Customer profitability

Save
    Written by HarmonyPSA on 2017-02-27 Last updated 2018-06-27 - 4 minute read

Customer profitability comes up a lot in our “does it do…” conversations. Luckily this isn’t a problem, Harmony delivers it as a standard background task whether you need it or not.

So, forget exporting piles of data into Excel and working all afternoon analysing data, only to realise your exports were missing something or were cross-period.

To make this work automatically, there is one calculation that you need to do as, although Harmony fully automates the sums, it needs to be fed a reasonable estimation of the fully loaded cost rate for each employee or group of employees in order to have any chance of being accurate.

As not everyone will have gone through this process before, in this blog post we explain the alternate methods for performing that calculation, once again to give you choice about how you treat the problem.

Warning – equations ahead, turn away now if you find them upsetting...

At first glance this calculation looks really simple. Each employee has a known salary and plans to work a set number of days or hours per year. Gross up the salary to account for National Insurance (aka Social Charges) and other allowances and you get:

That is a reasonable approximation of an individual’s direct, incremental, or marginal, cost per day. However, for calculating the fully loaded cost that should be used in profitability calculations; you need to take more items into account.  Note the divisor in this equation is the Effective Working Days per full time equivalent (FTE), generally between 220 and 230 days. It is referred to as such in the equations below.

Method 1 – Blended cost rate

In order to decide how to incorporate (sometimes called recover) your overhead costs into/via your manday cost, you first need to decide which of your revenue streams you are going to assume man-days act as the overhead cost distribution key. For instance, you may decide that software license sales are not manday dependent but the rest of the business (support and services streams) is.

So, to calculate the percentage of overheads that must be recovered via man-days:

The second key decision is which of your staff contribute to the revenue delivery channel. Normally, this would exclude management, sales and marketing, finance and administration staff, but include all others. We will call these people Delivery Stream Staff. The FTE value of this group takes into account part-time workers and any phased headcount profile your budget assumes during the year (another wrinkle to consider, phasing...).

The final decision is whether you expect your contractors (who are, in effect, under cost of goods employment) to contribute to overhead recovery. This will depend on what percentage of your staff they represent. For this example, we will assume that they don’t make a budgeted contribution to overhead recovery as they are a fully variable income stream.

With these assumptions, the fully loaded blended manday cost is calculated as:

Note: the total overhead budget here includes all salaries, burden, and other non-sales related costs

Method 2 – Fixed overhead recovery

The blended cost rate method gets you a good working number and will ensure profitability calculations are at least meaningful. However, it does not take into account individual salaries. If you have customers, projects or products that do not conform to a normal mix of staff, the result can be misleading and so lead to bad decisions.

To improve the granularity, we need a new cost definition which is the Annual Overhead Budget less the direct cost of the Delivery Stream Staff. We'll call this cost group the Fixed Overhead Budget. So, the individual cost rate for the fixed overhead recovery (FOR) method is calculated as:

This will give you a personal cost rate, but that may be too much detail and/or too much maintenance. A common middle road is to group staff into cost bands in the same way you may group them into charge bands. Replacing the marginal daily cost with group averages in the equation above will get you very accurate profitability numbers and eliminate the possibility of someone reverse engineering salaries from cost reports.

Method 3 – Variable overhead recovery

Fixed overhead recovery, in particular by bands, is accurate, practical and meaningful, but some would argue that it flatters high charging staff and under-values the contribution of the lower paid as they earn less but all carry the same overhead cost allocation. The answer to this is the variable overhead recovery (VOR) method.

Variable overhead recovery weights the share of overhead costs applied to each individual or band by their direct cost so more expensive staff (who presumably charge out at a higher rate) carry more overhead. This is calculated using the equation above but with a cost weighting applied to the overhead recovery function as:

Note: if banding is applied, the average marginal daily cost should be calculated on totals not as a straight average of the band numbers or average of averages effect will take place. Clearly, using this same thinking, we can incorporate billable targets (reduces delivery days) etc, but we thought if we included that, no one would read it.

Summary

Getting the fully loaded labour cost rates right is key to instant profitability analysis. If you are accurate in this calculation, at year end, the revenue numbers, where labour is the distribution key, will show all your overhead costs fully recovered and you will know where you made the money and how much. This is vital to tuning your business and maximising returns. However, for this to work, the analysis also requires a system that can automatically track the actual costs at each qualifying time booking level.  Harmony does.

So, with a little bit of effort up front you can click through to customer, contract and/or project profitability trends and discover a very close approximation to the truth for no work at all. How cool is that?

 

About the Author: Harmony Business Systems Ltd (HBS) is the company behind HarmonyPSA, the most complete cloud PSA software on the market. Developed with functionality to cater for even the most complex needs of MSPs, VARs, ISVs and Professional Services organisations, HarmonyPSA truly is the next generation of PSA systems. HBS is an independent company based in the UK. Follow HarmonyPSA on


Tags: Business, contribution analysis, profit analysis, profitability reporting, General PSA, worst customers, best customers

Categories

Recent posts

Subscribe to our blog