Managing Profitability
Problem Statement: Service Profitability is often an elusive KPI to track and manage. While most companies (rightfully) focus on ARR (Annual Recurring Revenue), Services are typically NOT an insignificant component of start-up and ongoing costs. Whether you are optimizing for ARR or Services as a standalone P&L, understanding the costs and revenue are critical to your overall business.
Objective: Define an approach to measure, report and improve client/project-level profitability with “low” implementation and operational costs.
Background:
Service Profitability is most easily managed at the highest (i.e. company level) as in a balance sheet.
Overall revenue minus overall costs provides margin.
It is relatively “simple” to determine if the company/organization is performing satisfactorily or in need of overall improvement.
However, for client and project profitability, organizations typically must go a much higher level of complexity and analysis including:
Multiple revenue models (milestone, time and materials, etc.)
Different cost components (client work, sales enablement, infrastructure)
Variability in resources (salaries, hourly rates/retainers, contractor vs. employees)
Other costs (facilities, benefits, etc.)
Model Components:
Projects - Profitability will be measured based on the “Project” level which will be loosely defined as a self-contained set of deliverables that typically follow a scoping, development and delivery basis.
Customers can have multiple projects
Staff augmentation work may not fit with the project definition, but can typically be measured on a regular (i.e quarterly) basis
Revenue - Revenue will be defined as all revenue that has been generated from a customer, typically in association with the project.
For the purposes of this model, revenue must be both recognizable (i.e. work has been delivered) and invoiced.
The revenue does not have to be COLLECTED, although in a rare situation where an Invoice is rejected due to poor delivery, this revenue may be excluded from the overall calculation.
For the purposes of the model, the “type” of revenue (milestone, hourly rates, other) is not important
Service Costs - Services costs are the most challenging aspect of the model. This component must balance the need for granularity/accuracy without adding a level of complexity that makes the model too difficult to manage/implement. Some general best/practices guiding principles include:
Hours Tracking - Most services business track hours for purposes of billing; As a result these are typically the best unit of measure for costs. In some cases, the team may only track hours that result in billed hours to the client.
It may be necessary to track ALL hours that company feels generates value (i.e. Sales support, internal projects, internal meetings).
Cost Rates - Ideally a “cost per hour” can be determined that will, in a typical time-period, correlate to total Services Costs incurred by the company. To oversimplify, if a company incurs $100 in costs in a month and records 10 hours of work, the hourly costs is $10. If the company was able to generate $200 of revenue, then its margin would be $100.
Cost Rates typically need to incorporate all “non-direct” costs (facilities, hardware, non-reimbursed travel, etc.)
Cost Rates also need to incorporate all non-revenue generating work (Sales support, operations, internal meetings)
As a services business, Cost rates must also must incorporate non-delivery team members (Executives, Operations, Sale Development) costs
If feasible, it there are different levels of seniority on the services teams, it’s advantageous to have differing costs roles by senior level (i.e. Principal vs. Strategist), especially if the actual costs of these resources vary. This can help encourage the use of lower “cost” junior resources to help improve profitability.
Non Service (or Outsource Costs) - These costs will be incorporated in bulk as they are accrued/invoiced. The working assumption is that the bulk of these costs are defined in advance and not variable. These can either represent fixed operational costs (i.e. a software purchase for a deliverable) or some form of deliverable-based (custom development, research).
Time Scale - In most Service orgs, using a calendar “month” to track costs and revenue is an effective model for tracking and reporting profitability. It provides enough current data for managers to understand issues and make course corrections.
However, for effectively measuring “project” profitability typically requires a longer time scale.
Option 1 - Project Duration (or Major Milestones) - While this approach is an intuitive one (all costs and revenue can be measured at once), the typical duration of projects can make it difficult to define a clear “end date” (or provide interim updates on progress for long-duration projects).
Option 2 (Recommended) - Quarterly Measurement - This model typically balances the need for regular measurement with an appropriate level of expertise.While not perfect (a team may spent more resources in Q1 to deliver a revenue generation milestone in Q2), this type of behavior tends to balance over multiple quarters (lower margin in Q1 but much higher margin in Q2). Note:Many “short term” projects will ALSO fit into this timescale for reporting.
