Three R's: Profitability Levers for Professional Services
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Within a product technology company, the Professional Services (PS) business unit is often one of the most poorly performing organizations in terms of financial objectives. The PS business struggles with achieving target gross margins and bottom line profitability. The many reasons for this poor performance range from internal alignment to compensation practices. In this article, however, I want to focus on the primary levers that must be managed for PS to reach acceptable profitability levels.
In any business based on profit and loss (P&L), the ultimate strategy is quite straightforward: Make more than you spend. The Professional Services business inside a product company is no different. There may be a spectrum of acceptable profitability based on how much product the services pull through, but at the end of the day the Professional Services business unit is usually required to carry its own water. How best to do that? What are the key levers you can use to drive a profitable professional services business?
An old business saying states there are only two ways to improve profitability in a business: You either raise the bridge (increase prices) or lower the water level (reduce costs). This simple universal business law clearly applies to a professional services organization. Specifically, the growth and success of a professional services organization is driven by three critical variables:
- Revenue
- References
- Repeatability
Revenue and references raise the bridge; repeatability helps lower the water. Every activity should be targeted at improving one of these three variables. If you're not improving in these three areas, you're probably not improving the health of your business. That is why I refer to this as the iron triangle of PS profitability (see Figure 1). Without the concepts of this triangle firmly in place, it's very difficult for the professional services business unit to be profitable. Break this iron triangle, and you dramatically reduce your chance for success.
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Figure 1 PS triangle of profitability.
Revenue
Revenue is obviously the first and foremost variable that a consulting organization must manage. It seems simple, but of course it isn't. There are many components to the revenue variable that must be understood and managed.
Revenue Types
There are three types of revenue for a Professional Services business (see Figure 2):
Direct revenue comes from billing out your direct consulting resources.
Pass-through revenue comes from passing through the products and services of other companies.
Reusable IP revenue is generated whenever your service organization is able to take the deliverables from one engagement and reuse them to generate more revenue.
Figure 2 Revenue types.
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Figure 2With pass-through revenue, you simply "pass through" the expertise that belongs to others. Direct revenue provides better gross margins (20–40%) than pass-through revenues (10–20%) because the end customer will allow you to charge only so much "uplift" for managing other companies. Typically, you can't tack on more than 15% when selling someone else's services. With direct revenue, you deliver the goods yourself and receive the entire margin associated with the service. Here's another benefit of direct revenue: When you're driving direct revenue, your employees deliver solutions themselves and build valuable expertise for which customers will pay a premium. These direct revenue activities allow you to build valuable intellectual property and reuse it. Which brings us to reusable IP revenue, the most attractive revenue of all. Reusable IP can bring gross margins anywhere from 50–100%, based on how much your service staff needs to fine-tune the deliverables from customer to customer.
Revenue Mix
The term revenue mix refers to the combination of direct revenue, pass-through revenue, and reusable IP revenue generated by an organization. The more direct revenue and reusable IP revenue you have in your mix, the better your gross margins. To prove this point, let's consider two firms that have different revenue mixes. Firm A has a revenue mix of 30/70/0. That is, 30% of their revenue comes from direct revenue, 70% comes from pass-through revenue, and 0% comes from any type of reusable IP. Firm B has a slightly different revenue mix of 60/30/10. In Firm B, 60% of revenues come from direct revenue, 30% from pass-through revenue, and 10% from high-margin reusable IP. Table 1 shows the impact this mix has on overall gross margins. Due to the healthier revenue mix, Firm B benefits with a gross margin 12.5 points better than Firm A!
Table 1 Revenue Mix
|
|
Firm A |
Firm B |
|
Annual revenue (millions) |
$100 |
$100 |
|
Direct revenue |
$30 |
$60 |
|
Pass-through revenue |
$70 |
$30 |
|
Reusable IP revenue |
$0 |
$10 |
|
Average margin on pass-through services |
15% |
15% |
|
Average margin on direct services |
25% |
35% |
|
Average margin on reusable IP |
60% |
50% |
|
Average Gross Margin Percentage |
18% |
30.5% |
Revenue Growth Rate
Revenue growth is typically a desirable objective. Almost every business has the objective to grow the top line. But with professional services, a cost is associated with aggressive revenue growth. The faster you grow your revenue, the lower your profitability will be. This correlation occurs for two reasons:
First of all, to grow direct revenue you need to hire consultants. When you hire new employees, a ramp-up is involved: New employees need training, onsite mentoring, and so on. With all this activity, your billable hours decline, which cuts into profitability.
The second reason relates to the revenue mix. Large growth rates in professional services revenues are usually fueled by driving large amounts of pass-through revenues. As described earlier, a revenue mix that's heavily loaded in pass-through will not result in high gross margins.
Figure 3 demonstrates how profitability and revenue growth curves could look over a four-year time horizon for a new professional services firm.
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Figure 3 Growth versus profitability.