what the case cost.
Here is an example that may help show the problem. We discovered a large transfer of funds that was not allocated to any specific expense category and tried to nail it down. Over time we discovered that an activity outside of the firm was being paid for. I really didn’t care if it was a salary, an expense or a charity. All I wanted to know was, what is the category of the expense so that I can do some business analysis. The best business process to follow would be to create a category for the expense and not worry what that category was as long as you know what it was for. Now when I start trending the burden rates, ROI and expenses I can get an accurate view of what is going on.
One of the measures you want to do in a business is determine the ratio between direct and indirect cost. The direct cost would be cost associated with creating the service which the law firm sells. So, for example, the attorney and paralegal salary would be a direct cost. Now you can debate a series of other cost like the case management system. Is this a direct cost for the service or a support tool which would be an in-direct cost? Many firms argue that a lot of their internal process has been transferred to a case management system with intelligence and should be counted as direct cost. As long as you are consistent with how you assign the cost items it really will make no difference overall to the trend analysis. The goal is to try and categorize the expense categories as direct and indirect. Now you can create formulas to track or do trend analysis. What you want to see is low in-direct cost because that cost is not producing revenue. You should have several financial metrics defined, like revenue, burden rate, ROI, and the direct to in-direct ratio to get a good picture of the Firm’s performance.
The same theory holds true in personal finance. While in business we tend to focus on revenue, in personal finance we tend to focus on expenses. The problem here is that we tend to put a favorable spin on the things we like. For example, I have it in my head that the motor home I want cost $36,000. I can work up a budget for this. Actually the motor home I looked at was listed at $81,000 and after discount on paper it was $66,000 and after the trade in was $36,000. So one that wanted it could rationalize that it cost $36,000 and one that did not want it could rationalize that it was an $81,000 motor home. Probably both would be right in their mind, but neither one would be entirely accurate. The reason this is important is, the way you perceive an expense will cloud your judgment. What is the real impact of this purchase? The amount of the expense is only part of the impact. You also have to decide if this is a direct or an in-direct expense. In personal finances a direct expense helps realize your vision. Again you can get in all kinds of discussions over what is direct and what is not. I think business is easier than personal to do this, so let’s look at personal. If our personal vision was to become nationally known educators (we share our knowledge through books, seminars and blogs) who live in their country estate, enjoying good health and a loving relationship, then any expense that supports that vision would be a direct expense. Buying motor homes, paying utilities, or going to the movies would be in-direct. The goal should be to keep direct high and in-direct low.
The intent of the story is to recognize what your expenses are, and also recognize if they are direct or in-direct. If you cannot do that you cannot prioritize expenses correctly. When you are looking at expenses you need to consider the real cost and if it is a direct expense or not to determine the true impact. One of the metrics that is often used is the ratio of direct to in-direct expenses. I would love to hear about your metrics. Other than the standard revenue number, what financial metrics do you use?