How to pick the right ones out of hundreds of possibilities
by Jeanne Urich, Service Performance Insight
With the growing contribution and significance of services to the bottom line, effectively monitoring, measuring and managing the services business has become critical. But with more than 200 metrics to choose from, where does an executive start?
Running a professional services organization (PSO) is complex. It’s a game that must be won with singles and doubles, not home runs. Thus, it’s imperative to know which key performance indicators are essential, the ones PSOs must continually measure, and the ones that are nice to have but not essential. Figure 1 shows the essential key performance indicators and Table 1 defines each KPI.
Figure 1: Key Performance Indicators — the Essentials
The challenge for services executives is how to balance customers, employees, partners and operations. Excellent services leaders spend 50 percent of their time with customers, partners and the sales organization and 50 percent with employees and operations.
Table 1: Standard Key Performance Indicator Definitions
The challenge comes in continually capturing new business while ensuring revenues and costs remain aligned, all while providing consultants with the tools they need to deliver high-quality projects. Service is a balancing act requiring effective selling and quality project delivery at the same time.
These are definitions and descriptions for the most important levers that organizations can pull to improve professional service revenue, margin and customer satisfaction.
Revenue: Revenue starts with services sales or bookings, which convert to clean backlog once all required contracts, master service agreements and statements of work have been completed, signed and approved. Resources are then applied to work the services backlog. Billings occur based on contract terms: time and materials, fixed price, milestone, deliverables, etc.
The ability to recognize revenue will be determined by the firm’s accounting practices. The Sarbanes-Oxley anti-fraud law has imposed a complex set of accounting rules on organizations, requiring executives to understand contract obligations upfront to avoid revenue recognition problems later.
Gross margin: Margin must be measured at several levels. Most organizations use subcontractors and lower-cost offshore resources for services delivery. Subcontractors provide a lower-cost variable workforce and provide a rich source of margin. Systems integrators must closely monitor hardware and software pass-through revenue and margin. And finally, since PS is based on applying highly skilled professionals to deliver project revenue, the most important measure is direct labor margin.
Subcontractor margin, hardware and software pass-through margin, and direct labor margin all add up to produce gross margin. For even the best-run PSOs that command high bill rates and high billable utilization, it is difficult to consistently sustain a services gross margin greater than 50 percent.
Regional margin: Most services organizations measure regional and line-of-business profit and loss in addition to the global PS income statement. Depending on a company’s accounting practices, corporate overhead costs may be apportioned to the region or line of business or kept in a corporate overhead cost center.
For example, if a company requires a 20 percent PS net contribution margin and its corporate overhead is 20 percent, it will need regions to produce a 40 percent margin.
Services margins are typically lower in EMEA than in the U.S. due to the increased cost of the following:
- Fringe benefits: Employee fringe benefit costs for health and benefits range from 22 to 25 percent in the U.S. but may be as high as 40 percent in EMEA, plus many countries include an expensive car allowance.
- Vacations and company holidays: In EMEA, typically four weeks’ vacation and 12 or more holidays compared to two weeks’ vacation and 10 company holidays in the U.S. This extra non-billable time is somewhat offset by an expectation of higher billable utilization in EMEA.
Net contribution margin: The true differentiator for professional services profitability is how the practice manages below-the-line costs. Embedded PSOs within product companies typically produce a net services contribution margin between 10 and 40 percent. According to the Service Performance Insight 2013 PS Maturity benchmark, average reported net margin (EBITDA) for independent firms was 15.6 percent and for embedded PSOs, it was 23 percent.
Typical overhead expenses (as a percent of total PS revenue) include:
- Direct labor expense (40 to 50 percent): Direct labor cost as a percent of total revenue.
- Fringe benefit expense (6 to 10 percent): Fringe benefit expense as a percent of total revenue.
- Subcontractor expense (7 to 15 percent): Subcontractor cost as a percent of total revenue.
- Sales (2 to 20 percent): Includes all direct sales headcount and fringe benefits plus non-billable business development travel and expense, commissions, incentives, and sales training.
- PS engineering and PMO (1 to 2 percent): This includes all PS engineering and PMO headcount; fringe benefits; and expenses such as labs, tools, delivery training and project reviews.
- Marketing (1 to 2 percent): This encompasses all services marketing headcount and marketing expenses, such as Web, PR, advertising, trade shows, sales training, customer satisfaction survey, references and services packaging.
- IT (1 to 2 percent): Comprises all IT capital expense, depreciation and headcount costs.
- General and administrative (5 to 20 percent): This includes PS corporate management, facilities and non-billable travel.
Most PS organizations underinvest in PS engineering and services marketing and overinvest in non-billable management overhead and non-billable travel. Sales expenses may be hidden as non-billable time for key managers and solution architects. As a PS firm grows and matures, investments in dedicated services engineering, project management office, knowledge management, marketing and sales can pay huge dividends by making services delivery more repeatable and efficient and services sales more effective.
Customer satisfaction: For product companies, one of the primary raison d’etres for a professional services business is to produce reference customers. This is a crucial measurement area, yet it’s often overlooked. Unless the organization is very large, typical customer satisfaction loyalty surveys are not granular enough to showcase delivery problems.
No matter how small the organization, executives should create a global project dashboard to continually monitor project health. SPI Research recommends at least quarterly project reviews with defined criteria for red, amber and green, plus ongoing knowledge sharing to continue to improve intellectual property and standardize the project delivery life-cycle methodology.
Workforce plan: The lowest common denominator is the health of the services delivery organization. Billable headcount represents an organization’s brand and reputation and its services delivery capability and revenue potential. From inception, executives need to quote tiered bill rates by skill level and measure employee utilization — both billable and non-billable.
SPI Research recommends creating an organizational stack ranking showing profit and loss by person. Executives may find 80 percent of company revenue and profit is produced by 20 percent of the workforce, which means it is imperative to identify the top revenue producers and ensure they are recognized and rewarded!
Resource ownership: An interesting dilemma arises when regions or practices own the fully loaded cost of consultants. This produces a disincentive to resource sharing. Methods to overcome resource hoarding include central resource management and cost or revenue sharing for loaned consultants.
Utilization: Organizations calculate utilization in many different ways. In the U.S., the standard definition is based on 2,080 available work hours per year — this translates to 260 available workdays per year in EMEA. Most standard utilization measurements subtract company holidays (10 in the U.S. and 12 or more in EMEA). The standard available starting-hour calculation in the U.S. is 2,000 and the standard available days in EMEA is about 240.
Primary differences in utilization definitions emanate from the varying treatment of non-billable hours for internal projects, customer satisfaction issues or business development (in the numerator) and whether non-billable personal time off is excluded from the denominator. Some organizations measure billable utilization as the actual number of billed hours divided by the total available hours (including non-billable roles), while other organizations report billable utilization based only on their billable roles and exclude all of the hours of their non-billable staff.
Regardless of a specific utilization formula, it is important to develop a standard utilization definition and to publicize and consistently measure it throughout the organization.
Recommendations for improving financial performance
With increased global competition for business and resources, consulting organizations must continually improve. These improvements cut across every aspect of the organization, and all departments must work together to achieve services performance excellence. Executives need key performance measurements, integrated business applications and a plan for continual advancement.
In sum, there are many levers for improving financial performance. Thus, executives should pick three to five key metrics to improve each year and watch the money grow!