PROFIT CENTER APPROACH TO SALES
by Carol Hammes
Use this proven method to analyze the profitability of every sale.
Insurance companies, hungry for more business, have been cutting some good deals with agents who have been savvy enough to ask for them. Carriers that previously had been giving an extra five points on business taken from another company are now giving agencies an extra 15 points on their entire book. These extra commission dollars have gone a long way to offset the reduced income resulting from soft-market premium levels. But even the largest agencies have a finite amount of premium dollars to spread around. And constantly switching of accounts from company to company is expensive and sometimes not in the customer’s best interest.
Unless you can keep expenses at or near current levels, profitability will eventually start to erode. This scenario makes the budgeting process all the more painful. Growth has to come from actual new accounts, either produced internally or acquired from someone else. It’s essential that the cost of putting these new accounts on the books and servicing them not exceed the cumulative income that they’ll produce. Simply to have more business is not the goal — it must be more profitable business. Whether growth comes by acquisition, internal production, or a combination, you need to target the type or size of accounts that will make money for your agency.
Until the latest generation of computer systems, it was often difficult to gather enough detailed information for more than a gut feel about the source of the agency’s profits. Now it’s possible to conduct a far more accurate analysis. Start by collecting information about the income and expenses associated with selling and servicing the major lines of business. This evaluation should yield a breakdown of three major groups of business written by the agency:
- Accounts currently profitable
- Accounts that could be profitable if sold or serviced differently
- Accounts that will continue to cost more than they bring in regardless of how they're treated
It might not be possible to get rid of unprofitable customers, particularly for agencies in small towns. But you certainly don’t want to target this type of business in the future, either by individual sales or through an acquisition. And if you must continue to service an unprofitable group of accounts, make certain that the rest of the business your agency writes by can more than make up the difference.
PROFIT-CENTER ACCOUNTING
The first step in the analysis is to set up profit center accounting for the major departments: generally Commercial Lines, Personal Lines, Life, and Health. If smaller Commercial, Contractors, Professional Liability, or some other type of business is handled separately, set up profit centers for them as well. Management will be in a much better position to make crucial sales, servicing, and marketing decisions if they have cold, hard facts to guide them. The more detail you can develop, the better. Agencies that have not used any type of profit-center accounting in the past, however, might want to start with a basic breakdown of commissions and gradually add more sophistication and expense detail. The administrative costs of the information-gathering process should not outweigh the benefits received.
The first step in constructing a profit center is to allocate the various income items. Net commissions and contingents directly received from business written by the department will be relatively easy to identify. To develop net commission, subtract brokerage commissions paid to outside agents or service center fees paid to companies from gross commissions. The Commercial Lines profit center might also have fee income and finance charges. In Life and Health, there might be expense reimbursement that the agency treats as income.
The allocation process becomes more difficult with contingent income received from multi-line companies. The easiest (although perhaps not the most accurate) way to separate this bonus income between Personal and Commercial departments is to apply the respective percentage of total premium placed in that company by the particular department against the total contingent income received. Investment income can be divided using the percentage of agency billed premiums in each department.
The next step in setting up a profit-center accounting system is to assign direct expense items to the respective departments. They might include:
- producer compensation for the accounts sold and serviced in that part of the agency
- CSRs, marketing/placement personnel, loss control/claims people, and clerical assistants who spend 100% of their time in that particular department
- related employee benefit and Workers Compensation costs
Allocate purchase payments and amortization related to the acquisition of a book of business to the appropriate department. If the acquired book has a mixture of different types of business, the most appropriate allocation of costs would be to use the respective percentage of commissions from each type of business, rather than the premiums.
Dividing up other expenses is more difficult; you might have to wait until you have additional information or time to proceed with a detailed program. Many agencies initially make a year-end calculation for the indirect expenses, rather than trying to divide them up between the departments on a monthly basis. After a couple of years of making these calculations, you’ll be in a better position to apply them on a monthly basis if you so choose. To do this, either add the formulas to the actual profit and loss statements prepared by your computer system or simply apply them against month-end results through an Excel or Lotus worksheet.
To determine the allocation of indirect compensation costs, first ask each of the employees who work for various departments to estimate the number of hours they spend in each. Then apply the appropriate ratio against the total W-2 compensation, plus related employee benefits and Workers Compensation premiums. If these people don’t have a good feel for where they spend their time, have them track their activities for a month or two. The receptionist should track how many calls and walk-ins are for Personal Lines, benefits, or Commercial Lines. Claims people can estimate the amount of time spent or count the number of claims handled for Commercial and Personal lines. Word-processing, mail, and file clerks can count the number of pieces that they handle for each department.
Because accounting department employees spend more time on agency-billed business, the percentage of this billing type for each line of business might be the best way to allocate these people. However, if they’re allocating producer commissions manually from direct bill statements, they might actually spend more time in handling business written with this billing method, (particularly in Life and Health, where there can be numerous company statements with small renewal items). Top management, the office or operations manager, and/or the computer coordinator might find it difficult to decide how much time is spent in any one area or might spend varying amounts of time from year to year. In this case, apply the percentage of total commissions received from each department against their compensation.
You’ll need to make some additional judgment calls for allocating operating and administrative expenses to each profit center. Depending on the nature of the expense and the way the agency handles it, you can apply five different allocation factors:
- Premium factor: percentage of total agency premiums in that line/department
- Commission factor: percentage of agency commissions in that line/department
- Billing factor: percentage of agency-billed premiums in that line/department
- Account factor: percentage of total number of agency accounts in that line/department
- Personnel factor*: percentage of total number of directly allocated people assigned to that line/department
[* Administrative and other non-allocated personnel are not included in this head count. For example, if there are three people in Personal Lines, five in Commercial Lines, two in Life/Health, and five producers, the personnel factor for Personal Lines would be 20% (3 divided by 15).]
Here's a list of selling, operating, and administrative expenses generally found in independent agencies with an indication of the most frequently used factor for profit center accounting purposes. In some cases, these factors will have to be adjusted to fit individual agency circumstances.
- Travel/entertainment/promotion-Most of these expenses are for Commercial or Group Life/Health accounts or prospects, and can generally be applied to the appropriate area by reviewing the producers' expense reports and other documentation of calls made and travel expended.
- Automobile allowance-Commission factor for the producers' books of business, excluding Personal Lines unless outside calls are made for that book.
- Advertising-General name-recognition ads should be allocated by commission factor, with specific marketing programs applied to the department for which prospects are being targeted.
- Occupancy/telephone/equipment rental/data processing/depreciation on fixed assets-Personnel factor.
- Insurance-Premium factor for E&O and personnel factor for office package with Group insurance and Workers Compensation handled as part of compensation costs.
- Legal fees-Allocate directly for specific purposes or use commission factor for general legal costs.
- Accountant fees-Commission factor for financial statement preparation and tax returns, billing factor in agencies using accounting firm for bookkeeping or batch processing.
- Taxes/licenses-Commission factor for general taxes and personnel factor for licenses, with payroll taxes being handled as part of compensation costs.
- Dues, subscriptions and contributions-Commission factor.
- Supplies/printing-Commission or account factor.
- Postage-Account factor.
- Outside services-Allocate directly or use commission or personnel factor, depending on which seems to be the most appropriate.
- Education-Allocate directly as compensation costs or use personnel factor.
- Bad debt write-offs-Allocate directly.
- Interest-Allocate directly for agency acquisition; use commission factor for internal perpetuation; use billing factor if the agency has had to borrow as a result of poor collection practices.
- Amortization-Allocate directly for agency acquisition; use commission factor for internal perpetuation items such as covenants.
- Deferred compensation-Allocate directly for agency acquisition; use commission factor for internal perpetuation and producer-vesting payments.
- Officer's life/director's fees-Commission factor.
- Miscellaneous-Allocate directly when the exact expense is known or use commission factor.
Profitability and Sales Management
Additional enhancements can be made after the profit-center accounting system is up and running and everyone feels relatively comfortable with its accuracy. For example, within certain departments, there may be work groups or teams that deal exclusively with one type of business entity (such as contractors) or with one line of business (such as professional liability). Profit centers can be set up for any group of accounts that has a determinable stream of income and direct personnel assigned. Results can then also be used for purposes of establishing bonuses for the people involved.
Even if you decide not to develop formal profit centers for sub-lines or teams, it's possible to gather some specific information on the relative profitability of each line or group of accounts. This is the same type of analysis that you would do if you were trying to determine the profitability of a certain size of accounts as well. Divide the number of accounts that are in the group into the total commissions to determine commissions per account. If the computer system keeps track of all transactions even if they are not invoiced, you might want to use transactions per account and commissions per transaction for the analysis. This could be even more valuable than simply using commissions per account.
The table below illustrates the profitability calculation for a book of Main Street Commercial business with 200 accounts and total annual commissions of $120,000. Producer compensation and related sales expenses are 35% of commissions. There is one CSR, whose salary and benefits cost is $30,000 per year. Overhead for other support personnel, advertising, and operating expenses runs 34% in this agency.
Data such as this can help the Sales Manager make decisions about whether the agency should continue to target this business-and if so, how it can be made more profitable. This might mean adjusting or eliminating producer commissions, changing the number or type of service personnel, changing procedures, or using automated systems. If all options are explored and there seems to be no way to make this type of business profitable for the agency, get out of this line. Over the past 10 years, a number of agencies around the country have identified books of business that they cannot handle profitably and have actually sold them to other agents. At the very least, you need to keep the producers from actively pursuing more of these accounts by restricting or eliminating their income from that business.
In this example, one solution might be to reduce the producer's commission percentage after the first year and pay the CSR to be a little more active in the servicing and renewal process. If the producer's commission is reduced to 20% on renewal and the CSR is promoted to Account Manager and paid $34,000 in salary and benefits, the account would produce a profit of $99 rather than $36 and would be contributing 16.5% to the bottom line rather than just 6%. If you retain the account for five years, the agency will net a cumulative profit of $432.
Assuming that the agency can handle such an account profitably, the next step might be to encourage the producers to bring in more. For example, you could increase the new business commission percentage to 40% for the first year. This would reduce the total cumulative profit to $402 per account-but if there are 100 more accounts because of this incentive, the agency is way ahead. What you do not want to do, however, is increase the producer commission for new business without doing your profit-center homework. The last thing you need is a flood of business that costs you more money to handle than it brings in.
Carol Hammes, CPCU, of the Middleton Group was one of the most knowledgeable and effective agency management consultants in the business. She will be sorely missed.