On Financial Metrics - professional services

Note to Readers: This post first appeared on our Managing the Professional Services Firm blog back on 19 July 2006. We are repeating it here because it provides a simple introduction to some of the key financial metrics relevant to consulting.

In discussions with some of my colleagues on time, time keeping and performance measurement, I found a degree of confusion about some of the terms I used in discussion. For that reason, I thought that it might be helpful to a broader audience if I provided some simple definitions.

Gross Fees

Gross fees simply describes the total value of work we have or will bill the client.

Disbursements

Disbursements are simply the cash-out costs directly involved in doing the job.These may be very small, bus or taxi fares, phone costs. However, in some consulting work they can be very substantial, especially where subcontractors are used.

Net Fees

Net fees, the amount we actually get for the job, equals gross fees minus disbursements. This is our real income.

Work in Progress

Work in progress or WIP represents work done but not yet billed. It includes disbursements where these are to be charged to the client.

Billings

The term billings simply describes the value of work actually billed to the client. These billings will include disbursements if these are to be recovered from the client.

Write Ups, Write Downs

Actual billings need not equal WIP. When we come to bill, we may find that we cannot bill the client for all the time involved. In this case, we have to write WIP down. In other cases, we may be able to bill more than the time directly involved. In these cases WIP is written up.

As an aside, write downs are not necessarily bad, write ups not necessarily good. A firm without WIP write downs may be undercharging, a firm with write ups over charging. It depends upon the circumstances.

Prepayments

Clients may pay us in advance for part of the work.In some cases, law is an example, these may be placed in a trust account and excluded from firm accounts until the funds are drawn down upon billing. In consulting, advance payments may be made upon contract start or on meeting certain milestones to help fund the job. In these cases, the prepayment is formally a liability in an accounting sense, diminishing as work is done and WIP created.

Financial Flows

These simply definitions provide the basic financial structure for the standard professional services firm.

As we do the work we create WIP. As our future billings, WIP is a key asset of the firm.WIP minus any write downs plus any write ups then translates into billings as we bill the client. So in balance sheet terms the WIP asset has been replaced by accounts receivable. Then as the client pays, accounts receivable become cash.

Management Issues

All this is pretty simple stuff. However, it does raise some important management issues.

To begin with, the fastest possible translation from WIP creation through to cash receipt is obviously very important and provides a first point of focus. Many firms focus on parts of the process only, usually billings to collection, whereas the whole process needs to be understood.

Secondly, disbursements need to be properly understood and managed especially where these constitute a significant part of gross fees. This is very important for independent consultants leading collective bids.

Thirdly, WIP itself needs to be properly understood and managed. In my view, this is one of the most common areas of failure within professional services.

As a first example, take the standard Government fixed price contract with payments against milestones. Failure to identify and manage WIP in this type of contract quickly leads to over-working at points along the job path, resulting in reduced hourly yields.

As a second example, firms who focus on billings sometimes ignore changes in WIP. They do so at their peril. A billings focus may help get WIP to billings, but this may conceal the fact that the firm's real position is deteriorating because increased billings come from reduced WIP. For that reason, performance statistics need to incorporate both billings and WIP measures.

WIP information is also important for multi-service firms working in different marketplaces.

Even in a single professional field like law, there are considerable variations between customer types and fields of law in areas like pricing, the pattern of WIP creation, write ups, write offs and billings. These need to be understood and accommodated.