Understanding your Efficiency Factor

For professional businesses, efficiency can be described as the ratio between revenue and the direct labour cost to produce that revenue.

The ultimate financial measure for an efficient practice is gross profit.  To improve gross profit from an efficiency perspective, you must ensure you carry the right amount of labour.  To determine the right amount of labour for your needs, you must have a “capacity management plan”. The starting point with a capacity management plan is to determine each team, department and wider businesses efficiency factor.

Efficiency factor

Efficiency factor is calculated by dividing revenue by capacity available.Efficiency Factor

The efficiency factor KPI is extremely important as it indicates which affecting area needs attention to increase profitability, if you have capacity for growth, or are carrying too much. Refer to the below table as a guide from our experience.

Efficiency Factor

Capacity Management

Capacity starts with understanding how many hours your professional employees are available to work, factoring all forms of expected leave and public holidays. The remaining hours will be what capacity is available (what’s possible).

Applying these hours by the relevant professionals charge out rate will calculate this into a monetary value. Once you have calculated the efficiency factor KPI, then you need to analyse what the percentage ranges mean.

Productivity

Most professional businesses confuse their capacity management with the revenue component of a budget which usually incorporates a productivity target.

Once administrative time is factored in, most professional businesses refer to this as a productivity target. Capacity management targets what should be possible for the business not what you would like to achieve.

Affecting Factors

Efficiency is influenced by the volume of work produced, number of revenues generating employees (fee earners), pricing of services, internal systems in place and the experiences of the professionals.

Time to Review your Revenue Practices

Firms become complacent, they continue the norms and assuming revenue will remain the way it always has. This is a dangerous thought process to fall into, and many firms step in and out of this mentality. With a slowing market in professional services sectors predicted over the next five years, “Legal” being one of the worst followed by “Accounting”, now more than ever is a good time to review and agree upon your practices revenue strategies. Remember HOPE is NOT a strategy.

Types of Revenue

The first place you start with any revenue strategy is coming back to the type of revenue your practice is generating. Revenue can be broken up into three high level categories.

  • Recurring revenue
  • Reactive revenue
  • Proactive revenue

Proactive Revenue

Proactive revenue is known revenue from year to year. For accountants, this can be your annual accounting services. For Lawyers, this can be retainers that you may have in place with your key clients. For Pharmacist, this can be your recurring prescriptions.

Whichever professional services industry you belong to, this type of revenue is controllable and quantifiable, it is the amount that may change from practice to practice.

Reactive Revenue

Reactive revenue is revenue that walks into your door. Regardless of your Revenue targets, the customer comes to you. They may have purchased from you in the past, or it may just be convenient or circumstantial. This is revenue that is not controllable or quantifiable.  You must factor this into your revenue mix, but you cannot rely on it to occur.

Proactive Revenue

Proactive revenue is revenue that is controllable and quantifiable but requires resources to generate. Resources of both time and money. You need to create product and then you need to market a funnel for a said product while nurturing the qualifying process. Depending on your product and industry this may require more time and effort but less product to market, or vice versa. Using myself as an example. I specialise in advising professional businesses. I have defined what industry I work with and the range of services for the industry. I have a multi-channel marketing approach to reaching my audience. And half of my marketing activities can be quantified.

Focus on what you can control

Your practice needs to shift its revenue strategies to activities that can be controlled and have the potential to be quantified in some way. For all professional services industries, the activity categories can be separated out as follows:

  • Product
  • Marketing
  • Sales
  • Production and delivery
  • Client relationship management

Time to Review your Revenue Practices

The first three activities are related to winning the work, with the final activity ensuring the client comes back for work to be performed. This is the important activity in my opinion as it is much easier to sell services to existing relationship … so make sure you build one.

Understanding Costs

The cost structures of your firm are fundamental to its longevity. Understanding the link between more revenue and additional costs required (or the opposite), cost allocations, fixed or marginal costs has significant impact on profitability.

Understanding costs will make sure your business is spending in the right areas as costs are not only tide to profits of a stable business, they’re also tide to generating revenue to grow or maintain current levels. Below are some initial area relating costs to challenge your thoughts for your business.

Types of costs

When people think of costs, they generally lead towards Fixed Costs which are predominately linked to labour and the majority of overheads. Fixed costs are fixed for a known period of time and can only be broken with notice.

One of the biggest mistakes even accountants make is incorrectly allocating fixed direct and indirect costs to review a true reflection of the business to provide meaning.

Then you have Variable Costs. These are costs that increase or decrease with usage or outcomes. The majority of variable costs are related to costs such as direct costs (including labour or contractors), utilities or commissions.

Costs allocations

You will also need to consider costs allocations in your business, especially at internal reporting levels. This will help identify profitability or team business units, service/product lines and even the success of projects. To have effective costs allocations, first you need to identify the nature of costs and how they are assigned to each area of your business.

Potential consequences

Cost Type Action Potential Consequences
Fixed Costs Decrease

 

  • Decreasing fixed costs can lead to greater profitability if sales remain unchanged or if gross profit drops by less than the decline in fixed costs.
  • Risk if those costs are needed to generate of revenue.
Increase
  • Increasing fixed costs can lead to greater profitability if sales increase through better service delivery by an amount which is sufficient to compensate for the increase in fixed costs
  • Risk if new revenue isn’t generated.
Variable Costs Decrease
  • Decreasing variable costs can be effective if the product or service quality is retained.
  • Risk if the service/quality levels drops and has consequential effect on sales
Increase
  • Improvement in product or service quality involves increasing variable costs but allows a higher price to be changed. This can improve profits if the price increase is both accepted by the market and sufficient to offset the higher variable cost.
  • Risk if the service or product cost increase is less than increase in revenue.

Economic principles

When applying economic principals to costs, there are a few key areas you need to understand. These are:

  • Profits are maximised when marginal costs equal marginal revenue
  • Shut down your business, business unit/service line or project when marginal and variable costs are equal
  • There is profit produced if price and quantity meet above average total costs

Note – Economic principals assume there is perfect competition and no other factors come into play i.e. knowledge, location, relationship value. You need to apply additional factors that concern your business.

Where do you start?

If you’re unsure of where to start in your business, then simply start with identifying your firm’s cost structures. Assign responsibilities around costs moving forward and understand your cost links before performing a current cost structure review.

Two Numbers

It is easily get lost in the numbers, especially when you don’t know where to look. Most of the time it’s a combination of knowing what data to gather and collecting said data in its complete form.

Having analysed numbers for thousands of professional businesses, there are two high level KPIs that you need to focus on to drive performance within your business. These are Average Rate & Lock-up Percentage.

Continually focusing on these two numbers gives you the framework to drive improvement in profit and cash flow. Average Rate directly correlates to driving the profitability while Lock-up Percentage focuses on improving cash flow.

Average Rate

Average Rate is the calculation of revenue received over professional employee labour paid. This KPI tracks performance of individuals, teams, departments and the business as a whole.

At a very high level, this KPI tracks performance by incorporating productivity, write-offs and recoverability over direct labour costs. As this number increases, so does businesses profitability (margin).

Average Rate = Revenue / Paid hours of direct labour

Lock-up Percentage

Lock-up is a term that refers to revenue that hasn’t been billed or collected. Lock-up is a combination of unbilled revenue (WIP) and revenue that has been billed but not yet collected (debtors).

Lock-up Percentage is the rate once Lock-up is divided by annual revenue. This KPI is very important for cash flow. By tracking how many days revenue sits idle and its comparison to revenue as a whole, we can understand how we can release cash.

If you’re struggling to identify which KPIs are important for your business, more importantly if collecting said data in its complete form is also an issue, start tracking Average Rate & Lock-up Percentage. These two key KPIs will set your professional business on the right track.