Profit is a non-negotiable KPI. Given that this is so, ensuring profitability should be the North Star of every project manager and CEO.
In this article, we’re going to cover in detail how you can take a purposeful route to profitability. Here is the TL;DR:
Select the pricing model that best suits the profile of the work. The less predictable a timeline, the more flexible your model should be.
Predict as best you can the flow of work, based on the tasks outlined, and the composition of the team, based on its difficulty.
Price the project according not only to your effort-to-serve, but also the client’s willingness to pay.
React to what you are seeing in the data. Deviations are telling you that your assumptions were wrong, and your next step should be to find out why.
Adapt your future approach based on the lessons you learn from systematic (and unsystematic) deviations, so that your predictions and your reactions sharpen over time.
Part 1: The formula for profitability
Profit is equal to revenue minus cost. To improve the profitability of a given project you must either increase what you charge or decrease the cost to deliver.
The factors that influence profitability vary from industry to industry. In a manufacturing business, the relevant metrics might be Cost of Good Sold or Number of Defects per 100 units. In this article, we will be focusing on firms that depend on people delivering expertise via a service that requires time to deliver.
Two pricing models
There are two basic ways that you can price an expertise-based project: hourly (based on time incurred), or fixed-fee. It is very important to understand the profitability dynamics of each model, as they are quite different.
Profit = (Price per hour minus Cost per hour) * Hours worked
Profitability = (Price per hour minus Cost per hour) / Price per hour
Example: Price per hour = $50, Cost per hour = $20, Hours worked = 100
- Profit = ($50 - $20) *100 = $3,000
- Profitability = ($50 $20) / $50 = 60%
You will notice that ‘Hours worked’ does not appear in the Profitability calculation. In other words, the time taken to complete the work does not impact the profitability. This is instead determined purely by the relationship between Price per hour and Cost per hour.
Ensuring the profitability of hourly projects is therefore straightforward if:
Your team tracks all their hours (and expenses)
You do not discount your fees
Your cost per hour calculation is accurate
Profit = Project fee minus (Cost per hour * Hours worked)
Profitability = (Project fee minus (Cost per hour * Hours worked)) / Project fee
Example: Project fee = $5,000, Cost per hour = $20, Hours worked = 100
- Profit = $5,000 - ($20 *100) = $3,000
- Profitability = $5,000 - ($20 *100) / $5,000 = 60%
While the result is identical, you will notice that profitability is now sensitive to the number of hours worked (more hours → higher cost → lower profitability).
Suppose hours increase by 20%. Let’s compare the revised profitability calculations for Hourly and Fixed fee:
Hourly: ($50 - $20) / $50 = 60% (no change)
Fixed fee: ($5,000 - ($20 * 120)) / $5,000 = 52%
If the hours increase significantly, the Fixed Fee project’s profitability can actually turn negative. And once your additional, fixed costs (rental, overheads) are taken into account, the profitability will deteriorate further still.
Whereas rates, fees, and costs per employee are under your control, the time required to complete a job is difficult to predict. The unpredictability of hours is what makes fixed-fee projects harder to manage from a profitability perspective.
When you commit to a fixed fee, you are taking on the risk of higher-than-expected resource needs.
So which path is better?
If hourly is a more reliable path to profitability, why not go hourly for all projects?
Some industries are more or less run this way. A good example would be the legal profession. Hourly makes sense for Law, as the resources involved are expensive (it takes years to train) and the length of work is generally dependent on outside factors (for example, there are generally two parties involved in a lawsuit).
It is not always possible to charge by the hour, however, and fixed-fee projects have certain advantages. For example, greater efficiency (i.e. fewer hours worked) increases the ‘effective hourly rate’ and brings higher profitability.
Suppose in the above example we reduce the number of hours by 20%. In the hourly approach:
- Profit = ($50 - $20) * 80 = $2,400
- Profitability = ($50 - $20) / $50 = 60%
Although the absolute profit is lower at $2,400, 20 hours have now been freed up, which can be used on other projects to earn the missing $600. Meanwhile, profitability of 60% is maintained. Not a bad outcome!
With a fixed fee, on the other hand:
- Profit = $5,000 - ($20 *80) = $3,400
- Profitability = $3,400 / $5,000 = 68%
Profit and profitability have both increased (by +$400 and +8% respectively), and 20 hours have been freed up to earn on other projects. Another way of looking at this is that the effective hourly rate has increased from $50 to $62.5 per hour (+20%).
Part 2: How to set yourself up for success
For a fixed fee project, the planning phase (where you set your pricing and agree on your resources) obviously plays a role in the eventual profitability of the project.
Once you are in the midst of the project itself, keeping a close eye on progress is important to ensure that you avoid the unexpected yet inevitable roadblocks.
Let's examine both of these points - planning and reacting - in detail.
Planning to succeed
As we’ve seen, there are three elements that go into the planning of a project.
Cost per hour
The cost per hour represents the skill and experience of the resources in question. A mix of skill levels will usually be needed. Therefore the overall cost per hour will be a blended average of these levels, in proportion to their planned participation.
It is good to be savvy, but skimping on resources or experience to boost profitability is unwise if it affects project quality. Even if clients are unaware during the project itself (i.e. the lower quality only becomes apparent when the project is over), the relationship and all future potential projects will be put at risk.
Time to complete
Except in rare cases, it is almost impossible to predict how long a project will take with exactness. In general, the smaller the task, and the less it is dependent on others (including the client!), the more predictable the time required will be.
For longer projects, it is best to break up both the timeline and the fee into shorter segments that are naturally more predictable. You should also add a contingency (e.g. +20% hours) in proportion to the level of factors outside your control (such as external).
While the Time and Cost per hour will give you a floor, pricing should never be a purely cost-based exercise. The higher above the floor price you can go, the higher the profitability and the lower the risk you will incur. The only question is, how high is too high?
This question is beyond the scope of the article, but in essence, the price should be based on:
Ability to pay. If the floor price is more than they can afford, the project is a no-go.
Willingness to pay. This depends on how they perceive the value of the task, and the quality you bring to it. This is initially determined by how well you communicate in the initial negotiations, and ultimately by the eventual results.
Over-selling a project and pricing too high runs the risk of disappointing a client later on if the price is not in line with the value you are capable of delivering.
The job of a project manager is to detect deviations from the plan in time to correct them. Each project will have a manpower budget, based on the number of hours predicted for a given phase and team composition.
If a project is overshooting its budget, this is a red flag that the manager must investigate.
Poor resource allocation
Overall hours booked may be in line with expectations, but if there is a skew towards the senior members of a team, profitability will decline. It is common for experienced employees to hoard tasks and under-delegate because ‘It’s quicker to do it myself.’
Top tip: A real-time time-tracker will immediately reveal higher-than-expected hours. If digging deeper reveals the issue to be over-utilization of seniors. the manager can intervene and work out a more equitable distribution of workload.
What if the hours booked are just too high?
The reason for this could be:
A dysfunctional or inexperienced team. Drawing the team’s attention to the overrun should - ideally - have the effect of focusing their attention on the task in hand, or else flush out the true reason for the excessive hours.
Scope creep, or excessive client demands. The team is doing more work than they were initially supposed to do. In such cases, the project manager should be to sit down with the client and review a copy of the original statement of work.
Scope creep is dangerous, and can quite easily come about as:
Clients can sometimes interpret fixed fee projects as like an “All You Can Eat” buffet, where they ‘own’ the project team for the duration of the engagement.
Meanwhile, project managers are understandably eager to please, and follow a ‘customer is always right’ policy.
A precisely worded statement of work can often come to the rescue in such situations.
Material changes to project plan
‘Scope creep’ aside, it may happen that a major change or expansion to the original project plan is unavoidable. However, if project fee stays the same, this will obviously play havoc with profitability.
In cases where the higher workload is the result of the client’s wishes, or unforeseen circumstances (like a new regulation), it is reasonable to re-open the fee discussion.
No matter how good you are or how diligent your team is, things will go wrong.
While no project goes completely to plan, every mishap is an opportunity to learn. And data is your friend!
Diagnosing whether, how, and why deviations from the planned budget took place will be key to better planning, budgeting, and pricing next time round.
Hours booked: did we underestimate the effort?
Mix of resources: did we have the wrong allocation?
Timeline: when did things start to go wrong and why?
As should be obvious by now, but bears repeating, it is important that a project manager be involved in the planning, pricing, and post-mortem discussions as outlined above.
Profitability is not something that just happens, nor is it something that can be guaranteed if you follow the right steps. It is more like an ongoing war against uncertainty, whereby one accumulates stamina and new tactics over the course of each new battle.
In a separate article, we’ll be looking at measures that companies can use to compare the profitability of different projects and choose where to invest their resources and capital.