How To Manage Margins In Professional Services

To manage your firm, you need to know the most important ratios.

Utilisation is by far the most important for most, but the amount of time recorded on timesheets shouldn’t automatically be billed to clients. Often it is, but sometimes adjustments need to be made at the time of billing to take certain factors into account. Perhaps a particular fee earner’s efficiency wasn’t what it should be: we all have bad days, right? Or perhaps a staff member needed to get up to speed on a task they’d not done before. Adjustments to hours made at billing give rise to a measure called “Realisation”. Expressed as a percentage, it measures the amount of time realised. Usually 90% or 95% is a good target, depending on the firm. “Average Rate” measures discounts allowed. These measures also work for firms who bill fixed fees or a combination of fixed fee and time. Simply divide the fixed fee component by the hours worked to get the effective rate.

A lot of firms don’t track staff costs on bundled services or fixed fee projects; they believe the price has been set and the outcome can’t be changed. Apart from the obvious weakness of not knowing the project’s profitability and therefore the opportunity to improve the pricing accuracy of future projects, these firms also miss out on knowing the profitability of time and material projects. This is because the true cost of staff time is not accurately attributed between the two. I believe that properly tracking project profitability, regardless of using hours or units completed, is the essential foundation of a successful service business.

The gross profit of your business is the sum of the gross profit on all the individual projects.

It is also the sum of gross profit of all the individual staff members, individual clients, market segments, service types and geographical locations. It sounds like a lot of work but in the process of discovering one of these, the results of the others – the ones that suit your business – are usually easy to work out. This is done by adding the average hourly cost of each employee to your utilisation report.

The cost per hour is total salary and on-costs divided by 80% of available hours, multiplied by hours billable on that week/project/ etc. or the total cost divided by the number of tasks done.

It sounds complicated but it’s actually quite simple. The sum of all the staff, or projects or teams, etc, for any given period should align with the P&L.

When a shop sells stock it takes away “the cost of goods sold” to get “gross profit”. For a service firm your cost of goods sold is people’s time and associated costs. Anything else is an overhead.

Thinking about the numbers in your firm this way will probably bring about a fundamental change to the way you plan and manage. Your tax accountant will list your people costs as an overhead but it’s not, it’s part of the cost of delivering your product.