Properly calculating your costs – and margins – is critical if service businesses are to achieve and retain adequate profitabilty. By Sue Hirst *

Many service businesses start out with one person looking after clients. ‘Value’ delivered to the client is the key component from the customer service prospective. Whether it is a kitchen appliance repair service, or a law firm, staff time is the commodity available to buy and sell from the financial prospective.

Once the business starts to grow and employ more service staff, this is when it’s important to understand how much you pay for staff, compared to how much revenue comes into the business as a result. If you are going to expand and employ others it’s important the exercise results in increased profits, otherwise you may as well stay a ‘one man/woman band’ and avoid the hassles. We often see the situation where a business is more profitable prior to expansion.

The way to ensure expansion is a profitable exercise boils down to four things:

  • Measuring
  • Planning
  • Action, and
  • Measuring again!

Measuring may sound a strange thing to do before you’ve actually done anything. Understanding the basic formal of 1/3, 1/3, 1/3 helps here. The basic ‘rule of thumb’ in service business is that one third is for wages of the staff, one third is for on-costs of employing staff, such as leave, superannuation, space, IT etc. and one third is profit for the business. Starting out with this objective in mind really helps along the road to profit.

Planning targets based on the resources available is a great start to ensuring profit. For example an employee is paid $30 per hour for 38 hours a week for 52 weeks of the year, which totals 1976 hours per annum and wages of $59,280. That employee is probably only available for 46 weeks of the year, taking into account annual and sick leave which totals 1748 hours per annum. The cost of that employee’s billable time then is $33.91 per hour which is $59,280 divided by 1748.

Then you may need to allow for travel and non billable time, so let’s allow say 20 per cent for that. The billable hours now reduces to 1398 which is 38 hours x 46 weeks = 1748 x 80 per cent. The cost now jumps to $42.40 as we have less billable hours available to sell. Our target annual revenue for this person would be $59,280 x 3 = $177,840. The hourly charge out rate would be $177,840 ÷ 1398 = $127.21. In theory we should make $59,280 profit from this person, if 1398 hours are billed out each year.

Action then comes into play. I heard an example recently of a town planning firm which had a $90,000 a year surveyor knocking pegs into the ground, when a $25,000 a year employee could have done the job. For every hour the surveyor does this it’s costing the business $136.64! Multiply that over a year at say 3 hours per week, and it could be as much as $20,000 – straight off the bottom line. The lesson here is, don’t have highly skilled people doing unskilled work. Managing has a big impact on how people act on the job. Poor resource allocation can be very costly.

Well-conceived quotations can have a big impact on profit. Allowing for all the work to be carried out is important to avoid unnecessary ‘write-offs’ ie time that cannot be charged to the client. Well trained people helps to avoid sub-standard work that needs re-work, causing increased costs on the job. If write-offs occur it’s critical to investigate and identify reasons, for future improvement. Pushing internal failings onto clients by over-charging can be a source of disputes and refusals to pay.

Client selection is a good way to avoid problems. If a prospective client is demanding and difficult from the beginning, it probably isn’t going to get any better! It’s not always easy when you are keen for work but in my experience in business, choosing who you deal with makes life so much simpler. If you have to discount to retain a client or to get work in the first place ensure there are valid reasons for it. For example, a ‘loss leader’ is valid, whereas slicing off profit to get a ‘one-off’ job isn’t. Discounting to retain a client may be valid, but ensure you learn the lesson from it, so it doesn’t happen again.

Measuring against the original target on a regular basis is vital to profit. There’s a saying ‘If you can’t measure it, you can’t manage it’/ Monthly reporting on the basis of 1/3, 1/3, 1/3 is a good start. Measure how much revenue has been created per employee. Time sheets help with this. Most bookkeeping software systems have a function to do this, or you may need job management software. The benefits will far outweigh the cost. Regularly compare the value invoiced to the value paid for staff. Work on improving the revenue: salary ratio by focusing on issues that affect it.

*Sue Hirst is Director of CAD Partners – CFO On Call – a team of 60 financial control experts.

Source : my business Magazine March 2010 issue

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