Although they don’t like to think in this way, Professional Services Organizations (PSOs) are businesses just like any others. They profit from the difference between revenue and cost. They sell time to their clients, and they buy time from their employees.
Many PSOs sell time by the year, the month, the week, the hour or the minute, with carefully calculated rates, for each client, for each grade, for each activity and location, but many don’t do this. They come up with ingenious (and sometimes highly risky) ways of selling time that aren’t obviously related to the time that they spend, pricing by project, or by task, or based on the success of whatever they do.
But in the end, it comes down to the same thing: professional service staff spend time thinking about their clients’ problems, or doing things for them. These things might include adding up debits and credits, programming a new software system, managing the construction of a building, drawing plans for a bridge, devising a legal argument, or disbursing charitable funds. They use the skills and knowledge they’ve gained through education and experience to provide value for their clients. In all cases, they spend time and obtain revenue.
The vast majority of PSOs, therefore, if they are to be efficient, need measurement.
What should they measure?
If profitability is the goal (or in the case of the not-for-profit sector, the reduction of cost), then what’s important is to measure and manage everything that threatens it:
What threatens profitability?
– Idleness
If your professional staff aren’t busy enough then you’re likely to be incurring cost without gaining revenue. Utilization is a measure of idleness, or rather of its opposite – busyness.
– Discounted prices
Even if your professional staff are busy and all their time is invoiced at the rates you’ve contracted with your clients, you’ll still be in trouble if your rates are too low. Standard Fee Variance compares the actual fees you charge with the fees that your target or budgeted rates would earn you, these being the rates on which your projected profitability is based.
– Activity shortfall
If utilization and fee rates are in line with your plans, your overall rate of activity may still fall below the levels predicted in your forecast (of course this necessarily implies a smaller team of professional staff), leading to lower gross margins, a smaller contribution to overhead costs and a risk of losses. Activity Variance measures your shortfall against (or excess over) forecast. It is made up of all values affected by fewer or greater numbers of staff.
– Unrewarded effort
If your professional staff are busy but their time isn’t invoiced then your service margins are likely to be squeezed. Realization is a measure of the efficiency with which you turn time into revenue.
– Underestimated costs
The cost of your staff is the equivalent of variable cost in manufacturing. It should vary in proportion to ‘production’ (revenue); staff costs should rise with revenue and headcount, and fall conversely. Standard costs are often calculated for available hours, based on expected utilization, and including direct costs that increase or decrease with headcount (i.e. salary, taxes, social payments, car costs, mobile phone, etc.). Notional profitability for an hour’s work is calculated by comparing fees with costs. When costs are underestimated, profitability will therefore fall below expected levels. Keeping an eye on the accuracy of your standard costs is essential.Standard Cost Variance is this measure.
– Uninvoiced Work in Progress
A PSO can seem to be very successful, can even appear, for a short time at least, until the auditors turn up their noses, to be very profitable, without even invoicing. This is because PSOs can often recognize revenue that they haven’t invoiced, in the form of Work in Progress. This is work that can potentially be invoiced at a known value (less provisions). Work in Progress is a common feature in PSOs that perform work that can be invoiced on completion of phases, or on success, or at project completion. But a company that has too much Work in Progress is a company that has too little cash. WIP Days, a measure of the number of days of revenue that is tied up in WIP is a measure of this risk.
– Underestimated overheads
The management of overheads in PSOs is not significantly different from the management of overheads in non-service sectors. However, remember that your overall profitability is predicated on your professional staff delivering sufficient gross profit, or ‘contribution’ easily to cover your fixed overheads. Overhead Variance measures the difference between planned and actual overheads.
– Debtor Days
Managing debts, ensuring they are paid and making the appropriate provisions when there is a risk that they will not be, is part and parcel of the management of any company. It is no more or less important in PSOs, and improper debt management can as easily destroy a PSO as any other, limiting cash available for growth, or the financing of WIP. Debtor Days, when properly analyzed, can also be an indication of deeper discontent amongst your clients. Debtor Days, a measure of the number of days of revenue that is tied up in Debt, is a measure of this risk.
These are probably the eight most important financial Key Performance Indicators (KPIs) for a PSO.
If you can make these measurements then you can answer some important questions. If profits are lower than forecast, is it because:
– You’re selling less work than you planned?
– You’re selling at lower prices than you should?
– Your staff aren’t as busy as they should be?
– You can’t charge all the work you’re doing?
– Your fixed price projects are running out of control?
– Your staff costs are higher than you’d planned?
– Your overheads are greater than you’d planned? Is it because of several, rather than any single one, of these issues? Which problem should you tackle first?
Read more in my book – Eight Measures for Professional Services Management – http://37.46.83.165/http/LinkedIn%20Docs/Eight%20Measures%20for%20Successful%20Professional%20Services%20Management.pdf
Adam Bager
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- Eight Measures for Professional Services Organizations – No. 5 – Standard Cost Variance - September 21, 2016
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- Eight Measures for Professional Services Organizations – No. 4 – Realization - September 21, 2016