As a CEO or owner of a growing company, your business feels busy, you seem to be making money and you want to hire more people. But can you?
How can you know with 100% confidence whether you can afford to hire another person…or not? How fast do they have to ramp up? What happens to them (and your profitability) when this big project is over?
Indecision like this is rampant in agency-type businesses such as consultancies, where labor is the main product. To make that decision, you need good forecasting. This article is the fourth in a series solving five common mistakes that I see almost all agency-type businesses make — ones that erode your visibility to profitability.
These mistakes are not difficult to fix and can give you much better control over your profitability. As a business owner, CEO or CFO, that means you can steer your ship much more precisely. This final article covers mistakes #4, in (not) Forecasting, and the biggest error of all: #5, Poor Project or Estimate Pricing.
Mistake #4: Lack of or Poor Forecasting
The fourth biggest mistake we see in service-based businesses is in financial visibility to forecasting. As in, not having any. And not being able to make hiring decisions by other than the seat of your pants.
Forecasting is crucial to running your business, and you need to set up your systems to feed you those numbers. How do you create reliable forecasts going forward? Agencies vary tremendously in how they want to do their estimating — and that’s the challenge. The answer has to do with the type of business you run. You have three main options.
1. Labor-driven Forecasting
Some organizations make forecasts from a labor perspective because their visibility around demand from their customers may be too hard to figure out. Think about a law firm. They may have 400 to 500 clients, whom they serve with a team of 20 partners and associates. In many ways, that law firm has no idea when their clients are going to have a legal need. How do you project revenues and profits?
When future projects are uncertain, use labor forecasting as the primary driver of the forecast. You might say, “Our staff associate Jessica has been billing 150 hours a month, on average, every month for the past year (with some variability, of course). So let’s forecast her at 150 hours monthly. I don’t see anything that is going to massively change in the near term for Jessica.” For a law firm, it’s likely more comfortable predicting from their labor history.
Then, suppose they’ve been talking to new companies and developing a pipeline of new clients and deals. They’re planning to add two associates and a new partner in the next quarter. You can add the new employees into your forecasts as well. Create a “billable” ramp-up period until for revenue and add their salaries at cost to see the impact of profitability and cash flow. And begin to gather institutional learning as to what your firm’s “ramp up” period really is!
2. Customer- or Project-driven Forecasting
Not everyone has an unpredictable project pipeline. Contrast the law firm with one of our consulting clients, where they have 20 to 25 consultants working on just five or six large projects (or customers). In addition, they have a very detailed pipeline of future projects.
For them, we would forecast with the revenue profile for each of those six projects, noting milestones and when they end. Then we look at the handful of projects that they hope will come in the door and add those in.
For this consultancy, billable projects is the primary driver. Then we build the forward-looking model based on that primary revenue driver and the labor is then a secondary driver to the forecast. As this consultancy reviews their growth plans, they do a sanity check on Labor to make sure they’re going to have enough “team” to deliver the projects.
Another method is to look at every customer you have and find a monthly average for revenues. Say client ABC brings in about $1,000 of business a month. You can now say at a customer level, let’s predict they’re good for $1,000 a month, then estimate average income for all customers.
3. Combining Both Methods
Certainly, the most sophisticated way to forecast is to look at everything. Look at every customer’s revenue, then look at labor (or vice versa), and make sure that from a bottom-up and top-down approach, they’re both telling us similar answers.
That can get pretty intensive as a method. But we bring those three approaches to our clients to say, let’s think about the nature of your business and how we can best forecast it. Is this a customer-level analysis? Is this a project and pipeline analysis? Or is this a labor analysis? And we really try to put that in play.
In the end, accurate forecasting contributes to building better profitability.
Mistake #5 (Drum Roll — This is the One the First Four Were Preparing You For): Pricing Your Services Profitably
Pricing, pricing, pricing. The last of these five common mistakes is in pricing your services and projects accurately. Tackling this issue involves learning from your past mistakes and adjusting your pricing in the direction of profitability. It’s fairly simple to understand, yet can be very difficult to master — especially if you are making the four previous mistakes.
The challenge here is knowing whether you are pricing correctly. What can you use to help you figure out what is “correct”? Too many service-based businesses fly by the seat of their pants here, guesstimating. That kind of approach, however, can drive you toward less than stellar results.
One obvious way to price well is to look back at similar projects in the past. Compare what you projected or charged versus what actually happened and how events affected your profitability in the end. The idea is to create a way, with more granular data, for you to look back and say, “This is what we bid this project at. Here were the challenges. And this is what happened in terms of cost overruns.”
Maybe project costs ran over but it was a client problem that you couldn’t control. With the first four problems solved, you can see that and say, “Hey, this was the client’s issue so let’s mitigate that potential overrun in this next proposal by doing XYZ.” Maybe you’re not going to change the price, but you might change the terms of the agreement so that you are not the one left holding the bag.
Or you might see, “Man, we totally underestimated how much architecture work there was. We had to run it past several other departments for approvals, but we didn’t consider that in the proposal. Next time we have to bid this type of project higher for architecture, to reflect our labor costs accurately.”
That’s a simple example. But you can see the benefits of having the granular details. Having costs by work type in your project profitability shows you where the margins are. Having actual-to-budget or actual-to-bid comparisons gives you future adjustment points. And having realization rates in all these key metrics helps drive how you can price going forward.
As you learn and adjust, you can avoid speed bumps and hiccups and pitfalls on new projects. You can work more efficiently and profitably. Certainly, there’s plenty of art and gut and experience that goes into pricing well. But this process is also exactly what finance can do for you. It gives you a numbers lens to use in running your business.
Getting your historical profitability lens into the equation adds to your company’s decision-making prowess. That’s the last piece of the pricing challenge that we see.
Fixing the first four will bring you here — to where you have all the information you need already set up in your systems. You can track costs accurately and price more and more profitably going forward.