Forecasting Bottom Line Profitability at the Professional Services Organization
Most Professional Services managers or directors annually participate in the management accounting exercise of forecasting future billings and profitability. The prevalent model in experience-based Professional Services Organizations (PSO) are time and materials-based billing projects, where charges to the client are based on the actual hours consumed, typically up to a not-to-exceed number. However, the dominant model in an efficiency-based PSO is deliverable-based billing, often at a fixed price. Two distinctly different formulas are required to calculate billings and profitability across these practice areas and billing types.
Consider the month of November 2015. A typical utilization model for a PSO estimates 20 available business days per month. In the United States, Thanksgiving reduces November to 20 days, and if your firm gives your team the day after Thanksgiving off, November is just 19 billable days.
Forecast billings = # of staff * # of hours * forecast utilization rate * average hourly rate
Annual staff cost = (salary + variable compensation) * loaded cost
Profitability = forecast billings – (staff cost / 12)
Forecast billings = 1 staff * 19d * 8h * 75% * $200hr = $22,800
Annual staff cost = $80,000 salary + $20,000 commission * 1.2 (for healthcare, 401k, etc) = $120,000
Profitability per staff member for November = $22,800 - $12,000 = $10,800
In a time and materials based billing model, maximum billings are dictated by the number of personnel on staff and their average utilization rate in a given month. The utilization rate can be artificially controlled by holding down hiring, which increases utilization. However, this benefit is balanced by the risk of staff burnout and long wait times for clients.
By comparison, if your PSO uses fixed-price, deliverable-based billing (or milestone billing), the prior formulas are not meaningful. Unlike time and materials based engagements, fixed-price engagements have a hard limit, frequently billed either at the time of booking or in milestone-based increments. This is the standard model for an efficiency-based PSO or practice area, with many specialized junior to mid-level staff working on repeatable projects.
Consider the example of a fixed-price service offering that costs $5,000 and requires two staff to deliver. Your firm estimates that you will sell six of these per month, on average. The number of hours required to perform the services is not shared with the client and is not relevant to your firm’s bottom-line profitability. That assumes that the internal estimate of duration is reasonable and would result in a profitable hourly charge if the service were offered on a time and materials basis.
Forecast billings = 6 service * $5,000 = $30,000
Annual staff cost = 2 staff * ($60,000 salary + $10,000 commission * 1.2 (for healthcare, 401k, etc)) = $168,000
Profitability for any month = $30,000 - $14,000 = $16,000
In a fixed-price, deliverable-based model, profitability decreases relative to the number of personnel required to deliver the service. Therefore, service offerings that require less personnel to deliver are preferable as they increase the net profit per staff member. However, requiring less personnel for service delivery requires mid-level to senior-level staff who can fill multiple roles on a project, thereby increasing staff costs.
Both billings models can be profitable for a PSO, and neither is fundamentally superior. While the experience-based PSO may have higher billings, it also carries higher staff costs. The efficiency-based PSO may have lower billings, but with lower staff costs it can produce the same net profitability.