Profitability at Professional Service Firms: Do You “Get it,” or Not?

By Jonathan Wolter

As a professional, one might presume that the economics of consulting firms, marketing and PR agencies, law and accounting firms, and other types of professional service organizations are relatively straightforward. In terms of making money and turning a profit, many people think – “how hard can it be, right?”

Yet, it is surprising how many of these companies live at the edge of financial viability, sometimes years into their lifespans. And today, as more companies shift their revenue models from product-sales and proprietary/IP-centered concepts to selling services, knowing how to maintain profitability and manage cash couldn’t be more critical for professional service firms.

At FLG Partners, we’ve identified four imperatives for effective and efficient management of professional service firms:

• ECONOMIC MODEL: Understanding the basis and inherent leverage of the economic revenue model
• MANAGEMENT REPORTING SYSTEMS: Planning and implementing the right systems for financial and operational management
• PEOPLE: Measuring performance, managing accountability, and incenting behavior
• CASH: Monitoring and forecasting cash sources and uses to ensure adequate cashflow

PROFESSIONAL SERVICES: ECONOMIC MODEL

The economic model for professional service firms must derive adequate revenue from selling professional time to recover both variable and fixed expenses and then produce the desired profit for the enterprise. Billing rates need to be adequate to cover the total cost-per-hour for billable resources and yet be sufficiently competitive. This is especially tricky when the most-costly resources (principals and partners) are necessarily committed to business development activities and have non-billable time which must be recovered by billable work performed by lower-cost (and less experienced) staff members. Determining the utilization rate is critical. The utilization rate is calculated as the number of hours worked as a percentage of total hours available to be worked. A firm’s utilization rate will differ across the workforce – as more experienced members of the team incur non-billable hours dedicated to business development and firm management. The firm must establish a basic economic model, essentially an algebraic relationship, equating profit with the variable expense of labor hours worked, based on the firm’s utilization rate across skill levels, that also recovers fixed expenses.

MANAGEMENT REPORTING SYSTEMS IN PROFESSIONAL SERVICE FIRMS

Next, the firm needs consider minimum reporting requirements. Service firms commonly have HR, accounting, and CRM systems which do the job of accurate reporting from the company level. But many of these organizations fail to establish systems which allow them to effectively budget and then track and record actual revenues and expenses at the project level. Project-level tracking of actual revenue earned and expense incurred is critical data. In order to manage effectively, the firm must measure actual hours worked compared with completion of the budgeted effort to determine if the project is on track for profitable completion. All too often, there is work to be completed after the total level of arranged revenues have been invoiced – causing diminished profitability. Project tracking and reporting over the full course of the project also exposes the actual level of expense incurred versus the originally budgeted expense of the engagement revealing whether the project was appropriately priced and appropriately managed. Ideally, comparisons of actual versus budgeted performance should be made on the same time-interval as the recurring payroll period.

The other primary focus of attention is managing indirect overhead expenses. We have seen many firms, both large and small, ignore escalating fixed expenses without updating their related economic revenue model. Overhead expense “creep” reduces profitability significantly.

PEOPLE

Next, the firm needs to manage and balance the skill sets of its team members. Talent management is key – from recruiting to performance measurement to compensation and incentives.

An important and fundamental decision here involves how individual managers are rewarded for both developing new business and managing project P&Ls. Many professional service firms create “centers of excellence” by sector with teams centered around key industry verticals, and each led by a market-recognized subject matter expert, a partner or principal. But what happens when one vertical’s team is at 100% capacity and a new client is landed in that sector? How does that partner find resources to staff the new project? Can they “borrow” staff and, if so, who gets credit for delivering the revenue?

While there are generally two viable options here, “revenue follows resources” and “revenue follows client,” many firms give revenue credit to the partner who provides the staff to get the job done as this maximizes incentives within the firm to quickly mobilize underutilized staff – this is the “revenue follows the resource” model. Alternatively, some firms give revenue credit to the sourcing partner – regardless of who provides the resource – this is the “revenue follows the client” model. An effective hybrid exists – which provides revenue-earning “points” to the sourcing partner and revenue-delivering “points” to the partner who provides the resources. Whichever policy is followed, it is critical that this fundamental decision be made and clearly communicated by the firm’s management team on (or before) Day One. Not figuring this out ahead of time sets the stage for significant internal conflict, often degrading into “the strongest personality wins” jousting sessions which get in the way of client service, profitability and firm unity.

People management is also essential when it comes to assigning accountability for performance and incentive management. Who is selling the work and who is doing the work needs to be transparent across the enterprise. Middle managers need be given incentives to be team players and share resources, manage staff turnover and maximize productivity within their teams while they also manage team members to meet project outcomes, client satisfaction levels and their own individual utilization targets.

CASH MANAGEMENT

Most professional service firms are labor intensive enterprises – therefore, cash must be managed effectively to meet payroll and support the expense structure.

Liquidity is the availability of cash – and is critical for all businesses. Probably the most important aspect for ensuring this is structuring client contracts so that cash is received periodically across the lifespan of the engagement rather than in a single lump sum payment. Balancing the timing and flow of cash collections and expense disbursements across the project’s duration enables the firm to ensure that one, or several, projects from do not become a net cash drain on the firm. And at a high level, the anticipated monthly flow of overhead expenses should also be forecast so that lumpy payments (such as those for payroll, rent and insurance) are anticipated and accommodated.

Finally, when managing fixed-fee projects, remain aware of the potential for “scope creep” – instances in which the project team is informally asked by a client to expand the project’s negotiated scope. When this occurs, defined procedures should escalate these requests back to the project manager for repricing and up-selling – if not, performance expense will increase, revenue will be left on the table and project profitability will suffer.

Sustaining profitability at a professional service firm is both an art and a science. But by making the right investments in modeling, systems, people, and cash management, you can set your firm up for success and to compete and win.