How to Measure Profitability to Improve Your Professional Services Business
Professional services organizations seeking to improve project profitability often have a myopic focus on revenue generation and resource utilization with the hopes that these tactics are sufficient to optimize their KPIs. While revenue growth and healthy utilization are essential, forgetting to manage your profit margin for service business can have a dramatic impact on the business’s long-term performance. The most successful professional services organizations know this all too well.
This article will take a closer look at several of the common myths that still surround how to measure profitability in professional services. A profitability equation is a mix of art and science, so if any of the below statements sound familiar, it may be time to take a look at how you are currently determining the profitability of your business.
While hourly bill rates should be set at a level that ensures profitability, they do not guarantee it. Using bill rates as a profit target ignores the other factors that go into delivering a project. Overruns, operational inefficiency, revenue leaks and scope issues all have an influence on profitability, so organizations should have an understanding of how to measure profitability.
Recommendation for How to Measure Profitability: Bottom-Up Revenue Forecasting
The most successful professional services organizations will build a bottom up revenue forecast for each one of their projects. These forecasts will contain details about the type of resources needed, their bill rates, and their labor costs. This resource mix will provide a planned profit target for the project.
During the delivery process, managers can keep tabs on the resource mix and its contribution to ensuring profitability. If the project drops below its profit target, they can take actions like using more experienced team members to avoid “write-downs.”
This statement might as well be saying, “this is a fixed price project, so let’s see how much money we can lose.” The failure to track effort against projects, regardless of the professional services contract structure being used, is one of the biggest mistakes organizations make in terms of project margin calculations. Making accurate estimates is hard, and if an estimate is off by even a little, it will erode professional services profit margins. Service leaders will have no idea if profit margins begin to slip if proper time tracking isn’t implemented throughout the project.
How to Measure Project Profitability with Comprehensive Time Tracking
Track every hour, against every project, always. Successful organizations know this, and they drive a constant drumbeat of time compliance. Time tracking accuracy pays dividends, resulting in greater visibility into utilization and profitability, faster process improvement based on actual effort, and quicker invoicing. Add these factors together, and your professional services organization has a wealth of information for identifying problem areas, creating better estimates, and getting paid faster.
This view is nearsighted, and often associated with fixed price contracts. The rationale is that calculating profitability on fixed price projects can get a bit complicated; the revenue amount is fixed but the cost is highly variable. However, abandoning profitability measurement due to the complexity will create problems for your organization. Understanding how to measure profitability during a project will influence how that project is managed, resulting in better performance.
In fact, most modern professional services automation solutions (PSA tools) take care of the heavy lifting. These tools are able to calculate mid-project professional service project margins on fixed price work, right out out of the box. SPI Research’s recent Professional Services Maturity Benchmark Survey highlighted just how much influence PSA software can have on project margins and ensuring profitability. Compared to businesses that did not run their professional services firm on a PSA solution, those who did saw nearly 25% stronger project margins. That translates into some serious bottom line growth.
Consider a PSA Application as "Project Profitability Software"
Successful professional services organizations leverage purpose-built tools that do a great job determining how to measure profitability of their business through organizing their work and proper project accounting. These systems manage revenue on fixed price work based on “effort to date” and “effort needed to complete the project.” This revenue recognition approach unlocks mid-project profitability. It provides managers with a clear project margin calculation and a precise view of project health, no matter where the project is in the delivery process.
Moreover, using a PSA application will consolidate the siloed information that exists in stand-alone project management, time entry, scheduling, and budget tracking solutions. They also help to eliminate the series of loosely connected spreadsheets many professional services organizations operate on. This delivers a single version of the truth and does a much better job of providing the right information, to the right people, at the right time.
Another mistake when determining how to measure profitability and calculating profit margin for service business is to treat non-billable time differently than you would billable time. If the work is related to a client or project, then it should have an influence on the project margin calculation. Building out estimates, compiling proposals, and negotiating contracts all take time and should be factored into project profitability.
If you don’t do so, your professional services net profit margins will be overstated and you may not be pricing your jobs at a rate that will truly earn your target margin.
Bonus: Download a free guide to learn more about how to measure profitability and drive growth at your professional services organization!
Rethink The Impact of Billable Utilization
Track sales time and other non-billable effort the same way you would any other project-based time. However, this time should be segmented appropriately so that a long sales cycle doesn’t make the project manager look like they delivered a less profitable project.
The way you organize your work is crucial when it comes to tracking non-billable time. Successful organizations will often deploy two strategies to account for this time. The first is a multi-project approach. Pre-sales efforts go against their own project, and then, if the business is won, a second project manages the delivery effort. These two projects would both roll up to the same contract, engagement, and client. This allows for profitability analysis at different levels, and also helps managers understand the impact of pre-sales effort on the project margin.
The second approach focuses on capturing labor cost for things like defective work, relationship management, and general goodwill. Successfully capturing this time requires the ability to track it within a project’s task structure. This time tracking strategy will enable team members to associate non-chargeable time with the appropriate task, providing further visibility into where problems occur.
At the core of all of these common struggles that professional services organizations face when it comes to how to measure profitability and improve it, is the assumption that the firms are, in some way, tracking their labor investment on each project. This is not the truth for all organizations. Many professional services organizations, especially those who have not adopted a robust project delivery platform, shy away from loading labor costs into their project tracking. This is either because the tools they use do not have the capacity to track that information, or they are worried that the information will fall into the wrong hands.
These are valid concerns, but the visibility into mid-project profitability also carries tremendous value. This method for improving project profitability enables service leaders to understand project health through a fourth dimension that is often overlooked by traditional project management methods: value of the project to the organization. Traditional project management methods balance budget, schedule, and quality as the indicators project success. Yes, these are crucial, and focusing on only one often comes at the detriment of the others, but ask any service executive what makes a successful project and they’ll probably tell you “a happy client and a healthy profit margin for service business.”
Create Project Staffing Models that Drive Profitability in Professional Services
Leverage a robust project delivery platform, such as a PSA application, to model labor rates and control access to sensitive information. The first step to this process is determining who in your organization should have access to this information, and the answer to that will be different for every business. Some organizations will allow project managers to have visibility into profit margins directly, and others will reserve that information for delivery or program managers.
Regardless of your organization’s approach, a robust PSA tool will help with the effort of how to measure profitability. Most solutions on the market have tight permissions surrounding labor cost information. Some will go even further by allowing labor rates to be entered as a range for a specific type of employee and separating visibility into actual cost and margin percent into different permission structures.
These two approaches allow organizations to communicate general cost and profitability without identifying any one person’s specific salary or hourly pay. While this won’t provide exact profitability information, it will paint a picture that is close enough for managing a successful project.
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Eliminating the Barriers to Measuring Profit Margin for Service Business
It can be difficult determining how to measure profitability in a professional services organization, and the myths discussed in this article represent only five of the most common objections that businesses face when trying to establish frameworks for profitability measurement. Regardless of how successful or sophisticated your professional services organization may be, one fact remains—real-time visibility into project profitability drives stronger margins.
If any of the excuses outlined in this post sound familiar, it may be time to take an in-depth look at how your organization approaches their work and how to measure profitability, the systems and tools that support their delivery process, and the flow of information necessary to deliver successful projects.
If you are looking to optimize profitability, take a look at how other experienced professional services organizations are measuring their KPIs in this professional services benchmarking survey. You can then use this information and the recommendations here to develop a more sophisticated profitability strategy that helps maximize value while enabling long-term growth.