June 1, 2002
by Barry McNulty
Can you imagine leaving on a long road trip, without a destination in mind? Of course not. When you leave on a road trip, it’s best to have a map open in front of you. On that map you need to landmark two fundamental pieces of information. The first is your starting point, and the second is your destination. Without these basic details, reaching your destination would be almost impossible. So what does this scenario have to do with practice planning for a successful 2003? Just about everything.
Think of the destination as your financial goals for 2003. Next, think of your practice as the vehicle that will drive you and your family toward your destination. Now all you need is a good map. In the corporate world, successful companies have their map, or business plan, for the following year in place well in advance of their current year-end. This gives them the benefit of foresight. Practice planning is no different. By putting together a plan now, you can help ensure that 2003 is a successful and meaningful year. So let’s get started right away:
— Define your goals for the year. Goals include major accomplishments that would make you classify 2003 as a successful year.
— Develop practice strategies. Strategies help you reach your goals in the most efficient manner.
— Create feedback systems. Feedback systems monitor your progress, preferably on a quarterly basis. Without effective monitoring, you may not discover that your practice plan is ineffective until the end of the year. And by then, it’s too late.
Using the “Bottom Up” Method
When preparing your practice plan for the coming year, think about using the Bottom Up method. This method integrates your personal and practice goals and strategies. This is important because a cardinal truth of the economics of dental life can be stated as follows: Either your practice fulfills your personal needs, or your personal needs must be adapted to what your practice can provide.
With this method, you must decide how much you personally need in net after-tax income from your practice in 2003. Then, break down this income need into two broad categories. The first category covers the income you need to finance your Current Consumption needs. This includes your basic lifestyle expenses (BLE), vacations, car replacement, debt service and so on. The second category covers your Deferred Consumption needs. RRSPs and Registered Educational Savings Plans are the most common Deferred Consumption items. However, keep in mind this caveat: depending on your age and other circumstances, your RRSPs will not likely be sufficient to provide for your eventual financial security and independence. You may even need to supplement the amount you save beyond the maximum RRSP contribution limits. If traditional savings programs for your Deferred Consumption needs aren’t sufficient, you must identify the amount that should be set aside this year and include it in your plan for 2003.
To illustrate the planning process, let me share a case study from our files. It deals with a practice plan prepared in the fall of 2001. Dr. John (not his real name) and his wife, Janine, were both in their early forties, with two children. Like many people, John and Janine were not entirely sure of their BLE. They had never done a spending budget or anything similar, so the first step was to help them identify their BLE.
We recommended that they review their bank statements and personal credit card expenditures for the previous six months. They were to remove any extraordinary or non-recurring expenses, and factor in periodic payments (for example, they paid their insurance annually). This calculation determined that they normally spent about $6,300 per month on BLE. That figure was then adjusted to $7,000 per month to allow for contingencies and oversights. That amounted to $84,000 per year. In addition to this sum, John and Janine were planning on spending an estimated $18,000 on upgrades to their home within the year. Their estimate for vacations in 2002 was $15,000, and there was a practice loan, where the principal to be repaid amounted to $14,400 for the period. Remember, interest on practice debt is deductible, principal repayments are made out of after tax dollars. The total of these sums was $131,400. To this figure we added their savings for Education and financial independence. A projection indicated that making a $2,000 contribution to a RESP for each child, when the Canadian Education Savings Grant was factored in, would be sufficient to meet their estimated needs in this area.
With respect to financial independence John and Janine wanted to plan on reaching this stage by the time John reached 55 years of age. To be clear John didn’t necessarily want to stop practicing or do a transition. He simply wanted to be able to work out of choice rather than necessity at this point in his life. To reach this objective, we estimated that John needed to save $35,000 beyond RRSP contributions during the year in question. Incidentally, John could make the maximum RRSP contribution, while Janine could only contribute $5,400. This brought their total net income need to $189,300. It included the BLE for the year, RESP and RRSP contributions and the financial independence savings estimate. This was an after-tax figure, so to work out their net income, we simply calculated the cost. There’s an easy way for you to do this.
Most of us think in terms of the top marginal tax rate, however this factor only applies to taxable income over $100,000. For planning purposes, it’s more useful to work with an average tax rate for the whole family. An average tax rate is the amount you have to pay relative to your income after all deductions, tax credits, income splitting and lower marginal rates are considered. For example, if you made a net income of $150,000 and had to pay $50,000 in tax on that income, your average tax rate would be 33.33%. As a guideline, if you’re doing reasonable tax planning use between 30% and 40% as your average. The greater your practice net income (after all planning), the higher you should be on this range. To be more precise, have your financial advisor work out this figure.
In John and Janine’s case, their average tax rate was 35%. To arrive at their target practice net income, we divided the after-tax requirement by 65% (1-35%). That meant that John would have to earn an annual net income of $291,231 to cover all their personal needs. This illustrates the real power of this planning process. You see, John and Janine didn’t understand their requirements before going through this calculation. They thought they had a discretionary surplus. In fact, the practice was not generating sufficient net income to cover both their Current Consumption and Deferred Consumption. There was a deficit between their needs and their capabilities. Going through this planning exercise well in advance meant there was still time to devise strategies to make up the deficit. As a footnote to this case study, John and Janine are currently on target for 2002.
Managing Your After-Tax Practice Cash Flow
There’s an old saying that I really believe in: You need good information to make good decisions. Your after-tax practice cash flow is one of your greatest resources-but it is finite. To manage it properly, you must have the information you need to make sure it gets allocated to your priorities. Otherwise, this valuable resource could easily be spent on items of less consequence.
Once you’ve identified your estimated pre-tax net income requirements for 2003, you’ll be in a position to prepare your practice plan for the coming year. Use last year’s results as a base for your deliberations, and take into account any anticipated changes for the new year. Let’s deal with expenses first. Will you need to buy any new equipment? Have you added any staff; or are other costs, such as rent, increasing? Will any leases be maturing this year? You may want to research some ‘expense general’ categories to determine what norms would apply in your region. Comparing this data to your own expenses on a percentage basis can help identify potential areas where expense management may provide a benefit. In my experience, a great many practices can, with a proper plan in place, reduce overhead percentages by 5% or more. It takes some time, but it’s worth the effort. For example, if your gross production is $600,000, a 5% saving over a 5-year period can be substantial.
Next, look at gross production and collections. Once again, take last year’s figures and ask yourself what might change for the coming 12-month period. Has there been a fee increase? Will you work the same number of days? What might change in hygiene production? Are you satisfied with your hourly production and the hourly production of other producers within the practice? Are your accounts receivable well controlled? By the way, I like to see accounts receivable levels no higher than one month’s production in practices that don’t take assignment.
At this point you should be in a position to determine, after adjusting for anticipated changes, whether or not your practice will generate enough net income to meet your projected personal needs. If the answer is yes, then simply continue to monitor your progress and make sure the right funds are allocated to the right priorities. I recommend that you monitor on a quarterly basis. Monthly variances can be substantial because of holidays, sick leave, short months, and so on. Over the quarter, it should even out to the point that it’s comparable to your seasonally adjusted plan for the period.
On the other hand, if the answer is no, your practice is not likely to produce enough income to meet your anticipated personal needs, then you’ve prepared your plan in time to investigate strategies to address the deficit. Calculate the deficit in terms of daily production. Breaking the amount down in this way makes it easier to relate to your strategies. Areas to look at include hygiene production, your recall system, patient retention programs, and scheduling. You may also have to consider whether you need an associate. Or whether you should consider outside input from a practice consultant. One way or another, you must address this deficit. If you can’t see how increasing gross, decreasing expenses, or a combination of both is going to generate enough revenue to meet your needs, then you only have one viable option. Reduce your personal needs. In my experience, this isn’t a good alternative. It’s much easier to increase your income to the level that meets your needs, rather than to reduce your outflow to match your income.
Developing a practice plan now is a wise, proactive step towards ensuring your success in 2003. You’ll find it easier to make informed decisions and to ultimately take control of your financial future.
Barry McNulty CFP, RFP, CIM, FMA, FCSI is a financial advisor with Assante Capital Management Ltd., which specializes in working with dentists. The opinions expressed in this article are not necessarily those of Assante.