Professional Service Firms: How do you measure your profitability?

• Seda Bayraktar, CPA
• Partner
• Accounting Compliance & Reporting
• E-mail to Seda

Business performance management for professional service firms is essential for sustainability. Do you have adequate system that enables you to make well-informed decision?

In today’s business environment it is extremely crucial for the professional service firms to configure a systemized process for measuring their profitability so that their business may run and grow as they targeted. Capacity utilization, pricing and overheads should be taken into consideration in the determination of profitability in professional service firms as well as in making a well-informed decision in your business.

There are two important criteria that a service firm may systemize. First, they need to understand the billable utilization rate of their team. Even though the utilization rates may vary for different business types, a healthy service business may target a range of 80-90 percent billable utilization rate. As an example, if you are the partner of a service firm, you may measure from 80 to 90 percent of your employees’ total hours toward billable (or chargeable), client-facing working hours. The remaining time should be spent on non-billable (non-chargeable) but required business tasks such as business development, marketing, internal meetings, training, planning etc.

Secondly, they need to achieve and sustain a significant percent of profit margin across the business. In the service industry, margins are measured most effectively at the individual cost center level. They need to assess both how much spent for a cost center and the hourly billing rates accurately.

These criteria become even more critical for some service providers such law firms, accounting and audit firms, architecture firms or service providers that employs in-house professionals such as writers. At those firms, the management team should keep an even closer track on team productivity to ensure their employees’ billable utilization is as optimized as it can be in order to sustain growth while maximizing profitability. The ways of managing the profitability in a professional service firm could be summarised as follows:

Profitability should be measured on client and/or project basis

To derive profit from your clients/projects, you should first understand the variables that are placed in the profit equation. The baseline in this equation is always cost, but the kind of costs depends on your method of thinking. It is crucial to understand the costs on your projects prior to being able to come to a correct profit margin figure.

Even you think that your employee costs an amount per hour, we all know that it costs much more than this to have him or her working for an hour. We pay taxes and benefits on their behalf and we have overhead costs that must be covered to have him or her able to do their job. Thinking about the effects of these additional costs to our employee cost helps us to quantify the real costs of our projects accurately. The above-mentioned cost is a product of two components: Direct employee cost and overheads.

Direct Employee Cost, also known as payroll burden, is personnel-related costs such as salaries, bonus, insurance, payroll taxes, pension expenses and other benefits. 

Overhead includes any operating expenses not directly related to employees such as rent, office expenses, utilities, business development and marketing expenses, business taxes, insurance, and so on.

Understanding, estimating, and tracking the cost of direct employees and overhead is essential for running the day-to-day operations of all firms. It allows the companies to obtain a true picture of their projects and to determine whether their projects are profitable or not. 

Daily use of true and fair time sheets should be one of the requirements of the company management from its employees

Considering that direct employee costs are a significant portion of overall project cost, it is extremely important for employees to fill out a timesheet so that hours spent data is properly allocated to the engagements. Therefore, daily timesheet should be the requirement of service providers from their employees. It should be a part of an employee's responsibility to follow specific timesheet policies and procedures. Such policies and procedures may include daily updates, submission of time sheets including deadlines, explanation for audit trail etc. 

There are several good reasons for the firms to require this form from its employees. It is for facilitating 

Basic accounting principle of recording all costs accurately, consistently and timely,

Accurate, complete, consistent and timely billings to customers,

Calculation of profit margins for each individual project completely and accurately.

We suggest that the starting point should be to explain the employees why it is important and therefore a requirement. Every employee should understand the basic fact that the time they spent on projects is technically the source of the billing to the clients and actually the source of their salaries. 

In order to do that in your firm, specific policies and procedures that explain this requirement, the reason, and the exact procedures should be prepared and implemented. As with all company policies, time sheet related policies and procedures should also be read by the new hires at date of employment and updates should be required reading for existing employees. In addition, employees may be required to sign document acknowledging they have read, understand, and agree to comply these policies and procedures as a requirement of their position with the company.

Timesheet become a necessarily an important implementation that each service firm should have. Firms can loose a large part of their money if they cannot organize their employees in an effective way! 

Preparation of timely expense sheetsand their approval process should be included in the company procedures

Detailed and timely expense sheet is another important factor to follow the profitability in a service provider firm. An expense sheet should account for all expenses made for a project. This report may be broken down to each client/cost center to determine how much money spent for each project so that these costs can be charged to clients with a timely invoice. Employees should prepare expense sheets periodically (normally monthly) and all necessary supporting documentation should be attached to this expense sheet for accounting purposes. Important point is that you should be able to provide detailed analysis of expenses to your clients in case they require. 

Expense reports must be maintained for accuracy to ensure that the employees are not overspending.

Out-of-book income and expenses should be avoided

Needless to say, in order to track the income and expenses and calculate the profitability accurately, firms should keep the records of all its expenses and revenue in its books where it should derive its profitability results.

Project management should be supported with the relevant IT systems

There are software available designed to manage the full project lifecycle for professional service companies. A single system controls all aspects of project management and accounting with real-time project information shared across the firm. It is highly recommended for the professional service companies to use such software. 

We as the Cerebra team have a wealth of knowledge and experience to help your firm implement a system for tracking your project profitability to achieve sustainable growth. We would love the opportunity to speak with you about how we can help your firm.