Taking questions for upcoming collaborations

... and a quick post about some common pitfalls in margin reporting

Mar 05, 2023

👋🏼 Hi, folks! I’ve got two topics this week:

First, I’m excited to announce that I’ll collaborate with other experienced professional services entrepreneurs and leaders from related industries over the next several weeks.

The first collab will be with an experienced finance leader discussing investment bank M&A sales processes. The second will be with another professional services entrepreneur who built a great, fully remote working culture.

I will be trying out a new format for those posts, and I’d like to answer your questions! What do you want to know about M&A and selling services businesses? What questions would you ask the founder of an IT consulting firm with many lessons learned building a fully remote team?

Comment below or reply to this email and let me know your questions.

Not Reporting on Margin At All

The riskiest pitfall is not reporting on realized project margin at all. Unfortunately, this can be common for early-stage services businesses.

The sooner you develop the discipline for this reporting, the better off you will be. The administrative burden of this reporting only becomes greater as a business grows; it's much easier to figure out how to do this reporting at a smaller scale and evolve the capability as you grow than it is to kick the can down the road to when you have an even larger business. Businesses lacking this reporting may also be missing out on profit they could otherwise earn!

The fix:

Use your timecard data to calculate the total number of hours (whether billed or unbilled) by each staff member and by project.
Calculate each employee or contractor's “fully-loaded” cost for the hours they worked.

For employees, this includes the costs of benefits, employer-paid taxes, etc. To simplify this calculation, calculate a “load factor” by determining the total cost of those benefits and the percentage it represents for employee wages. In most US businesses, it’s pretty common to see load factors of 18-25%, meaning that the total labor cost of an employee is 1.8x - 1.25x their salary.

For contractors, this is typically much more straightforward, though contractors may be paid different rates depending on the project or work.
Calculate other unbillable expenses for the project.

This could include software or services you need specifically for that project or client that aren’t included in the business’ typical expenses. For example, if a client requires a subscription for a software or service you use only for them, that should be included.
Calculate the profitability and realized margin for the project or client. Profit for the project or client is easy: total fees billed - (total labor costs + total unbillable expenses). You can also calculate the realized margin by dividing the profit by the revenue.

You can use this data to compare your actual project margin vs. the expected margin you calculated when you priced the project. Is it different? If so, why? Can you improve the margin on this project? Can you improve how you price similar projects in the future?

Not Fully Accounting for Project Costs

This is common when a services business is monitoring the profitability of a project based on the billable staff directly responsible for the project but not accounting for non-billable staff who are spending time on the project.

For example, services businesses often have salespeople, account managers, or potentially even project management or other project oversight, spending time on a project but not billing the client.

Nothing is inherently wrong with unbillable staff working on a project, but it should be captured in your project-level profitability reporting. Time spent on a project is a cost regardless of whether the client pays. If the client isn’t paying for the work, the services firm is!

The fix:

Anyone who interacts with clients or contributes to client work should fill out time cards. Yes, this is unpleasant if it’s not the current practice. Yes, people will complain. Leadership should explain why this change is being made (to gain better insights about the business and the actual cost of servicing clients) and share the learnings as much as possible. This can be a good way for leadership to learn how much time goes into successful delivery and recognize the contributions of people who may not have been as visible.
Business expenses specific to a client or project should be recorded and calculated as part of the delivery cost.

That Adobe subscription a designer needed because the client insisted on Illustrator files instead of using Figma? Project cost.

The AWS bill for a dedicated development test environment only used for this client but billed to an employee’s credit card? Project cost.

Ideally, someone responsible for the project’s overall delivery tracks these expenses.

Not Fully Accounting for Client Management Costs

This is a variation of the previous pitfall. Here, project-level profitability fully reflects non-billable costs on a project basis, but client management costs are not being accounted for in reporting.

This is more common when multiple projects are active with a single client, and cross-project or more senior-level client relationship time is spent with client personnel. Again, there is nothing wrong with this activity occurring - it's often critical for success! - but it is a cost that should be reflected in the profitability of that client.

The fix:

Time and travel for client relationship building should be recorded similarly to project expenses. As relationships grow and a firm has multiple projects with a single client, it may take a lot of work to tie this directly to a specific project.
Over time, splitting this out as a separate line item may be helpful. One way to do this is to create a client management “project” in your time tracking system for this activity. This prevents hours that leadership may spend with a client on more top-level relationship discussions from distorting the client management that goes into a specific project.

Not Accounting for Pre-Sales Time and Expenses

It's common for services companies to invest in a client relationship or sales opportunity by spending time on pre-sales design, scoping, or engineering work. There is often non-billable expense tied to this activity, like travel to visit the client, entertainment expense for dinners, and so on.

Pre-sales time may be accounted for with the techniques mentioned above for existing clients, but how does this expense get captured for a prospect?

At the risk of being repetitious, there is nothing wrong with these expenses per se - it's the cost of doing business. However, they are often hidden sources of degraded performance that can only be uncovered with discipline.

Knowing how much it costs to land that big deal and whether that client relationship will ultimately be profitable is helpful.

The fix:

Establish some threshold for tracking pre-sales time and expense. There are diminishing returns for monitoring at a very granular level; for small firms, it can be too much. Having a threshold like “spending more than 8 hours building a POC or custom sales material” or “spending more than $2,000 on travel to visit a prospect” goes a long way to maintaining everyone’s sanity and capturing the costs that add up.
Record time and expenses for pre-sales with prospects above that threshold. This can be done by setting up a prospect as a client but marking all the time and expenses as non-billable.
Periodically review pre-sales costs. Once you’re tracking these expenses, you can check in monthly, quarterly, and yearly on the costs associated with selling and check to ensure they are good investments when a deal closes.

Not Taking Action

With the data outlined above, producing reports on the profitability of projects and clients becomes easy. Armed with this information, the leadership of projects or client relationships have the insight needed to know how profitable a project or client actually is. The pitfall some services firms fall into is having data about clients that are not profitable but not taking action.

Ideally, this information informs decisions about existing projects, like doing unbillable work to fix problems with delivery, adding more senior staff than you previously planned to help with a thorny issue, and so on. It also helps guide future decisions.

It also comes up when there is staffing contention (e.g., all other things being equal, it’s best to allocate billable staff to the most profitable projects or clients). Similarly, this data is used in pricing future work (e.g., a client with low profitability may need future work priced at higher rates, whereas you could more readily negotiate pricing with a client when their other projects have high profitability).

What happens when the data shows unprofitable projects, but something else is needed to correct the problem?

The fix:

Identify a single person who has responsibility for managing the profitability of a project/client. This can be a different person for each client, but the key is to have someone who knows it is her job to manage profitability. That person needs to be empowered to make the necessary changes to “fix” the problem, whether it’s working with the client to change rates, adjust staffing, etc.
Review client-level profitability monthly as a leadership team and set target profitability levels that every project should attain. If a project or client falls below that level, develop a plan to address it and measure progress against that plan.

In some cases, nothing can be done immediately - the project is already sold and staffed, and success for the client requires it to be delivered in a way that isn’t very profitable. It happens.

Leadership should ensure that the next project for that client gets priced more appropriately or that, over time, the focus is given to projects with better financial performance.

✌🏼 That’s it for this week. Don’t forget to submit your questions! I can’t wait to share these new collaborations with you. Make sure you don’t miss out when they get published by subscribing below.

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