Between increasing competition and a difficult economy, the struggle for professional services firms to maintain profit margins has never been more challenging. Firms need to keep a close eye on their profit margins to ensure continued profitability. There are several factors that can eat into the margins, but many firms fail to realize how they are responsible for such a situation. From legacy systems to revenue leakages, poor decisions can cost the firm significantly. A lack of visibility into projects can also cause firms to fail at accounting for all costs and billables. Some firms even fail to understand their ideal profit margin, which forces them to be satisfied with a lower figure.
How to Calculate Profit Margin for Professional Services Firms
Knowing how to calculate profit margin allows firms to understand the return they are getting from the money they spend. It also helps in comparing the profitability across businesses that have varying levels of profit and sales. Companies generally use gross profit margin and net profit margin, which offer slightly different perspectives on their financial health.
Gross Profit Margin
The gross profit margin lets companies know their profit after subtracting expenses from revenue. Tax, interest, and admin costs are not considered in the gross profit margin.
The formula for calculating gross profit margin is:
Gross Profit Margin = ((Revenue − COGS)/Revenue) × 100
where: COGS = Cost of Goods Sold
For professional services firms, the COGS will be the costs incurred to provide the service.
The gross profit margin reflects the firm’s ability to generate revenue while covering the costs involved in providing its services. Therefore, a higher number is always better as it denotes the firm is more efficient in generating profit.
Net Profit Margin
The net profit margin tells companies how much each dollar generated in revenue translates into their profit. It accounts for operating costs and overheads in addition to the total revenue.
The formula to calculate net profit margin is:
Net Profit Margin = (Net Income/Revenue) × 100
Where: Net income is equal to the revenue minus costs, operating expenses, interests, taxes, and other expenses.
The net profit margin does more than simply tell if the company is generating profit. It also lets the company know if its overheads and operating costs are contained.
While firms can calculate these margins manually, it is best to choose an automated solution that can generate up-to-date financial reports at the click of a button. As a PSA solution, Polaris can provide real-time visibility into project profitability and help firms discover potential issues quickly.
What Is the Ideal Profit Margin?
Profit margins, as seen above, can also be useful in comparative analysis. Firms can use them to gain an understanding of their success as compared to their competitors in the same industry.
An NYU report on profit margins for U.S. industries (Jan 2021) revealed that the net profit margin on average is 5.05 percent across industries. The same for global industries is 4.66 percent. For typical professional services firms in different industries, take a look at the numbers below. Do note that these numbers reflect U.S. industry averages as seen in January 2021.
- Financial Services: 20.13 percent
- Healthcare Information and Technology: 10.61 percent
- Information Services: 15.76 percent
- Software (System & Application): 19.99 percent
It is important to note here that the ideal profit margin can differ among businesses as there are several factors to consider. Some businesses are inherently low-margin ventures while others can have higher margins. It is not just the industry that can affect the margin, but also factors such as location, size of the business, and others. For example, healthcare IT firms or engineering firms typically have lower margins while consulting firms have higher margins. A new business with a smaller staff is likely to see higher profit margins, but that margin can decrease with time as the business grows and employs more staff.
What Affects Profit Margins?
For professional services firms, improving profit margins is not always about increasing the cost of services rendered. There are many reasons for decreased profit margins and firms must look into those areas first. Here are some factors that cause profit margins to suffer and how professional services can improve upon them.
According to a white paper by Avanade, modernizing legacy IT systems can help organizations reduce business operational costs by 13 percent. The same report also stated that modernization can help potentially boost annual revenue by 14 percent at least.
These numbers highlight the enormous costs that legacy systems are bringing to professional services. Using outdated systems can prevent firms from realizing their fullest potential, not only in profitability but also in the quality of services provided. They affect business continuity, reliability, and even security. The 2020 Cost of a Data Breach report by IBM noted that the average total cost of a data breach was $3.86 million. Legacy systems also contribute to a lack of visibility, which hurts performance and productivity in several ways, such as sudden resource shortages, missed deadlines, and a general sense of frustration.
Professional services firms must make it a priority to invest in modern systems and solutions that enhance the business instead of limiting it. Newer systems such as Polaris PSA offer visibility and data entry in real time, which helps managers monitor projects more effectively and make better decisions. Polaris can help improve efficiency, reduce inaccuracies, and contribute to overall profitability and productivity.
Lack of Automation
Relying on manual methods such as spreadsheets can impact profit margins as much as outdated legacy systems. Manual data entry methods are incapable of providing an accurate and holistic view of projects and their financials. Automation does more than just ensure accuracy, however.
Automation allows firms to reduce time spent on administrative tasks, freeing up resources to focus on more profitable activities. The right automation software can also track and maximize resource utilization while improving resource forecasting. They can track time across projects and tasks automatically, ensuring no time goes uncaptured. They give a complete view of what is happening across the organization in real time, enabling proactive decision-making. Reporting, analytics, and real-time alerts are just a few of the other benefits of automation.
All of these features and more are available in Polaris, and with them, you can significantly boost your profit margins.
While statistics on revenue leakage vary, the general consensus is that up to 5 percent of a business’s revenue is lost as leakage. Moreover, a report from MGI revealed that 42 percent of companies suffer from revenue leakage. If you want to improve profit margins, leaving money on the table is certainly the wrong way to do it.
Revenue leakage can occur for a number of different reasons. The lack of automation and the use of manual methods are two of the most common culprits. They contribute to a lack of transparency, which only makes it harder for firms to analyze problems such as pricing errors and incorrect billable time data. Many organizations also fail to account for all costs while calculating billables. For example, some organizations may fail to include the time spent on research or planning into the calculations.
To ensure that you are billing your clients correctly, you must track all billables correctly, including time spent on research. Polaris, with its AI-based tracking capabilities, helps you do exactly that. It is capable of tracking all work done by resources and automatically using that data to drive costing and billing processes.
According to the Project Management Institute, almost 50 percent of projects experience scope creep. For professional services firms, scope creep presents a never-ending challenge. However, one of the major contributors to this issue is a lack of visibility around the projects.
Firms need to have complete transparency around their projects, from the hours spent to the resources allocated. They need access to accurate information about task completion rates, budgets, and more, in real time, to ensure that the projects remain on track. The configurable and agile project management automation capabilities of Polaris can go a long way in alleviating most of these problems. It provides you with comprehensive reports on every project based on real-time data, allowing you to take notice of potential creep before they become uncontrollable.
Professional services firms cannot ignore profit margins as a metric in their quest to maximize profitability. To improve those margins, however, firms need to carefully evaluate not just their financials but their workflows as well. Legacy systems, lack of automation, scope creep, and revenue leakage are all problems that require an overhaul of organizational processes to eliminate. A robust AI-powered solution like Polaris can address all of these pain points and more. It will also help firms continue experiencing profitability in the long run.
If you want to learn more about achieving solid margins, we have the right resource for you. Discover how your firm can experience the profitability and agile growth it deserves.