Max Foster sat in his office on a bright May morning contemplating a problem that had been bothering him for several weeks. Max was the managing partner of a relatively small consulting firm in Calgary that was experiencing substantial growth in its revenues. The firm consisted of 3 partners, 12 senior consultants, and 30 junior consultants. They specialized in the design of major drilling operations in difficult terrain.
The firm prided itself in compensating its consultants very well and giving them an opportunity to do very interesting work. Max was wrestling with an erosion of the profitability of the firm in recent months as revenue was increasing, a strange occurrence that he could not explain. He expected that the decline in profitability was due to very high fixed costs in a volatile market. Their offices were in a magnificent building in downtown Calgary, which cost them $3,000,000 per year in rent. The offices were fully furnished with all the latest office furniture and equipment, which was being depreciated at the rate of $250,000 per year. There were eight office staff and the full cost of administration was $360,000 annually. Each of the professional staff consumed supplies in doing their work at the rate of $10 per hour billed to clients.
The firm had lost some recent bids for business and Max worried that their costs were not well understood. He wanted to change the way they accounted for their costs and how they compensated their consultants.
Each of the partners expected to earn $300,000 per year before profit sharing, while the senior consultants were paid between $125,000 and $150,000 per year. The junior consultants were paid about $75,000 per year, on average. The partners spent about 50 percent of their time promoting business and the balance actually doing consulting work. The rest of the consultants were not expected to do client promotion work but to concentrate fully on consulting.
Max's idea was to change the compensation package to every professional staff member, partners, senior consultants, and junior consultants to an arrangement whereby they received a base salary and additional compensation calculated on the basis of the number of hours billed to clients. In addition, every professional staff member would receive an expense allowance based on the number of hours billed, to be used at their own discretion.
He would pay partners a base salary of $100,000 per year and $100 per hour of productive work, excluding client promotion. Senior consultants would be paid a base of $75,000 plus $50 per hour billed to clients, while junior consultants would be paid a $60,000 base salary and $10 per hour billed. The expense allowance would be $50 per partner per hour; senior consultants would get $6 per hour billed and the junior consultants would get $2 per hour billed.
Max believed that consultants should bill a minimum of 1,500 hours per year and would ideally bill 2,000 hours per year to clients.
Required:
1. Determine the cost formula for each category of expense that Max is contemplating.
2. Estimate the total cost of running the business if each professional bills an average of 1,500 hours per year and if each professional bills 2,000 hours per year.