Occupancy Costs: “What About Regional Differences?”
Dr. J. writes:
It seems to me it would not be easy to put a set percentage of gross on your office space costs. There is such a large variance on the cost of space across the country.
I live and practice in Williamson County in Tennessee. This is one of the top 50 counties in the U.S. for gross income. I have a small practice that grosses about $400,000.00 a year.
Using your formula, my 2,000 square foot office should be renting for $16.00 per square foot. You can’t touch space in this area for under $20.00 to $25.00 a square foot!
Keep this in mind when you are making recommendations on where your office costs should be.
Paul Mazur, OD writes:
I would have to agree with Dr. J. Of all your expenditure guidelines, occupancy costs, for me, have never been tamed!
I would love to be paying $16-$18 for my 2,000 SF, but the reality is much higher and if practice growth is flat (like they predict), occupancy costs by percentage will increase.
Amazingly, even in this shaky economy, office space to lease or purchase is still premium priced.
Jerry Hayes, OD responds:
First off, I want to thank these two doctors for responding.
These are GREAT comments because they go to the heart of how ODs can use simple business concepts to manage their practices for greater profitability.
Don’t shoot the messenger
Yes, of course, we see regional differences in occupancy costs in terms of both rent and ownership expense.
And while the rent might be high in some parts of Tennessee, I know our readers in metro areas like New York City and San Francisco would love to trade lease costs with you.
I also want to remind my readers that the ranges posted below for practice overhead, are NOT necessarily the numbers Jerry thinks your practice overhead ought to be.
These numbers simply reflect what a broad range of optometrists report spending in their practices:
• Cost of goods (27% to 33%)
• Staff (15% to 22%)
• Occupancy costs (5% to 8%)
• Examination equipment (3% to 5%)
• Marketing and promotion (1% to 2%)
• General office overhead (6% to 9%)
• Doctor’s compensation (30% to 40%)
Also, I understand that these numbers may not agree with your expenses. I don’t see very many ‘model’ practices conforming to every expense category.
But I have worked with enough practices and seen enough good survey data to feel comfortable that these are ‘real’ numbers for the typical private practice OD.
Start with the end in mind
The trick to keeping your expenses in line — and your net income up — is, “start with the end in mind”.
By that I mean, first decide what you want to net in terms of a % of your gross. Whether your desired net is 25%, 30% or 40%, work backwards from that number to determine all your other overhead expenses.
The mistake I see most low-net (below 30% of annual gross income) practice owners make is that they rent their space, buy their equipment, hire their staff and set their fees without first calculating how those expenses will impact their income.
Practice overhead — are you proactive or reactive?
There are two ways you can use the suggested norms we gather from ODs across the country. You can work forward or you can look backwards.
Let’s use the example of two fictitious practice owners we’ll call Dr. Forr and Dr. Affta to illustrate the methodology.
Looking backwards at the data
Dr. Affta is reactive. He uses the data by saying, “Jerry, I just looked at that list of overhead expenses and see that most ODs spend 3 - 5% of their collected gross revenue on patient care equipment.
I expect to gross $500,000 next year and currently have $30,000 in annual equipment leases which means my overhead for equipment is $30,000/$500,000= 6%.
All I have to do is get my gross up to $600,000 ($30,000/$600,000= 5%) and I will be right in line with the average spending of other ODs at 5%."
Because he has already bought this equipment, Dr. Affta now has to earn less while he waits on his gross to catch up with his overhead.
Use the data to guide buying decisions
Dr. Forr, on the other hand, is proactive. He looks at the norms for other practices before he buys to better plan his spending.
He might say, “ I expect to gross $500,000 next year and currently have $10,000 in annual equipment leases which means my overhead for equipment is $10,000/$500,000= 2%."
Since Dr. Forr is only spending 2% of his annual gross on equipment related expenses at this point, he has room in his practice budget to buy more equipment without exceeding the suggested norms.
He could therefore choose to increase his lease payments by another $15,000 and still be within the 5% range. ($10,000 + $15,000 = $25,000/$500,000 = 5%.) Maybe he only wants to spend 4% of his gross on equipment.
Lesson: By estimating your future gross revenue and overhead, you are creating what accountants call a ‘Pro Forma Income And Expense Statement’.
When you plan your expense ratios in advance of spending the money, it’s not just easier to keep your practice spending in line with the national norms, you can actually plan for how much you want your profits to be. This method works even if you practice in a high-rent area.
Did you plan your occupancy costs before you rented?
Using this exact same methodology, I urge my readers to always do a little ‘back of the envelope’ calculation before they rent or buy office space, purchase equipment or hire staff.
Project your annual gross over some reasonable period of time and then make an informed decision as to how much you can justify spending.
For example, to stay in line with national averages, a practice grossing $400,000 per year can spend 5 to 8% per year on rent, maintenance, insurance, etc. That’s $20,000 to $32,000.
Of course, you have to factor in some level of growth in normal times (that likely won't be in 2009 because of the recession). Maybe it’s going to be $400,000 per year now and $600,000 five years down the road.
Why does it matter how much you spend on expenses?
So what if you spend 5%, 8% or even 10% on rent? Why does it matter?
It’s simple math. If 100% of your gross income equals $400,000, the number that should really matter to you is how much of that flows to you as net income.
How well you manage your overhead will determine whether your net percent is 25%, 30% or 35%. In the case of a $400,000 gross practice, netting 25% versus 35% is the difference between making $100,000 or $140,000.
Two practices — same gross income, different rents
To see how overhead affects net income, let's compare two practices in which all the expenses — staff, cost of goods, general office overhead, etc. — except for occupancy costs, are 60% of the collected gross revenue.
5% occupancy costs: In this case, a $400,000 practice with occupancy costs of 5% will net 35% or $140,000 (60% + 5% - 100% = 35% x $400,000).
10% occupancy costs: On the other hand, a $400,000 practice with occupancy costs of 10% will net 30% or $120,000 (60% + 10% - 100% = 30% x $400,000).
Increase your net income by planning better
So there we have it. Two practices that have identical gross incomes and identical overheads. Except, for their occupancy costs.
The practice with a 10% occupancy cost nets $120,000. The practice with a 5% occupancy cost nets $140,000.
That $20,000 per year in extra income is why you do the planning BEFORE you make a buying decision on how much and what kind of space you need.
Make informed decisions
Knowing all this, it is very possible that you, as a practice owner, might still decide to consciously spend more than the average OD to get a larger, nicer space in an expensive area. That’s your call. My job is to help you to make an informed decision.
Disclaimer: The information and opinions contained on this site are for discussion purposes only and are NOT intended to serve as legal, accounting or investment advice. ©2008 Jerry Hayes, OD. Not to be reproduced without written permission of the author.
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I currently rent my space
I currently rent my space from a corporation in which I am the owner. My occupany costs are probably closer to 10% of my gross. However, I am also building equity in the real estate which will be free and clear in ten years. I am sure I am not in a unique position with this arrangement. How do you factor the true occupancy costs in this situation?
Rents vary dynamically, not
Rents vary dynamically, not only regionally, but by local variations as well - higher in a retail area, in a hospital medical park, etc. Using the unique focus of the demographics of the area could make a high $ rent worthwhile if the practice is focused on the scope of the area - strong medical practice next to a hospital, high-end optical in a high-end retail area for example. That is how the percentage goals can be used as a guide.
A friend in the area was recently looking at moving into a new professional building, but in calculating the expense of the rent he determined he would need to double revenues to keep costs in line with the budget - so he walked away from the deal.
Dr. Hayes, In what category
Dr. Hayes, In what category would you include expenses for Professsional Liability insurance, contents insurance and Workman's Comp. insurance?
Thanks,
Dr. Kepley