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Understanding Utilization, Realization and Profitability in Your Professional Services Firm
Posted by Sylvia Lagerquist, CPA
Managing a professional services firm is a unique challenge in the world of business. Professional services as an industry stands apart because your business doesn’t sell a product, nor does it sell a generic service. Instead, it sells the specific services made possible by the very unique talents of the employees in your firm.
Your talent is your product, and since humans are not machines and managing them takes a combination of strategic focus and a personal touch, the professional services firm owner faces a daunting challenge: How to maximize the value of each billable resource in the firm in order to contribute to the company’s overall growth, while at the same time making those resources feel valued, appreciated and empowered with opportunities for growth.
With that challenge in mind, it’s important for professional service firm owners to understand three specific concepts related to billable employee effectiveness: utilization, realization and profitability.
Let’s examine each one to see how they interrelate, and how we can tweak them as a whole to optimize overall performance.
Utilization is defined as the amount of hours a given billable resource bills vs. the amount of hours the resource works. Since 40 hours per week is the typical standard for a full-time employee, utilization is usually calculated on this basis. For example, if an employee tracks 35 hours of chargeable work on client accounts during a given 40-hour week, that person’s utilization rate for the week was 87.5%.
It is important to understand two things about utilization. First, utilization standards can vary quite a lot depending upon a person’s overall responsibilities as well as the industry they are in. For example, a junior attorney in a large law firm who has no business development responsibilities whose primary responsibility is to churn through document review may be expected to maintain a very high utilization rate, whereas a senior partner with business development responsibilities and administrative oversight of employee teams may be expected to have a lower rate. This also varies by industry, as some industries have more overhead (non-billable) requirements, on average, than others.
Second, utilization must be considered in context. This context usually consists of the employee’s compensation, any business or personal leaves or other absences that are understood and accepted, and the nature of the firm’s current load of billable work. That is to say, employees cannot maximize their utilization of there is not enough billable work to fill their plates. The question in this case then becomes, what else can or should a billable employee be doing with that ‘gap’ time to help advance the business?
The second metric here is realization, which represents the actual revenue billed against the employee’s utilization. For example, if our employee noted in the above example is billed out at $100 per hour, then in our hypothetical week they generated $3,500 of billings at 87.5% utilization.
However, many factors may impact realization and create a gap between the utilization and realization results in real life. First off, the company may elect not to charge all hours billed to the account directly to the client. These write-offs may be due to good will, or due to senior management’s contention that the work completed should not have actually taken as long as it did. In addition, firms that bill project fees or retainers also may have a gap if the time that it took to complete the work exceeded the value of the retainer applied to that task and time period.
For example, if our hypothetical employee performed 35 hours of work that should have been worth $3,500 against a project retainer task that was budgeted at $2,500 to the client, then we have a $1,000 gap or approximately 30% off target.
In this case, the question is raised as to what the cause of the gap is. Is it because:
- The company inaccurately estimated the project fee or retainer (or knowingly ‘gave away’ the project), and the actual work legitimately takes longer?
- The company applied junior-level resources to a higher-level task and even with the differential in billing rates, the time spent on task ended up exceeding budget?
- The employee(s) are actually taking longer to complete the work than the company should reasonably expect of a person with their level of capability, training and experience?
In some of these cases, the company needs to either adjust its bill rates to align them with what the market can bear; or reconfigure its project estimating strategy so that realized bill rates (what is actually charged and paid by the client) ultimately align with nominal ones (what is planned as the intended bill rate) accurately.
One key step to consider taking here is to apply estimated timeframes to common tasks in professional services, so that when an employee works on a given task they can self-monitor their actual time spent on a task item against the generally expected range, and thus identify areas in which they may be working faster than expected (which is a good opportunity for accelerating their focus in that area), or lagging behind and could benefit from more training or supervision to master the task or focus area.
Bringing together utilization and realization is the critical but less commonly used metric of profitability. It may seem counterintuitive, but in professional services utilization and realization are the far more common metrics tracked when it comes to employee performance and operational effectiveness.
However, profitability is essential because it tells us where we should spend our time strategically, even when other metrics suggest that all other factors are equal. For example, a firm can have a high realization rate on a lower-level project (one that is billed at lower rates overall when compared to the compensation of the people performing the work) than it might achieve on another project where the billing rates are higher for less work, but more favorable when compared to the cost of the resources applied (i.e. the compensation of the employees billed to the project).
Citing our example again, our theoretical employee can work two weeks on two separate projects, both times achieving 35 hours per week out of 40 (87.5% utilization) and both times billing at $100 per hour. However, on the first project our theoretical employee is working with just one other senior person, whereas on the second project the majority of the work is being performed by lower-level resources and then being reviewed and approved by our individual.
In comparing these two projects, this means that if the first project and the second project involve the same number of hours, same billing rates and same realization rates, but the first project uses more associates and lower-level resources in the mix than the second project, then the first project will be the more profitable one. The first project will also produce slightly lower fees for the client, because of the lower billing rates of the resources used.
This distinction is important because it demonstrates another unique challenge for professional services firms: the value and essential role of leverage. Leverage in this case means using the most appropriate resource for a given task, and reserving the use of a higher-level resource for only higher-level tasks, when possible.
For example, if a $75 per hour resource can perform a given task, you generally don’t want to give that task to a $150 per hour resource — even in cases where a client will pay the applicable billable rate for whichever resource you choose. You will generate as much or more revenue when you use the higher resource, but you will also damage profitability and make it harder for the company to scale, because the most valuable resources are being over-constrained. It is important to understand that higher-level resources are generally harder to obtain and more difficult to replicate as the company grows.
As we have seen, it is critical for professional service firm owners to understand, track and manage against all three metrics — utilization, realization and profitability. By doing so, you will gain a comprehensive and accurate view of your business, the talent working in it, and the best pathways to growth and scalable success that you can pursue.
Image Credit: vickysandoval22 (Flickr @ Creative Commons)
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