Client Profitability vs. Labor Utilization: Have You Engineered a Healthy Tension?

Professional Disagreement_WIDER

Tensions exist in all businesses.  There’s the vying for budget dollars during the planning cycle, and the friction between salespeople and clients on pricing.  Accountabilities for meeting profit targets causes daily stress for business unit leaders.  It’s expected.  But we don’t necessarily look for it or engineer the system to create head-to-head conflict.

But in Professional Services there’s one area where such tension is not only healthy, but critical to achieving the full profit potential of the business.  And although it’s core to the economic model of the business, it’s often mishandled and diluted through suboptimal system design, inadequate performance metrics, and dysfunctional management processes.

I’m referring to the push and pull between client profitability and labor utilization, and between account managers and resource managers.

Start With a Clear View of the Business

Let’s illustrate the importance of clearly distinguishing between these two elements of the business.

Chart 1 below on the left presents two business units. They are both operating at a 10% margin. Based on this and on their revenue and cost structure, one might conclude that their performance is comparable. And if the bottom line margin is deemed acceptable, the analysis may largely end there.

Healthy Tension - Combined Charts 12_SMALLER IMAGE SIZE

But take a look at Chart 2 above on the right which makes better use of project-centric design and we see a very different story. This presentation divides labor cost between Direct Labor Cost (representing the cost of hours expended in delivering services to clients) and Labor Overhead (representing the cost of all non-revenue-producing hours such as administrative and business development time). The former is used to calculate Client Contribution, which is the incremental profit from an individual client (presented here in the aggregate for all clients).

So in this chart we see that Business Unit A is generating a much higher Client Contribution Margin at 60% while Business Unit B is much lower at 45%. This could be due to better scoping and pricing at the outset of the client engagements, or better project execution in controlling hours and labor mix. However, the roles are reversed when it comes to controlling Labor Overhead. Here, Business Unit B is performing much better with a 10% Labor Overhead ratio while Business Unit A is much less productive with a 25% ratio. The strong Client Profitability generated by Business Unit A is effectively leaking out of the system due to poor labor management.

Leverage What You Already Know

So why is this important? Through the application of internal benchmarking and continuous improvement, perhaps some of the strategies, processes and disciplines utilized by Business Unit A in the area of client and project management could be adopted by Business Unit B to improve its Client Contribution Margin. Conversely, we should be seeking to have Business Unit A replicate Business Unit B in the area of labor management so as to improve its Labor Overhead ratio.

And what happens if each business unit matches the better performance of the other in their respective areas? A lot, as shown in Chart 3 below. With both units operating at a 60% Client Contribution Margin with a 10% Labor Overhead drag, we increase the Operating Margin from 10% to 25%. Even if they don’t make it the entire distance, there’s still plenty of room to significantly impact the company’s profitability.

Healthy Tension - Combined Charts 3_SMALLER IMAGE SIZE

So with the basics out of the way, where is the healthy tension? It comes in the way we structure accountabilities for delivering Client Contribution and Labor Productivity. Within the operating model there needs to be individuals whose primary focus is to deliver Client Contribution (generally Account Managers and Project Managers) and this is what they should be measured on. Likewise, there should be individuals whose primary focus is to manage Labor Productivity by ensuring that the resource pool matches the project needs thereby maximizing utilization.

While Account Managers want the resources when they want them – regardless of volatility in demand – Resource Managers can’t have people just sitting on the bench waiting for the call to come. And there’s the rub. As businesses grow, they generally hit a point where it makes sense to restructure the operating model around resource sharing to drive greater efficiencies. If we did this in the above example and assumed that as a result a little more productivity could be squeezed out of the system, it might look something like Chart 4 below.

Healthy Tension - Combined Charts 4_RETRY2

Here we’ve assume for purposes of illustration that merging the labor pools results in 2 percentage points of greater efficiency, thereby reducing Labor Overhead from 10% to 8% of revenue.

Those operating in this arena may be saying, “Of course we do this. We look at client profitability and utilization all the time.” But how well? Degree and nuance matter.

Help People Do the Right Thing

For example, an important element to successfully managing on this basis is the Financial and Project Accounting system, because if it’s not designed strategically in a way that mirrors the economic model of the business it can create misaligned incentives. Using an advertising agency backdrop, let’s assume that there is a need on a project for a Junior Copywriter. The Project Manager puts in the request but finds that there are none available. However, there is a Senior Copywriter available but his cost that would normally be charged to a client project is significantly higher than the Junior Copywriter that is actually needed. If the system is not designed to handle this scenario (by discounting the Senior Copywriter’s cost to the role he is filling on this particular assignment), then there is an incentive for the Project Manager to bring in a freelancer for this role. This would be detrimental to the overall company since it adds avoidable cost, but it’s perfectly rational from the Project Manager’s viewpoint and is the right decision. Furthermore, if the decision is forced upon the Project Manager by assigning the Senior Copywriter without any cost adjustment, then the performance measurements will be distorted. The client project will look less profitable than it really is (since it didn’t need or want the more senior staffing), and the resource management will look better than it really is (since in actuality it was sitting with a resource that wasn’t really needed at the time). Multiply this by hundreds of projects and resources and you can envision how it would undermine the effective management of the business.

A solution would be a system that measures direct costs based on the role filled and captures and presents the hours and cost corresponding to role-shifting, resulting in better visibility and actionable insights.

. . . But It Doesn’t Happen By Itself

So if you’re in the Professional Services industry – perhaps in the leadership of an advertising agency, consulting firm, or IT services business – you should be asking yourself three critical questions right now:

  1. Is my operating model, organization structure, and system of accountabilities aligned in a way that fully recognizes the economic levers of project management and labor management?
  2. Are my systems designed in a way that mirrors the economic model of the business and that drives toward the decisions and behaviors that will optimize performance?
  3. Are these basic performance principles broadly understood throughout the operating population of the organization?

If the answer to any of these questions is “no,” you should act to change the current situation and create the necessary mechanisms and tools to reach your full performance potential. And a little friction is fine . . . it might even shake loose a few extra dollars of margin.

What are your thoughts? How have you dealt with this challenge? I’d love to hear your perspective.  Email me at John@sro-solutions.com.