I’ve witnessed too many service-based businesses shut down their operations because the owners just could not make ends meet. The most common problem? Little visibility to profitability. I’d estimate that about 90% out of the 20 agency businesses we work with exhibit one or more of the 5 main issues. In this series of articles, I’ll tackle each of these five common issues and show you what you need to do.
Agencies include architectural or interior design firms, marketing agencies, consulting firms or professional services groups. They can be software development, web dev, and law firms as well. The main feature is human labor as the primary revenue-generator.
Understanding the accurate cost of each project or client is crucial, especially as your projects grow in size or complexity. This information allows you to make good business decisions around future project pricing, your estimating process, staffing, billing and more.
If you run an agency-type business, here’s how to move towards better profits by improving your financial analysis. We begin by looking at the most common mistake I see: not tracking expenses and revenues by customer or project.
1. Costing to Individual Projects
Companies that struggle with profitability have rarely set up jobs in their accounting systems to break out individual projects within each customer. This is one of the big mistakes we’ve seen folks making.
When you have unique projects for a customer, it’s very easy in most accounting systems to break them out: project one, project two, project three. You could break a long-term or continuous project into key phases of the project as well. When you can distinguish between projects, you’re creating cutoffs and you can start to analyze your profitability.
2. Tracking Time Accurately
We’ve run into a number of agencies where time tracking is not done at all or not done with rigor. They pay the team’s salary and assume that they’re getting their stuff done. They manage workload and workflow, but don’t necessarily manage time based on a customer or a project. It’s a big deal to switch, but also allows you to manage your business. When you don’t know your profitability, you can’t improve it.
One of our AVL clients recently started to track time. They had a base of 20 to 25 employees who weren’t managing their time. They just thought, “As long as I’m efficient and effective, then we should be profitable.”
The primary challenge for them was a shift in company culture. They had to tell everyone, “No, we need you to enter your time every hour and tell us what you do every day by customer and project detail.” There was lots of good discussion with the employees as to why they were doing this. Making these shifts are not necessarily an easy thing to do from a people perspective, but it is worth it when you can run your business well.
Tracking time details is easier to do from a software and technology perspective. One tool we see used quite often is a software program called Harvest. Harvest will track employees’ time and convert that time into invoices. If you do invoices directly related to time, like on a time and materials basis, you can send those out. Or invoices can be done in a different way outside of Harvest. This software can be configured to interface with QuickBooks® or any other general ledger accounting system, so it’s pretty friendly from that perspective.
3. Accrual Accounting for Revenues
This is a key issue. We run into many agencies that still do cash-basis accounting. That can work for many companies, and in some agencies it works just fine. A challenge arises, however, when you start to have larger projects where there are major timing differences between when the work is being performed and the billing.
Using cash accounting, you run into significant discrepancies between revenue earned and cash flow. For example, if you do a year-long project where the whole price is billed at the end, you’ve paid people their payroll for a year and you’ve not received any money. That example is extreme, but it’s hard to see the profitability of that customer during that project if you’re on a cash basis, without watching revenues earned (but not collected).
We work with our clients to line up their revenues with their costs on an accrual basis. Shifting to accrual accounting takes a little bit of finesse and experience, but once you have the ability to analyze your projects’ revenues accurately, it adds so much more power into what you’re doing.
4. Charging & Allocating All Expenses
When not all costs get charged or allocated to a project, you can’t see its true profitability. When you track time by project, you also want to accurately assess the cost of that time. You want to know the exact cost of your team and then push that cost into each project.
Overhead. If Jim works on Company ABC project for a week, then a week of his salary should hit that project as a direct charge. Other costs should be allocated, too, including the cost of Jim’s benefits, or his overhead rate.
Other Expenses. There could be other costs that are directly related to that project that you want to allocate, such as direct IT costs. We also worked with an agency in which the sales costs to do the proposal and “win” the deal were significant and when the company actually took into account the entire cost of the deal, including the proposal phase, it was unprofitable, to their surprise!
Payroll. Payroll detail is another issue. Many business owners don’t realize they can ask their payroll provider to separate their staff into departments or different groups. Many providers will do this at no cost to you, as part of the payroll service your organization is buying. In most cases, you can ask for two dimensions of costs, for example, “I want to know my payroll costs in Colorado and I want to know my marketing team’s cost there.”
When you get your payroll report, those totals can be separated in a way that you can push to costs. In this way, you’re accounting for those costs correctly and you’re allocating them correctly.
Allocation Decisions. Let’s say you have six staff working on client projects. Their manager doesn’t work directly on those projects but supports the staff. There’s a couple of ways to allocate the manager’s cost to projects. One: you could have that manager report their time by project. Or two: you could allocate the manager’s salary based on how the staff reports spending their time, assuming they are equally supported. The benefit of doing payroll detail is understanding the true cost in each group.
5. Watching KPIs
The last key issue we run into is not watching key performance indicators that can help agency-type customers identify what’s really going on.
Customer Margins. This whole article is about customer or project profitability. So you want to see a report and KPIs around each customer’s/project’s margin. Many of our clients with long-term projects will not only look at their profitability to date, but (as discussed in a future article) in terms of visibility they’ll ask, “Is this project on track? Are we going to finish on time? Are we going to get the margin that we expected out of it? If not, why not?” So margin is a key KPI.
Team Utilization. There are three other KPIs that we just don’t see often, but should. One is utilization, or what percent of total hours are being charged out to projects. You’ll see this when you pay a salaried staff person to be there full-time, but they’re only billing clients 22 hours a week out of their 40. Doing the analysis around team utilization will also inform you what’s going on in terms of overall business profitability. Then you can ask: Is this an employee issue, is this a too-few-projects issue, or is this a client issue?
This week I talked to an agency that said, “Many of our people are sitting around waiting for our clients to get us the information we need to move forward. On a fixed-price $100,000 project, we have been waiting for two weeks. I can’t bill the client anymore, I’m paying payroll and my people aren’t busy.” Understanding your utilization and the root cause behind problems is extremely helpful.
Realization. You thought the project was going to take X hours, but it actually took Y hours (more); what’s your realized rate? For every hour Jim spends on a project, we would like him to bill $125 an hour. Because the project took a lot longer, he’s only realized $82 per hour.
When you see realization rates at 82 instead of 125, you can ask, “What’s causing that? Are we underpricing this opportunity?” Watching realization starts to provide profitability analysis from yet another angle.
Actual vs. Budget. When you create a proposal, you typically know what you committed to the client. How are you tracking now, relative to that budget? On larger projects, it’s important to watch your budgeted expenses and revenues v. actual. This is most critical in a situation where you have a fixed-price proposal (or the like) with a true budget you need to hit. It becomes important to know where you stand on that and whether you are on schedule.
The more ways you look at profitability, the more ways you can improve it. Did any of these issues sound familiar to you? How can you improve your visibility to profitability today?