Measuring profitability helps professional services firms (PSFs) determine whether a project is worth its weight in resources, time, and effort. It also allows you to prioritize multiple projects effectively, even when they are competing for limited resources. Not only has it become more challenging to find and keep employees, but marketplace globalization has also increased competition among PSFs, and clients have become emboldened to demand more for less. As Thomas J. DeLong, Senior Fellow at Harvard Business School, aptly stated, “In the past, the work of [PSFs] was a gentleman’s game — and now it’s a blood sport.”
Measuring profitability is easier when you’re working with a physical product. But as a professional services firm (PSF), your services are made up of intangible products. You sell time, knowledge, and expertise, which means your profitability isn’t determined by the value of production units, but rather by a combination of capacity utilization, pricing, and overhead.
A Case for Strong Capacity Utilization
Utilization is the percentage of time spent on billable projects as it relates to the total time worked. It is calculated by dividing the total capacity utilized over a specific period by the total production capacity multiplied by 100.
For 2020, Statista reported the average worldwide utilization for PSFs was around 71%. However, the average can vary significantly by firm type. According to the 2020 Deltek A&E Industry Study, the average utilization for A&E firms is around 61%. According to Clio’s 2020 Legal Trends Report, the average utilization for law firms is half of that at 31%.
Between utilization, pricing, and overhead, utilization generally wins out for the largest source of profit improvement. Suppose you have 50% utilization and a 5% profit margin. In this case, just by increasing selling efficiency by 10%, you could double your profits. How do you increase selling efficiency? Depending on your firm’s circumstances, it could be a shift in resources from new account to existing account development, for example. But one of the most significant opportunities to improve profitability coincides with improving the way you track time.
Accessible, User-Friendly Time Tracking
Employees of PSFs are also unique in that they usually accrue both direct and indirect costs. Part of measuring these costs effectively involves analyzing your present and historical ratios of support staff to professional staff, as well as comparing them to the ratios of other firms. The average percentage of professional costs that are non-chargeable also varies by firm type, but one thing is certain – the way you track time will affect your profits drastically.
It’s best practice to use an automated software solution so that employees can track billable work in real-time from virtually anywhere. No matter what method you use, it should not be overly complex. Employees are more likely to adopt user-friendly time tracking methods and straightforward policies.
Pricing, Profit Margins & the Profitability Index
It’s crucial for a PSF to be assertive and confident in its pricing. If your firm’s pricing is governed by fear of bargaining, rejection, or losing business, your pricing model will not enforce fair returns. You have to trust that most of your clients will likely pay for relationship stability, but you also have to be prepared to walk away when necessary.
High-dollar initiatives are not the same as profitable ones, and accepting projects with slim profit margins can negatively impact your overall financial health. Your gross, operating, and net profit margins help you measure profitability. However, they do so retrospectively, as they help you analyze past performance. The profitability index (PI) is a formula that can help your PSF forecast and make profitable decisions. PI is calculated by dividing the present value of future cash flows that the project will generate by the project’s initial cost. A project will result in a loss if the result is less than one. The project will be profitable if the result is greater than one. If the result is zero, the project will break even.
Your overhead rate is calculated by dividing your indirect costs by your direct costs and multiplying by 100. Cutting overhead costs can help you increase your net profit margin, so it’s critical to set stable staff-to-overhead ratios and adhere to them. But, as far as cost-cutting goes, overhead can be deceiving. These costs often appear to be the most controllable; however, overhead offers the least opportunity for savings. Because your employees generally accrue both indirect and direct costs, what seems like an opportunity to reduce indirect costs and overhead may be an opportunity to improve capacity utilization in disguise.
ARB’s Professional Services Firm Advisory Team provides tax, accounting, and advisory services to architecture firms, engineering firms, law firms, marketing agencies, and consulting firms so that they can shift the primary focus back to client service. And we understand your industry through and through. After all, we are a professional services firm too!
I want to help your firm develop savvy, sensible solutions to measure and optimize profitability. If you’d like to discuss your strategy, contact me today.
by Jason LeBlanc, CPA
Jason LeBlanc joined ARB in 1997 and has been a principal for the firm since 2016. He is the Practice Leader for both ARB’s M&A Advisory Group and Nonprofit Advisory Services Group. Throughout his career in public accounting, Jason’s focus has been on M&A advisory services and providing accounting, compliance, and consulting services to clients in the professional services firms, nonprofit, and automotive sectors. He works extensively with organizations subject to Single Audit reporting requirements.