As a senior audit manager at E&Y, and 25 years subsequently as a senior finance executive at businesses in a number of different industries, I have worked with management to improve the profitability of staff working on client-chargeable projects.
Chartered accounting is not unlike the legal profession and other consulting businesses where you are providing professional services. But I have also worked in advertising and in IT, where the challenges surrounding delivery of services at a margin are just as applicable.
In creative advertising, staff typically charge their time (via timesheets) to campaigns within a project management system. The time is added up for the strategy, creatives, production, account teams and others, to measure the cost of delivery for the staff within the agency, who are working on a campaign. The external costs, such as media production houses, specialists in market testing, the costs of getting staff to the client for meetings and for the shoot are referred to as hard costs, and these are also added to the campaign costs within the project management system.
The costs of a campaign are all budgeted and agreed in advance with the client, and the team leaders will compare the actual costs to the budget as part of management of the project. At least, they should be…
In media advertising, there may be a team of staff who are retained full-time to service one, or a limited number of clients, buying and selling the media space and liaising with clients to reach the markets that each ad is targeting. Again, there is likely to be a finance resource in the back office adding up the costs of each team and ensuring that sufficient revenues are being charged to each client to cover the costs.
In the IT sector, you might have a permanent team of software developers working to integrate your product into the client’s legacy environment. You may also have a support desk fielding inbound calls from your customers. You may have teams of staff providing outsourced services, on your software platform, on behalf of your client. And you may also have teams of staff working on new product development.
Again, in most cases, a project management system will be used to track the costs of delivery of these services, and you might have team leaders or a finance resource investigate these results periodically to check that they are being delivered profitably.
The analysis of project margin will be reliant on the accurate calculation of the cost of the resources used that has been loaded into the project management system.
An error in the costing methodology may show in a variance from target margin either on a project, or on an individual client. And ultimately it will show across the business P&L if the miscalculation of costs has led you to under-charge for your services.
But there are numerous other factors which can impact profitability of one client, or across the whole consulting team:
Are you staffing with permanent employees in circumstances where the workload rises and falls? And if you’re employing staff on a full-time basis, who covers the cost when staff are sitting “on the bench” ready to go, but with no work to do?
Are you charging a flat rate to clients but over time, annual promotions or scope creep are impacting the cost of the staff above CPI?
Are you allowing for the additional cost to cover staff leave (including sick and annual leave)?
Where your staff work on the same client for extended periods, do the staff sympathise with the client come billing time, and give the customer free services by not charging them for all the time worked?
Where rework is necessary due to issues with delivery, is this charged to the client, or just absorbed by the team?
If your staff attend training for a week, how do you recover their cost for that week – including the training costs? Are they back-filled on the project?
Where the client has an issue with the amounts billed to them in any month, or for any deliverable, how do you control the issuance of credit notes to the client?
All the time “worked” by your staff, including sick and annual leave time and bench and training time - must be recovered from your revenue streams – either by covering the cost within the charges to your clients for the billable services provided, or by other business revenues (i.e., treating them as overheads, so reducing your profitability).
[See my blog post on Revenue Leakage, which discusses a number of these issues, at https://stephenmeares.wixsite.com/website/post/revenue-leakage].
Should you decide that these issues are just a hazard of doing business and should be treated as an overhead, then good luck to you.
One CEO I worked with at a $20m business was aware that his average billability of his consulting staff was around 65%. That is, for every hour they worked (and he paid their salary for) they only charged their clients for 40 minutes. He said that in his experience, this was about as much as you could expect. So he advocated a do-nothing approach in a situation where the folks in my old big-4 Chartered firm would have had an aneurysm.
Undaunted, I did some data analysis within the ERP to try to improve the situation…
As the problem was pervasive right across the consulting practice, I did not focus on the individuals involved, but rather worked on the total numbers across the entire division.
As a sidebar, I note that at one US multi-national I worked for, the pool of consultants sat within it’s own cost centre within the GL. Entries were generated automatically by the Oracle ERP that we used, from the timesheets, to reclassify costs from this cost centre to the business unit (cost centre) that owned the customer revenue. So at the end of the day, the business unit would have the revenue and (timesheet) costs, and the consulting practice “pool” cost centre would have the salary and other direct costs, less the amounts charged out to the business units (as a credit).
If the consulting pool had a net charge at the end of the month, then they were not charging enough out on their timesheets to recover their costs, if it was in credit, then it was charging too much (which was not a bad thing). This was a great litmus test on whether the practice as holding its’ own, but there are many factors which influence the overall result, so any variance is not necessarily providing an answer, as much as asking a question: Why?
In this case, the CEO and Board had already expressed some frustration that my predecessor had been unable to calculate the consulting team’s multiplier (that is, the multiple of salaries that the team’s revenue represented).
When I arrived at this business as a contractor, the CEO and Board knew that a key metric for a consulting business was the consulting multiplier. They knew that big-4 chartered firms and legal practices looked for multipliers as high as 2.2 times salaries. But the finance community had never been able to provide the multiplier number for this business, probably because there were some issues in the accounting and reporting to isolate the actual salaries paid for the practice alone, which was therefore unknown.
At this point I would direct the reader back to the list of bullet points above – identifying that the team is under-charging clients (in comparison to the salaries incurred) is one thing, but knowing what is causing that miss, is another. It may be arising from any number of issues within the business, and this list is not exhaustive. Perhaps you just have too many staff on the books for the amount of work you are delivering?
This is where a detailed, deep dive into the data within the project management system will be invaluable.
A utilisation report from the project accounting system will show the staff who have the highest and lowest billable hours. But beware – are all the hours shown recovered from the customer, or are a significant portion written off, and therefore worthless?
If some staff simply don’t have the billable hours that might be expected, it would be worth understanding why this might be the case. Are they providing a mentoring function and training other staff? Are they people with specialist knowledge who may be critical to the team at times, but at other times are less busy?
Reviewing margin by client and discussing the issues concerning profitability with the project leaders will provide additional insight. It may reveal whether any of the issues listed above exist, causing revenue leakage.
Your standard customer delivery contract may not provide sufficient protections for your business, such as providing you with the ability to charge additional fees, in excess of the amount quoted. (This should be permitted where circumstances changed from what was the reasonable basis of your understanding at the time of giving the quote).
In fact, you should be able to recover all the reasonable costs of delivering the work, and your Master Services Agreement (MSA) should lay this out in plain sight.
Training your project managers to be unafraid to negotiate and bill additional fees where they have overrun the budget due to circumstances beyond their control may be key to improving your service profitability.
This may not be an easy fix, but in my experience, it often falls out of a general increase in commercial acumen, especially where you introduce a strong MSA.
It is also possible that your cost rates – and bill rates – are simply insufficient to recover the costs of the team. This might especially be the case where the cost rate has not taken into account the down-time of the team.
The cost rate calculation:
Billable hours:
(Annual hours – annual leave – public holidays – sick days) x Utilisation %
((7.5 x 5 x 52) – (7.5 x 20) – (7.5 x 11) – (7.5 x 10)) x U%
(1,950 – 150 – 82.5 – 75) = 1,642.5 but say 1,650 x U%
Rounding to 1,650 is fine here as different states have different numbers of public holidays, some staff do not take all their annual leave or sick leave each year, and some staff will work some overtime from time to time. These variables make this calculation an estimate at best.
But the greatest impact on accuracy of the model is the utilisation assumption. This will have an enormous impact on the cost rate.
Utilisation & Cost Rates
As part of my management of the practice, I run a model where I take the billable hours from the project management system and compare this to the assumed billable hours which was included in the cost rate calculation.
There will be enormous variation between staff, and often between the various levels of seniority of staff (more senior staff tend to spend time on administration and staff training, which may not find its’ way onto the client tab). Some months are shorter than others, and some months tend to have more annual leave taken than others…
Using the overall utilisation across the entire workforce should recover all of the costs of the entire workforce, across the billable hours of the entire workforce. Certainly the utilisation rate and other variables can be finessed in the model to reach a point where the billable hours at the standard cost rates will recover all the costs of the practice, over the long run.
The utilisation rate can then be used to calculate the cost rate per hour across the 1,650 available hours of each employee. If the cost figure includes all the direct costs of running the practice – including salaries, super, leave, payroll taxes, plus its share of overheads – then I refer to it as a “burdened” cost rate, as this is the hourly rate inclusive of all costs, including a share of the corporate overhead.
Bill Rate
Sometimes, a business will bill customers based on the outcome of the service provided. Other times, a business will aim to recover the burdened cost based on hourly rates of work performed on that client.
If your target is to earn 25% margin on this part of the business, then your burdened cost rate must be marked-up by 33%, on average. Just take the burdened cost rate and mark it up to get the bill rate by role.
Outcome
Once you have all the pieces in place, you should get consistent financial results from various data within your ERP:
Your billable hours target used in your costing model should be close to the billable hours metric provided by your project management system;
The cost value charged to the projects should be close to the total cost of running your practice (including a share of overheads);
Each project should be earning the 23% target margin [1];
The contribution (total revenues less total costs including overheads) of the practice should be close to the target margin.
By working collaboratively with the team leaders and project managers in the business discussed above, I was able to increase the commercial acumen of middle-management and increase their appetite for improved performance.
By simplifying and adding appropriate KPI reporting of the consulting teams’ salaries and other direct costs, I was able to demonstrate that they were initially only earning a multiplier of 1.1 times direct costs
. That is, they were barely breaking even on the services of the consulting team of some 70 staff.
The CEO, with the support of the Board, had to concede that this was too low to be sustained. We agreed that rather than making the target seem impossible at 2.2 times, we would set the target multiplier figure at 1.8 times. That way, I could show that every small step from 1.1 to 1.2, then 1.3 and upwards, was a step in the right direction.
Over the ensuing 20 months, I worked with the SLT and the practice team leaders, to address this issue, and ultimately achieved a figure of 1.8 times overall. This translated to improved EBITDA of over $860k year on year.
See also my blog post on managing a business through the use of Key Metrics - https://stephenmeares.wixsite.com/website/post/success-in-using-kpis
As it happens, this improvement in consulting margin was largely lost to the Board, due to issues in the software costs of the business that were charged by the major supplier. But it was nonetheless enormously satisfying that the CEO who had previously said that 65% utilisation was about all one could expect of the team, could see that I had been able to add almost $1m value to the bottom line by managing the financials of the consulting team.
[1] Where a project margin rises or falls substantially in a given month, this will form the basis for a conversation with the project manager, who will be aware of the causes of such a variance. These can be documented for the CEO and Board reports where significant.
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