Most professional service firms are partnerships and they either charge by the hour or on a fixed-fee basis for a specific service. There is a well-known formula governing profitability when hourly rates are used. This formula can be applied to a team as well as to the firm as a whole. It is:
Average equity partner profit = gearing x utilization x charge-out rates x margin x recovery
Gearing (or leverage) is the ratio of junior to senior professional staff. (The use of the term ‘gearing’ here is different from the way that it is used in financial accounting. There it refers to the ratio of borrowings to shareholders’ capital employed.) If a team can deliver its services with less senior time and more junior tim it enhances profitability by getting more work done by people who cost less. Innovating in new processes, harnessing the benefits of electronic technology and investing significantly in improving skills are essential accompaniments. It is a very good way to drive up profits.
Utilization is the number of hours charged. If utilization is increased, on average, within the team, then more profit can result. However, this has to be done with care. It is unwise, from a long-run perspective, for partners and other seniors to increase the number of their chargeable hours at the expense of time for leadership and obtaining new business. There is also a risk, from a profitability viewpoint, to expect trainees to charge a very high number of hours because the supervision costs will be so much greater.
Charge-out rates are the fees charged per hour. If these can be increased through better service, innovations and a reputation for outstanding work then profitability can be enhanced significantly.
Margin is the ratio of profit to fees. This is primarily influenced by productivity (utilization x charge-out rates) and gearing. The remaining costs of delivery are overheads. There may be room for some savings here but they are unlikely to be significant.
Recovery is the proportion of work in progress that is billed. It is not unusual for people to under-bill. They feel that the level of work in progress is too expensive and that the client will object and perhaps go elsewhere next time. Increasing recovery by a very small percentage can produce a significant increase in profitability. The extra portion goes straight to the bottom line.
Teams in some firms have fee growth targets but no profit targets. Whilst growth of fees can be viewed as a measure of success in terms of position in the marketplace and the provision of career opportunities, it may be a delusion as far as profitability is concerned. Growth in fees, without a reduction in delivery costs or an increase in fee rates, will, broadly speaking, have a neutral effect on profitability. Measurement tools have a significant effect on people’s behaviour. When teams and individuals have fee growth targets, but no profit targets, people are enticed to chase fees even if the work involved is unprofitable. The result is often high income and low profits for the team. It makes sense to have both profit and fee growth goals. Since in most medium to large professional service firms the nature of work undertaken varies considerably from team to team it is helpful for each leader and team to work out the most appropriate mixture of gearing, utilization and charge-out rates necessary to achieve their own profit-per-partner targets.
These days quite a few firms offer at least some of their services on a fixed-fee basis. They have learnt how to cost their service delivery, achieve a market-determined fee and generate a profit. In those firms that have been more used to charging by the hour, increased specialization and client pressures are now also leading to the use of fixed-fee contracts. A fee is quoted in advance for the service to be offered. Some professionals who are not used to the process find this a frightening prospect because it involves turning the conventional approach to costing on its head. The new requirement is to start with a market price and then work out how to deliver the service in a cost-effective and profitable manner. However, there are benefits. It becomes possible to build premiums into fees to cover investments in research, information technology, new methodologies and so on that may have been made previously. The problem of recovery (the proportion of work in progress that is billed) disappears. However, if your team provides fixed-fee services it is still important to calculate productivity (utilization x hourly rates) and gearing to determine the costs of service delivery.
There are two other useful financial measures. These are targets for unbilled work in progress and for receivables. They allow you to monitor the promptness both of billing and of clients paying. Both are important for cash flow and can impact on profitability.
The financial measures described here are mainly appropriate for partnerships. Some of the concepts, however, may be helpful to incorporated professional service firms and also to departments of professionals within corporations if they charge internally for their services.