Building the Professional Services Income Statement

STEP 1:  THE METRICS THAT MATTER
By Jeanne Urich, Managing Director, Service Performance Insight

This is the first article in a three-part series examining the metrics that matter for running a professional services business. This article looks at key metrics, typical targets and the impact of small improvements. In the second article, we’ll provide descriptions and industry averages for the critical components of the professional services income statement — both revenue and expense. The third article will reveal the best practices and profit and loss statements of the top PS firms.

KPI

We’ll show actual results from the 2015 Professional Services Maturity benchmark, which provides a benchmark of technology professional services organizations — both embedded (within hardware and software technology companies) and independent (IT and management consultancies, architects, engineers, etc.). All three articles share insight, measurements and guidance to help professional services executives improve profitability.

What metrics matter for professional services?
Running a professional services organization, or 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 critical. Figure 1 shows the most important metrics for measuring a professional services organization.

Figure 1: Metrics That Matter for Services Organizations
Figure 1
Source: Service Performance Insight, August 2015

The question is how to continually capture new business while ensuring revenues and costs remain aligned. At the same time, PSOs must provide consultants the tools they need to deliver high-quality projects while growing their skills for the future. Professional services is a balancing act requiring both effective selling and project delivery. Client satisfaction is the ultimate goal to ensure clients pay their bills, continue to buy and provide great references and referrals.

What are typical KPI targets for professional services?
As the professional services market comes of age, standard measurement targets are emerging based on the type of services delivered — software or SaaS implementation; customization and integration; hardware and network installation, configuration and optimization; management and business process consulting; and so forth.

The targets for software consulting differ from those of business and management consulting. More commoditized services garner lower fees that require higher utilization rates to generate profit. However, net margin should be equivalent to more complex services due to lower labor costs. Significant factors affecting profitability include market demand, reputation, workforce quality and skill level, geography, risk and complexity, and depth of intellectual property, etc.

PS targets depend on the charter and mission of the service organization. If the organization’s mission is to “create referenceable customers” at any cost, then the services organization may not be a profit center. If the mission is to “support sales and drive product revenue,” then the organization may run on the low end of billable utilization and revenue per person while accentuating metrics around bid/win ratio, customer adoption and cost of sales.

Measurements for smaller, startup organizations benefit from accentuating “building client references” rather than services profit. Targets for larger, more mature service organizations gain the most from focusing on the highest possible service revenues and margins while ensuring clients are wildly satisfied.

Figure 2 highlights target metrics for a PSO within a software company.
Figure 2: KPI Targets for a Software Company PSO
Figure 2
Source: Service Performance Insight, August 2015

Small improvements can produce big results
In the people-intense world of services, the primary cost driver is labor cost. Small improvements that enhance labor productivity can quickly add up to yield significant profit increases. Figure 3 illustrates how small improvements can produce big results. If the organization makes a 10 percent improvement in four or five key performance measurements, due to leverage and the cumulative effect of the improvements, the organization could improve both revenue and margin more than 50 percent!

Figure 3: Small Improvements Can Produce Big Results!
Figure 3
Source: Service Performance Insight, August 2015

Priority Improvement Recommendations
Now let’s take a look at priority improvement areas. The following suggested tips and tricks will enhance your bottom line:

Revenue. In the revenue quadrant, the best accelerator is to improve sales productivity — through better deal qualification, marketing and stronger references. The best revenue accelerators are increased sales productivity, improved bill rates and larger projects. Improving sales capture rates and sales effectiveness is a much lower cost alternative than chasing every deal that moves because of a weak pipeline.

Improvements in sales productivity also show up in better price realization. Bill rates are market sensitive but can be dramatically improved through better estimating, effective project delivery, change control, references and project quality. Hourly bill rates almost always produce a higher margin than daily rates.

An interesting phenomenon is that a given percentage increase in either utilization or bill rates produces a similar bottom-line impact. The corollary is that services margin cannot be made if the PSO cannot charge twice the fully loaded cost of consultants, or if average billable utilization falls to below 50 percent.

Margin. The best way to improve margin is to lower costs and to make more profit on every facet of the business. Be careful to ensure the organization makes at least a 30 percent margin on subcontractors and offshore resources. Across the PS industry, subcontractor delivered revenue consistently averages 13 percent of total revenue. If subcontractors and offshore resources are overused, it may compromise delivery quality and put client relationships and knowledge capture at risk.

It is surprising to see how many PSOs do not adequately mark up their subcontractors or bind them to the firm’s contract terms. Executives do not want to be in a situation where they are paying contractors on a time and materials basis but charging customers on a milestone basis.

The other key margin lever is to reduce non-billable overhead by running a lean business. One effective strategy is to zealously measure and publicize non-rebillable travel and expense. If organizations spend a fortune in non-billable travel for business development, this clearly indicates a need to improve marketing, lead generation and deal qualification.
Many leading firms like to set a “non-billable” expense target per person, say, $2,500 per quarter. This target may be too low for business development staff, but it is a good number for the overall organization and incentivizes the team to carefully monitor telecom charges and those sneaky free meals! Normally, the organization should have very limited non-billable travel expense for billable consulting staff.

Client satisfaction. No matter the size of the organization, PSOs must keep a master project dashboard and have a mechanism for impartially tracking project quality. Some key metrics are proposed vs. actual hours per task, milestone or deliverable. Catch problems early — an overrun early in a project says it’s time to reset expectations, execute a change order or improve project management. Failed projects ruin a firm’s reputation and can have a devastating effect on profit.

The best way to improve sales productivity and project margins is to sell more projects to existing customers or at the time of initial product sale. Just a 1 percent improvement in services attached to product sales can produce big gains in revenue while lowering the cost of sales.

Invest in services sales compensation to motivate the sales force to include services with every deal. A best practice is to compensate product sales representatives at the same commission level for product and services sales.

Resource plan. An important profit lever is employee retention. Attrition is incredibly expensive. On average, it takes almost a year to recruit, hire and ramp a productive new consultant, which makes replacement hiring costly. Best-in-class PSOs focus on recruiting the best and invest in training to shorten ramp time.

One of the most important levers is to ensure the most productive (and most senior) consultants stay with the firm. Create a compensation plan that encourages them to develop new business, mentor new employees or build infrastructure. Treat them as crown jewels, not billable objects, and find ways to reduce the burden of travel.

With utilization, executives need to run the organization at a target billable utilization, say 75 percent, to cover costs and produce margin. However, running the organization too hot through excessive utilization has the unintended consequence of negatively impacting customer satisfaction and attrition.

The other significant workforce lever is reducing overhead. That said, the non-billable headcount should be less than 30 percent of total headcount with a target ratio of 10 to 1 of employees to management. Pay careful attention to headquarters spend. Through the use of integrated business applications, PSOs are reducing non-billable administrative headcount by automating resource management, time capture and billing.

Next time, we’ll analyze the professional services income statement. Stay tuned to learn about the benchmark averages for revenue and costs across hundreds of professional services organizations, along with best practices for maximizing revenue and profit!

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