By Jeanne Urich, Managing Director, Service Performance Insight, LLC
Step 2: Analyze revenue and costs
This is the second article in a three-part series examining the metrics that matter for running a professional services business. Part one looks at key metrics, typical targets and the incremental impact of small improvements. In this one, we 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.
Based on eight years of benchmarking more than 2,000 professional service organizations, by far the most important questions and variances come from our income statement analysis. Both revenues and costs show enormous variability — not just for embedded versus independent services providers — wide variances are also seen across professional services verticals and different size organizations. There are no definitive right or wrong answers as services-based businesses are comprised of many different business models with varying sources of revenues and costs.
The secret success formula is based on maximizing the productivity and profit of each business line while limiting unwarranted overhead. Our research continually shows that the most successful services businesses are also the fastest growing. Early-stage service organizations are typically very decentralized while more mature organizations move to centralize critical overhead functions such as finance and operations, IT, PMO and resource management. Centralized overhead activities are typically less costly than decentralized.
Flat or negative growth in a services business is deadly because of the high cost of finding and retaining talented consultants. Without enough new and interesting work and clients, high-priced consultants will start looking elsewhere for new opportunities where they will be able to grow their skills and income.
Analyze your income statement
We recommend PS executives begin the process of profit improvement by analyzing their income statement, and comparing it to the 2015 Professional Services Maturity Benchmark. This comparison provides insights into where they can increase revenues or reduce costs to improve profitability. The following sections highlight the various components of the PS income statement.
• Direct gross PS revenue – Directly delivered PS revenue that does not include re-billable travel.
• Reimbursable travel and expense revenue – The revenue recognized from re-billable travel and business expense.
• Indirect gross revenue – Revenue from subcontractors and other outside resources.
• Pass-through revenue – Revenue from hardware, software, materials, etc.
• Direct Labor expense – The cost of direct billable labor, not including fringe benefits, vacation, sick time or overhead. Non-billable labor expense for sales, marketing, IT, general and administrative, etc. should be shown in those categories.
• Fringe benefit expense -Typically this expense is based on a percentage of direct labor cost. It is the cost of employer-provided healthcare, pensions, vacation and sick pay for billable personnel.
• Billable travel and business expense – The cost of travel and business expense that can be billed. These costs may be equal to the revenue from rebilling travel and business expense. Most firms are not able to charge a mark-up on re-billable travel and business expense. They may however charge consultant time spent while travelling. Billings for consultant travel time should be shown in direct gross revenue. If the consultant is not engaged in billable work while travelling, travel time is typically charged at a lower bill rate.
• Non-billable travel and business expense – The cost of travel and business expense which cannot be billed to clients. Non-billable travel and business expense for business development should be included in the cost of sales. Costs shown here are typically for non-client related business travel for training, company meetings, etc.
• Subcontractor and outside consultant expense – The cost for non-employee contractors and outside consultants. This cost is offset by indirect gross revenue. Typically firms target 25 percent or more markup on subcontractors.
• Pass-through expense – Expense for hardware, software, materials, etc. that can be rebilled to clients. Typically firms mark up the cost of re-billable hardware, software and supplies to cover their procurement, handling and shipping costs. Typical target markup is 15 percent or more.
• Sales expense – This comprises the cost of sales headcount, bonuses and non-reimbursable sales expenses.
• Marketing expense: This includes the cost of direct and indirect marketing headcount, bonuses and marketing program expenses.
• Education, training and certification expense – The cost of education, training and certification expense across the organization.
• PS IT expense – All IT expense both capital and depreciation for the IT infrastructure including personnel, equipment, software, networking, etc.
• Recruiting expense – Direct and indirect headcount, costs and fees for recruiting.
• All other general and administration – The cost of all non-billable headcount not already shown in sales, marketing, IT or recruiting. Includes facilities, general and administration overhead.
We have found typical overhead expenses — as a percent of total PS revenue — should fall into the following ranges. If your expenses exceed the benchmark averages, your organization is most likely spending too much, which lowers profit.
• 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. This number varies depending on the percentage of total revenue generated by subcontractors. In the 2015 PS Maturity Benchmark, subcontractor-generated revenue averaged 13 percent of top line revenue.
• Sales (2 to 20 percent).Includes all direct sales headcount and fringe benefits plus non-billable business development travel and expenses, commissions, incentives and sales training. Sales expenses are typically low for embedded PSOs because they rely on the product sales force to generate PS opportunities. Embedded PSOs are typically not allocated a corporate sales charge. There is tremendous variability in the cost of sales as many organizations rely on their consulting staff to develop business. In many cases, PSOs do not capture the true cost of business development; it may be represented as non-billable time for consulting staff.
• Engineering and project management organization (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. This expense should include the cost of non-billable time for consulting staff spent on improving tools, methods and infrastructure.
• Marketing (1 to 2 percent).This encompasses all services marketing headcount and marketing expenses, such as website, 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. Embedded PSOs may receive a corporate per headcount IT allocation.
• Recruiting (1 to 2 percent). In today’s talent-constrained market, both recruiting costs and time to find and hire consultants are growing at an alarming rate. Most PSOs use a combination on in-house HR and external recruiters.
• General and administrative (5 to 20 percent).This includes PS corporate management, facilities and non-billable travel.
2015 PS Maturity Benchmark income statement
2014 was a good year for PS profitability. Profit for both embedded and independent services organizations increased as did the profit reported by all geographies. Average net PS profit for the entire benchmark increased to 13.2 percent in 2014 as compared to 11.4 percent in 2013. Embedded service organization (ESO) net profit increased to 19 percent from 15.4 percent in 2013. Independents saw profit increase slightly from 10 to 10.8 percent.
Table 1 compares the income statements of the 2015 Professional Services Maturity Benchmark for 220 professional services organizations. Sixty-seven are from embedded services organizations (ESO) and 153 are from independent professional services organization (PSO).
Although still not yet at pre-recession levels, most key financial metrics improved from 2013 to 2014. The bottom line is that profit improved almost across the board for professional services organizations in 2014. The benchmark shows strengthening demand, utilization and bill rates which led to higher revenue yield by consultant and employee.
With improved demand, PSOs did a good job of limiting non-billable overhead and discretionary spending. The overall PS market grew revenues at 10 percent, unchanged from the prior year but firms did a much better job of balancing supply and demand, leading to bottom-line profit improvements.
Focus on both revenues and costs
Above the line, revenue is driven by revenue by account, client or project. Revenue generated is typically based on the number of hours worked at an average bill rate. These are fairly easy numbers to get and report. Below the line, revenue is offset by labor cost and overhead. Yes, your organization can improve revenues while reducing costs.
Here are activities you might consider to improve revenue and cut costs:
• Focus on improving sales and marketing effectiveness to capture more installed base business while keeping a lid on sales and marketing expense.
• Add more strategic services that command higher rates. Focus on selling and delivering larger projects.
• Develop repeatable services packages to demonstrate client value and reduce the cost of sales and marketing.
• Create dedicated consulting sales and delivery roles. Excellence comes from specialization. Immature organizations may be spending more and getting less by employing a jack of all trades model in which everyone sells and delivers.
• Invest in superior talent. Winning and keeping top clients is based on providing top consultants with unique insights. Arm them with proprietary tools, methods and knowledge that enhance client success and ROI.
• Tightly measure and manage consultant billable utilization and bill rates to drive high productivity.
• Provide rewards and recognition to enhance employee engagement.
• Keep a tight lid on overhead and fixed costs by reducing facility costs and limiting non-billable roles while investing in systems and tools to automate time capture and billing.
• Ensure clients are satisfied and willing to be a reference.
Professional services organizations that focus on understanding and improving their income statement generally perform at higher levels and grow faster and more profitably than those that do not. They invest in services that offer both growth and profit potential, as well as in the talent who will ultimately deliver superior results.