In this series of articles I am looking at how to measure the performance of a professional services organization (PSO). I assume, perhaps ambitiously, that all PSOs engage in some kind of planning, forecasting or budgeting process, so that a certain level of profit can be anticipated.
- Actual results may differ from the plan due to:
- Lower or higher than planned utilization of staff
- Lower or higher fee rates than planned
- Lower or higher realization (conversion rate of fee value to revenue through invoicing)
- Lower or higher overall activity than planned
- Lower or higher staff costs than planned
- Lower or higher overheads than planned
It is important to understand which of these factors are at play in your actual results. This article deals with ‘standard fee variance’.
The idea of ‘standard fees’ may be an alien one. What I don’t mean by ‘standard fees’ is a price list that you might optimistically publish to your clients. What I mean is the fee rates on which your financial plans are based, and which, if you exceed them, could mean more profit (all other things being equal), and which, if you fail to meet them, could mean lower profit or even losses. They are central to budgeting, financial planning, and revenue planning in a professional services organization.
One of the reasons for reticence about standard fees is that budgeting costs is a much easier task than forecasting revenue, especially if you’re assuming that your professional service team is fixed in number. But your finance director and your shareholders aren’t likely to be satisfied with a cost budget without a revenue forecast.
How can you approach forecasting?
The first thing is to understand the constraints:
- You cannot achieve what is physically impossible. By this I mean that you cannot earn more revenue than your staff are capable of earning. Their working days are limited and utilization has an upper limit.
- You cannot charge fees that the market will not support.
- You must make a first constraint sets an upper limit on the number of days your staff can work, and therefore the number of fee-days that can be charged.
Standard Fees can be defined in this way:
Standard Fees, usually associated with grades, roles, and business streams, are target fee rates on which revenue forecasts have been built.
They should take no account of any effects of realization (of failure to realize, as revenue, the full value of time). Realization is a separate measure.
There are two approaches to the determination of standard fees:
- You can start with cost and multiply it (assuming a target gross margin %) to arrive at fee rates, or
- You can start by considering what the market will reality, whichever method you start with, you will have to look at the numbers from both points of view.
Starting with costs and an assumed utilization rate you may arrive at a rate that the market will not sustain. Starting with what the market can bear you may discover that your gross margin (after realization has increased or decreased your revenue) is insufficient.
In these cases there are only two alternatives:
- Reduce costs
- Increase revenues How? Costs Assuming that overhead costs are under control, the only costs we can be seriously concerned with are the costs of professional staff. How can these be reduced?
- By increasing utilization. If this can be done then more fee days can be achieved to offset costs, but this is only possible if the market allows it, and if realization is unaffected.
- By increasing realization. If this can be done then more revenue will be achieved from the same fee days.
- By employing staff at lower salaries. This takes some time to achieve, and can only be a long-term goal. It may also threaten the quality of the work you do and, in turn, the realization you achieve.
- By changing the balance of fixed salary and bonus so that employment costs reach budgeted level only if utilization and revenue increase.Revenues
- By using more sophisticated fee rate structures. Fee rates are usually associated with employee grades, and are even published, on occasion, to clients. They are like hotel ‘rack rates’ in that they represent the highest rate the PSO charges. They should usually be pitched higher than the average fee rates that you’ve assumed in your forecasting, since most clients see them as the starting point for downward you can set your rates more cleverly if you break the fixed link between an employee’s grade and the rates you charge. It is often better to charge on the basis of role since an employee may be capable of more roles than one, and you may thus be able to increase the average fees you charge.
Whatever techniques you adopt in anticipation of challenging margins, or in search of increased profit, you will forecast on the basis of an average or target or standard fee rates that you believe can be achieved. This fee rate will probably be associated with an employee, or more typically, with a group of employees, by grade or default role.
In complex PSOs that work across international boundaries, and which may contain more than one business stream, you will probably associate standard fees with combinations of grade, business stream and company (or country), especially if markets are substantially different in each of these. But you may choose any other meaningful combination of criteria against which to hold your standard fee rates, as long as comparison with actual rates remains possible. As with all systems, however, it is sensible to keep complexity at bay if possible. This is no exact science. Think always in terms of what you will do with the information that you hope to obtain.
As long as you can achieve actual fee rates that are close to your standard fees then your PSO should meet its planned profits (as long as all other measures are as planned).
If your rates are higher or lower than planned then a variance will emerge between the value of your fees if they were calculated at standard fee rates, and your actual fees.
Standard Fee Variance can be defined as follows:
- Standard Fee Variance measures the difference between actual fees charged to clients and the standard fees that would be charged for the same work, these also being the rates on which revenue forecasts have been built. They may usefully be analyzed by Grade, Role, Business Stream, Department, Company and any other useful segmentation.
- Actual Rates on fixed price
This definition of standard fee variance depends on the concept of actual fee rates. So let’s look in a little more detail at this concept. Actual rate is a simple enough concept in the case of time and materials projects, when every second of professional work is potentially chargeable. But how do we handle fixed price projects when there is typically a lump sum for a project or subdivision of a project?
You might think that it is meaningless to associate standard rates with fixed price projects. After all, revenue doesn’t depend in any way on how much time you spend on the project. Nor does it depend on who executes the work.
But this is a fallacy. If you are not imagining notional rates associated with the staff you plan to deploy on the project then you’re entertaining a very risky proposition, because you have arrived at a price without any calculation at all. True, you could claim, on the other hand, that you are fully aware of costs. And in this case, that’s fine, since you’re relating potential revenue to potential costs, and effectively defining rates as marked up costs. This is a slightly different method, but the result is the same.
You can think of it in two different ways:
You can determine a discounted or uplifted rate proportional to standard fee rates and apply this to estimated days.
Alternatively, you can uplift costs in proportion:
It doesn’t much matter which method you choose. Both deliver a notional fee rate that can be compared with standard fee rates to determine standard fee variance.
And once you can monitor standard fee variance you can act on it. Because, all other things remaining constant, if your actual fees are lower than standard fees then your profits are under threat. If they are higher, then you’re doing well.
Standard Fee Variance is a useful leading indicator of how well you’ve judged the market. If you have overestimated your rates then you must use all the tools at your disposal, as listed earlier, to claw back profitability:
- By increasing utilization
- By increasing realization
- By reducing staff costs
- By reducing overhead costs
- By negotiating fees more aggressively and cleverly
Latest posts by Adam Bager (see all)
- Eight Measures for Professional Services Organizations – No. 5 – Standard Cost Variance - September 21, 2016
- What Can You do About Low Utilization in a PSO? - September 21, 2016
- Eight Measures for Professional Services Organizations – No. 4 – Realization - September 21, 2016