The Cambridge Dictionary defines profitability as “the fact that something produces or is likely to produce a profit”. But what does that actually mean in the professional services industry? And what metrics can we use to measure profitability? In this post, we’ll find out the answers to all those questions.
There are several different metrics we can use to measure profitability in the professional services sector. The most common way is to express profit as a ratio, or percentage, known as a profit margin. Businesses also report profits as a dollar amount, although this has its limitations. By measuring profit as a ratio, businesses have a more consistent view of financial performance across the year.
There are three different types of profit margins.
Gross Profit Margin
Perhaps the simplest to calculate, the gross profit margin takes into account total revenue and direct costs. We express it as a percentage.
Revenue is the gross income received through the sale of goods or services. It’s measured in dollars or equivalent currency. In the professional services industry revenue comes from client projects.
Direct costs are those that directly relate to the completion of a project. This includes the wage costs of the professionals involved, as well as other expenses. This is also known as the cost of goods sold (COGS).
To work out the gross profit and margin, we use the following simple formulas:
Gross profit $ = Total revenue $ – COGS $
Gross profit margin % = Gross profit $ / total revenue $ x 100
To help us understand, let’s see some examples.
Jane is a marketing consultant at an agency and helps small businesses with a wide range of marketing needs. Her hourly rate is $100. She has just completed projects for two different clients.
Project 1: SEO
Jane has helped a local firm to rank higher in search engines. The client was charged $4000 for the project. It took Jane a total of 28 hours, and there were no other direct costs involved.
Total revenue = $4000
Direct costs = $2800 (28 hours of Jane’s time at $100 per hour)
Gross profit = $1200
Gross profit margin is 30% = $1200 / $4000 x 100
Project 2: Facebook Ads
Jane helped a translation firm attract new clients through social media ads. The total cost of the project to the client was $2500. This project incurred more direct costs than project 1:
Jane’s time = $800 (8 hours at $100)
Graphic designer = $200
Campaign cost = $500
Client meeting = $400
Total direct costs = $1900
Total revenue = $2500
Gross profit = $600 ($2500 – $1900)
Gross profit margin is 13.3% = $600 / $4500 x 100
As we can see from the calculations, the gross profit margin for each project varies greatly. This metric is useful as it allows us to see the profitability of our products and services. Understanding this information is an essential first step in determining overall profitability.
The gross profit margin is used by businesses to determine pricing and competition in the marketplace, as well as the efficiency and productivity of those involved in the delivery. By ascertaining this information, businesses can optimize pricing and workflows to drive more profit.
In Jane’s case, we can see her SEO project commanded a margin of 30%, which is an industry average for professional services. Whereas the Facebook ads project only managed a 13.3% gross profit margin. These percentages are useful to the agency as it allows them to see where growth opportunities lie, and where improvements need to be made.
In this case, the agency may want to review its pricing for PPC projects as well as the direct costs. And with such a strong margin, it may look to sell more SEO services as a way to generate more growth. It could also identify training needs, as well as a competitive marketplace.
Operating Profit Margin
The next way to measure profitability is operating profit margin, which measures a firm’s profit based on its sales revenue and operating costs. This goes one step further than the gross margin and takes into account all indirect costs involved, which are also known as overheads or operating expenses. In the professional services industry, these include such charges as:
- Office rents
- Wages of team members not directly involved in the project, like IT support or HR
- Employee health care
It’s every operating expense on a company’s balance sheet that isn’t a direct cost. They are generally fixed costs, while COGS vary for each project. As it pertains to the overall operation, and not a project, operating profit is usually reported on a monthly, quarterly, or annual basis.
To work out operating profit and margin, we take the following information from an income statement and use a simple calculation formula.
Operating profit = Total revenue – COGS – operating costs
Operating profit margin = (operating profit / total revenue) x 100
To help us understand, let’s use two imaginary software firms as an example. They’re competitors to each other and have similar services and pricing. We’ll look at their operating profit margin for quarter 2.
Firm A
Total revenue for quarter 2: $100,000
COGS: $70,000
Operating costs: $5,000
Operating profit is $25,000 = $100,000 – $70,000 – $5,000
Operating profit margin is 25% ($25,000 / $100,000 x 100)
Firm B
Total revenue for quarter 2: $100,000
COGS: $70,000
Operating costs: $10,000
Operating profit is $20,000 = $100,000 – $70,000 – $10,000
Operating profit margin is 20% ($20,000 / $100,000 x 100)
As we can see, both firms have the same total income and COGS and therefore the same gross profit margin. This makes sense as they’re competitors. The big difference is in the operating costs, with Firm B running with higher overheads than Firm A.
Whereas the gross profit shows us how strong a firm’s service offering is, the operating profit helps us to understand how efficiently it’s run. Firm B’s high operating expenses could be a sign of a bloated internal structure, expensive rents and costly suppliers. Because it has strong gross profit, the lower operating margin tells us improvements need to be made in the day-to-day running of the business.
Net profit margin
The net profit margin is similar to the operating margin but takes into account all revenue and expenses, and not just those involved in the day-to-day operations. This includes costs such as taxes and debt interests as well as non-sales revenue, such as investments. Net profit is often referred to as the bottom line, as it shows the overall financial health of a business. It is used by stakeholders to determine the stability of a business, as well as the risks involved in lending or investing.
To calculate the net profit and margin, we take the following number from the financial statement and use a simple formula:
Net profit = Total revenue – COGS – operating expenses – interest expenses – tax
Net profit margin = (Net profit / total revenue) x 100
Let’s go back to software Firm A.
Firm A
Total revenue for quarter 2: $100,000
COGS: $70,000
Operating costs: $5000
Taxes and other costs: $5000
Operating profit is $20,000 = $100,000 – $70,000 – $5,000 – $5000
Net profit margin is 20% ($20,000 / $100,000 x 100)
As we can see, Firm A makes a post-tax profit of 20%.
Summary
So let’s recap the different KPIs for measuring profitability and their uses.
Gross profit margin takes into account the direct costs of goods sold. It’s used to determine how profitable products and services are.
Operating profit margin takes into account COGS and also all operating costs. It’s used to determine how efficiently a business is run and to benchmark its performance against competitors.
Net profit margin takes into account COGS, all operating costs, and then non-day-to-day costs like tax and interest. It’s used to determine the financial health of the business,
What is the project profitability index formula?
Profitability Index (PI) is a formula used in project management to help determine how profitable proposed projects will be. Gross, operating and net profit margins are effective KPIs to measure profitability, but can only be used retrospectively to determine past performance. PI, on the other hand, is used to help professional services firms with forecasting and decision-making.
PI is expressed as a ratio:
- if greater than 1, the project will be profitable.
- If equal to 0, the project will break even
- If less than 1, the project will be a loss-maker.
PI is important in project management as it allows firms to decide which projects to take on, and which to reject.
To work out PI for a proposed project, we use the following simple formula:
PI = Current value of future cash flows / Initial cost of taking on the project
Cash flow is the money that goes in and out of a business. For project management in the professional services industry, it’s what the client will pay for the project. While the initial cost of the project is the amount required to deliver the project, similar to COGS.
There are other factors to take into account, but for the sake of this article, we’ll keep things simple.
So, let’s go back to software Firm A. The team is assessing whether to take on 2 projects: X and Y.
Project X: The present value of future cash flow is $50,000 and the initial cost of the project is $35,000.
$50,000/$35,000 = 1.43
So project X will be profitable and should go ahead, as the PI is greater than 1.
Project Y: The present value of future cash flow is $70,000 and the initial cost of the project is $71,000.
$70,000/$71,000 = 0.99
So, with a PI of less than 1, project Y is set to make a loss – even though the client will pay $20,000 more.
Through evaluating PI, professional services organizations can prioritize work with higher project margins.
Ways to improve your net profit margin
So now we know the different ways of measuring and forecasting profits, let’s look at how we can drive up our net profit margin.
Track and invoice for all billable hours
The most successful professional services businesses make a habit of time tracking and invoicing for all billable work. By tracking all the billable hours spent on a project, businesses can collect data which over time allows them to build an accurate picture of future project completion time.
With this data to hand, we can determine project scope with greater precision, including the exact allocation of man-hours needed. This reduces the risk of underquoting and ensures we keep to a strong gross profit, which feeds into the net profit margin.
Collecting time tracking data also allows us to see if there are any time-consuming tasks in the project delivery. Automation of inefficient tasks can allow projects to be completed quicker, which will mean a lower COGS and higher gross margin.
Improve and optimize your employee utilization rates
Employee utilization rate is an important metric used in professional services organizations to determine productivity. It measures the percentage of employee time spent on billable activities vs administrative tasks.
To track employee utilization rates, firms need to be tracking time spent on projects. Once we’ve got this data, the rate is calculated using the following formula:
Employee utilization = Total billable hours / Eligible working hours x 100.
Let’s go back to our software firms A and B.
Firm A’s employees work 40 hours per week and spend 34 hours per week on billable work. So they have a utilization rate of 87.5% (35/40 x 100).
While firm B’s employees also work 40 hours per week, but only spend 29 hours per week on billable activities, which means a utilization rate of 72.5% (29/40 x100).
So we can see firm A’s team is much more productive and spends a lot more time on billable work than firm B. And so they can complete projects faster, and take on more work, which means more revenue. This difference in productivity will have a direct impact on the net profit margin.
Reduce overhead costs
While man-hours are by far a business’ biggest expense, we can increase our net profit margin by controlling our overhead costs. Businesses should regularly review operating expenses and compare them to previous months and quarters to see where savings can be made.
Professional services organizations should also consider client retention as a way of reducing operating costs. High advertising fees mean a higher cost of acquisition, which translates directly into a lower net profit margin.
But if our clients come back to us again, that means less marketing costs spent on gaining new business. Several factors contribute to client retention, but some of the most important are pricing, quality, and completion time.
By tracking hours, we can give our clients a more precise time frame, which minimizes the risk of missing deadlines and annoying the client. It also allows us to eliminate inefficiencies in the operation, which ensures quality output, keeps COGS under control and maintains a competitive price for the client.
With competitively priced projects completed on time and to a high standard, professional service providers will retain their clients. Through retention, we reduce our cost of acquisition, which brings down our overall operating costs and increases our net profit margin.
Tools that can help
Several project management tools can help businesses with time tracking, resource utilization, and profit indexing. These are known as professional services automation (PSA) software.
PSA programs help project managers build a “bottom-up” forecast of a project’s potential, using past data to map out all the tasks and costs needed for completion, including real-time man-hours.
These tools are automated, so project managers can assess the viability of a proposed project at the click of a button. This allows them to quote more projects quickly, allowing them to take on more work.
Other metrics to keep in mind
As well as our three main profit margin KIPs, profit index, and employee utilization, there are other key metrics that professional services businesses should also track to help with profitability.
Annual revenue per billable consultant – This is how much income each billable professional brings into a business each year. It should be offset against the labor costs and ideally at least double the cost of each employee. The higher this is, the more profitable the business.
Annual revenue per employee – This is the total sales revenue for a business divided by the amount of all employees in the company, not just billable team members. The higher this is, the more efficient the business.
Project overrun – This is how much a project goes over its budgeted cost or time as a percentage. Tracking this is essential to ensuring profitability as whenever a project overruns, it eats directly into the profits. PSA tools can help avoid project overrun.
Project margin – This is effectively the gross profit margin for a project. It’s the percentage of profit left over after deducting COGS.
Conclusion
In the professional services industry, there are several different ways to measure profit. Gross margins help us to understand the profitability of our services, operating margins are used to measure efficiency, while net margins determine a firm’s financial health. Before taking on a project, professional services organizations can use profit indexing (PI) to determine its value. And to optimize profitability, time tracking and use of professional services automation (PSA) software are essential.
