The Perfect Storm

Most labor-based service companies run with a set of Key Performance Indicators (KPIs) for operations measurement. For service companies, often there are at least four: (1) billable time as a percent of payroll hours or dollars, (2) project profit assuming an applied company-wide overhead, (3) actual overhead or actual manageable overhead, and (4) receivables (bills) outstanding (unpaid). For companies that earn most of their income by selling hours, they also often have a measure of the labor multiple they are selling called the productivity index. This ration provides the average revenue received per dollars of salary. The numerator includes all profit from internal employees as well as subcontractors.

Each company defines their KPIs in different ways and calls them something different. For instance, project profit could be called ‘gross profit.’ Accounts receivables could be called ‘days turn of AR’ and can be further defined into unbilled and billed portions. In many companies, unbilled AR is the same as ‘work in progress’ (or WIP). This creates havoc when comparing companies and doing acquisitions.

There is no right or wrong with any of the identifiers. It is cultural and historical to each company in how they operate their levers. With that being said, I think the following is very important:

A management team must create an “apples to apples” historical base of data for at least the past five years—the longer the better. Line managers need to understand the bottom line profit effect of each parameter by its incremental change. For instance, you should understand from history that every 1% point of chargeable time affects the operating profit by approximately XX % per point. Understand what 10% points of overhead change will have on your bottom line, etc. Some smart analysts can draw three-dimensional envelopes of the variables to visually show the effect of change. These create ‘rules of thumb’ that are essential to understanding the business.

If you re-organize and mix things up, do your best to re-create history under the new organizational structure. Even though it may not be quite accurate accounting-wise, do everything to re-create the rules of thumb or it will be another five years before you re-establish them. Accountants detest efforts that do not create accurate and closable results like the recreation of history, but the rules of thumb need to be approximate just enough to give confidence of effect. Whatever you do, do not lose relativity to the way you have historically run your business. Having those rules of thumb provide immediate knowledge of cause and effect and speed decision-making.

Sometimes when you measure the same KPIs year after year, incremental decay results that is not noticeable. This incremental decay does not appear to be very bad because it is just slightly lower than the year before. But when incremental decay continues for the next three to five years, its effect is considerable. It is very important to not simply measure year-over-year change as most accounting groups do, but measure current year compared to three years ago deltas. By doing the longer-term view, you detect the incremental decay of the same KPI.

Occasionally it is also helpful to challenge the KPI, which is a completely different approach. Two examples that come to mind are the chargeable time inverse evaluation and the enterprise ‘perfect storm’ approaches:

The inverse thinking for direct time presuming that chargeable time is really just total time minus unchargeable (or indirect) time. Instead of analyzing and pressuring the chargeable time, analyze the reasons for the indirect time. Again, look at the historical trend of three to five years in each of the manageable indirect categories. The largest indirect categories are usually marketing, training and standby time. Paid time off and holidays are considerable, but generally are not manageable. By pressuring accountability for the major unchangeable accounts, people are forced to charge ‘standby’ for projects. You might find that people charge marketing or other indirect accounts, rather than run over budget on projects. This practice must be detected and stopped, or you will never be able to tell how to price the next job, if you are overstaffed or if you have poor project management. You can’t move forward to correct the issue if you don’t know which issue is the culprit. Managing indirect time often illuminates the problem more clearly.

The second enlightening approach is to occasionally do a ‘perfect storm’ analysis. This entails choosing a period of time not skewed by seasonal variation or an unusual temporary event. Then, have your accounting analysts calculate the profit potential of the company—taking into consideration if there were few project overruns, chargeable time was at an optimum level, taxes were optimized, there was normal historical claim or write down levels, and overhead was a rate assumed in your pricing. This condition is the ‘perfect storm.’ In other words, strip out all the forms of profit leakage caused by inefficiency from the perfect storm. If you find that your predicted profit exceeds actual by more than 30%, begin to examine the leakages to deal with the two most severe ones. If the leakage is more than 50%, you have a crisis and rectification must be immediate. Every company needs to know how much potential profit they are leaking and why.