The word every professional services organization wants to hear is ‘profitable’. It is the difference between growing a business and going under. Most business owners understand profitability in its fundamental meaning. But owners should be looking beyond a simple profit dollar amount, as this does not indicate why the business is profitable.
In this guide, we’ll cover what you need to know when it comes to measuring profitability in professional services, as well as including all the vital formulas you need to calculate the key figures to help you assess whether your business is healthy from a financial standpoint.
1. MEASURING PROFIT MARGINS
In any industry where project management is a core tenant, the profit margin allows a company to gain a greater understanding about their business and how solvent it actually is. Analyzing profit margins gives project managers a clearer picture of growth, revenue and operational costs.
Services teams must also bring in more money than they put into a project if they want to increase their bottom line, and not just cover the costs of a project. Having a good understanding of profit margins helps businesses decide internally on the projects that are worth pursuing.
Gross Profit Margin
Arguably the easiest to calculate, gross profit margin looks at the total revenue and direct costs, which is then shown as a percentage. A simple way to define the gross profit margin is the percentage of revenue that remains after the cost of goods sold (COGS) has been deducted.
Revenue refers to the income received through the sales of your goods or services. Direct costs are ones that relate directly to a project’s completion. This will include the wage bill for all staff involved, and various other expenses.
The higher your gross margin, the more money you will have to invest in your organization and achieve growth. It’s worth noting that in SaaS, many companies choose to run services at a loss because their focus is on maximizing ARR.
To calculate the gross profit margin, it’s best to use the following formula:
Gross profit margin = (Revenue - COGS) / Revenue * 100
Operating Profit Margin
Our next way of measuring profitability is operating profit margin. This measures a company’s profit based on its sales revenue and operating costs. This differs from gross margin in that it goes slightly further and incorporates all of the involved indirect costs, also known as overheads. In professional services firms, overheads will include things such as:
Office rental space
Salaries of employees not directly involved with a project, such as HR
Employee benefits and healthcare
An easy way to spot an overhead is to look on your company’s balance sheet and pick out anything that is not a direct cost. These are typically fixed costs, whereas the cost of goods sold will vary from project to project. Since most operating costs are concerned with the overall operation, and not a singular project, operating profit is often reported on a periodical basis, such as monthly, quarterly or annually.
To calculate your operating profit margin, we use this formula below:
Operating profit margin = (Operating income / Revenue) * 100
Net Profit Margin
The net profit margin is quite similar to the operating profit margin above, but it also takes all revenue and expenses into account, rather than just those that are involved in the day-to-day operations.
This includes things like tax and non-sales revenue, such as investments. If you’ve heard of net revenue, then you’ve probably heard of the bottom line, which is what it’s sometimes called, because it displays the wider financial health of a professional services organization. Stakeholders find it very helpful as it allows them to measure the stability of their business, and assess the risks associated with investing or lending.
To calculate the net profit margin, we grab the following figure from the financial statement and put it into this formula:
Net profit margin = (Net income / Revenue) * 100
2. PROFITABILITY INDEX
The Profitability Index (PI) is a helpful formula used by project managers to give them a clearer idea on how profitable a proposed project will be. The three formulas shown above, gross, operating, and net profit margins are all useful KPIs if you’re looking to measure profitability, but these can only be used retrospectively to assess previous projects and performance. This is where the Profitability Index differs, as it is used by professional services firms to aid forecasting and decision-making.
PI is shown as a ratio. If it is greater than 1, then the project will be profitable. A PI of 0 indicates that the project will break even, and if it is below 1, then the project will not be profitable and will in fact be a loss-maker.
With this in mind, it is clear to see how useful PI is when it comes to firms deciding which projects to undertake, and which to reject.
To calculate PI for a project, use the formula below:
PI = (Present value of future cash flows) / (Initial cost)
Let’s see this in action. Let's say that a project has a present value of future cash flows of £100,000 and an initial cost of £50,000. The PI for this project would be 2.0, which means that the project is twice as profitable as its initial cost.
3. EMPLOYEE UTILIZATION RATE
When it comes to professional services, the employee utilization rate is a very important metric to track if you’re looking to determine productivity. It measures the percentage of hours available that employees spend generating revenue for project-based services.
Billable hours will include the time your staff spends on the billable activities, which are those that you will charge your customer for. Non-billable work can be a mixture of time spent on projects that you do not charge for by choice or alternatively additional effort you put into an engagement to get it back on track that you can not charge for - in effect “eating the cost”.
Once you’ve got data on the time employees spend on projects, the employee utilization rate is calculated using this formula:
Billable Utilization % = (No. of billable hours / No. of available hours) x 100
4. TRACK PRODUCTIVITY WITH PROJECT TIME TRACKING
Many of the most successful professional services organizations will be able to keep an eye on the productivity of their projects by utilizing time tracking. By tracking all of the billable hours spent on a project, firms can collect important data which, when accumulated over time, enables them to get an accurate picture of the completion time of future projects.
Having this data at your disposal means you can determine project scope with much improved precision, and be able to allocate the exact number of man-hours required to complete a project. This means underquoting is far less likely and ensures the gross profit is kept strong, which in turn fuels the net profit margin.
The collection of time tracking data also lets a business spot any time-consuming tasks throughout the project delivery process. Many inefficient tasks can be automated, which can see projects be completed much quicker, meaning a lower cost of goods sold and higher gross margin.
5. USE A PROJECT MANAGEMENT TOOL TO GATHER PROFITABILITY DATA
Powerful project management software can help professional services firms to track time, expenses, and even revenue and profitability. Precursive helps project managers build a “bottom-up” forecast of a project’s potential using historical data to visualize and plan out all of the required tasks and costs for completion.
Precursive also automates many of the tedious, repetitive tasks, meaning project managers can assess a project’s viability at just one click of a button. This allows projects to be quoted much quicker, enabling them to take on more work and thus maximize revenue.
MEASURE PROFITABILITY WITH PRECURSIVE
Assessing your bottom line should go far beyond just looking at your bank account. Successful professional services organizations do well to know that the true determiner of financial health is the product of thorough analysis of business activities. The use of a reliable project management software can give business owners and project managers alike an insightful look into their company’s profitability.
Precursive’s project accounting capabilities and reporting allows you to see the profitability and margin of any project, for any customer, at any time. With the forecast of performance as well as the tracking of variance, Precursive provides an accurate measure of the profitability of the portfolio of work.
Take a look below at just some of the key areas that Precursive can help with if you’re looking to increase profitability:
Repeatable playbooks: This helpful tool can simplify project management and drastically reduce the time it takes to onboard customers, leading to faster time-to-value.
Customer collaboration: Keep your customers in the know from start to finish by sharing your progress and plans with them directly from Precursive.
Reporting & analytics: Track the performance of every project and see progress across all customers.
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Did you find this article helpful? If so, take a look at the articles below to learn more about how professional services and SaaS can work together to maximize profitability:
