For a professional services firm to survive in uncertain times – including but not limited to pandemics – they must understand and critically evaluate these important questions:
- What expenses are fixed and what are tied to revenue generating activities?
- What return are you getting on the expenses directly tied to revenue generating activities?
- How efficient are you at producing the work you are currently undertaking?
- What is your firm’s average break-even point (BEP) per month?
- If under the BEP, then what is the firm’s cash burn rate until they cross over the break-even point?
- Does your firm have partner and operational alignment?
1. What expenses are fixed and what are tied to revenue generating activities?
The cost structures of your firm are fundamental to its longevity. Understanding the link and interrelationships between generating more revenue and the additional costs required (or the opposite), cost allocations, and fixed or marginal costs has significant impact on profitability.
Understanding costs ensures your business is spending in the right areas, as costs are not only tied to profits of a stable business, but they’re also linked to generating revenue to grow or maintain current levels.
One of the biggest mistakes even accountants make is incorrectly allocating fixed direct and indirect costs to review a ‘true’ reflection of the business and provide meaning.
Total costs = Fixed costs + Variable costs
When people think of costs they generally lean towards fixed costs, which are predominately tied to labour and the majority of your overhead expenses. Fixed costs are fixed for a known period of time and can only be broken with notice.
These are costs that increase or decrease with usage or volume of activities. The majority of variable costs are related to costs such as sales and marketing activities, direct costs (including labour or contractors), utilities or commissions.
You will need to consider costs allocations in your business, especially at internal reporting levels. This will help identify profitability by 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.
- 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 revenue
- 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
- Decreasing variable costs can be effective if the product or service quality is retained
- Risk if the service/quality levels drop and has consequential effect on sales
- Improvement in product or service quality involves increasing variable costs but allows a higher price to be charged. 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
2. What return are you getting on the expenses directly tied to revenue generating activities?
Once you have broken down your firm’s costs structure, your direct costs and revenue generated will need to be assessed and analysed. This will include the productivity/efficiency of your professional employees, but more importantly, your marketing and sales activity spends.
3. How efficient are you at producing the work you are currently undertaking?
For professional businesses, efficiency can be described as the ratio between revenue and the direct labour cost to produce service-related revenue. How efficient your work force can finalise client work (job), including write offs, is directly tied to capacity management and costs to produce your average revenue per job.
By understanding the break down in efficiency, you can improve your direct costs, and even repurpose these costs savings to the right revenue generating activities.
Determining your efficiency factor
‘Efficiency factor’ is calculated by dividing revenue by capacity available. The efficiency factor KPI is extremely important as it indicates:
- which area of your business needs attention to increase profitability; and
- whether you have capacity for growth; or
- if you are carrying too much labour.
Read more here: Understanding your Efficiency Factor
Efficiency factor = Actual Revenue ÷ Capacity
4. What is your firm’s average break-even point (BEP) per month?
Once you understand the difference between your direct, indirect, variable, and fixed costs at a minimum, you can then determine what your average break-even point per month is to hit as a non-negotiable for the firm’s survival. Be careful – firms often make the mistake of assessing a lower cost month verse the current average cost spend.
Break-even point = Fixed Costs ÷ Contribution Margin
5. If under the BEP, then what is the firm’s cash burn rate until they cross over the break-even point?
For most firms running at below cost turnover figures, it is even more critical to understand the firm’s cash burn rate (i.e. how fast you are losing money and at what pace). Once you understand this, then you will have an idea how much money it will take to get back on track. You can plan in advance for your firm’s survival.
Calculating cash burn rate
- Select a relevant period for calculation (usually the current and last two months)
- Normalise these amounts for any expected seasonality (i.e. holiday wind up or down)
- Find the difference between the starting and ending cash balance for the selected period
- Divide the total by the number of months in the selected period
- This is your current cash burn rate. Compare to a calculation of the previous period(s) to determine a negative or positive trend. This will be better visualised via a graph for ease of understanding.
6. Does your firm have partner and operational alignment?
Partner alignment is when all partners are aligned to the business strategy, not necessarily to each other personally. Personal outcomes will drive behaviours in a business context.
When a firm is trying to survive, this alignment is more important than ever.
If you have decision makers making inconsistent decisions, your cost of doing business increases. The firm will also start to decrease its efficiencies (productivity), adding further costs above what costs are predicted to increase.
You will also send mixed messages to your employees who will need to help the firm survive. This is dangerous and can lead to poor culture and employment turnover.
The first step to building a successful partnership is to get REAL with each other on what your personal goals and objectives are. Once this is out in the open, you can focus on setting an agreed business strategy that is achievable.
The business will have standard systems and processes that we must all adhere to for consistency, efficiency, and quality assurance. But each partner must still be able to produce their results using the resources of the firm, each team may have a slightly tailored approach depending on their skillsets and industry specialty.
Your firm must have a purpose other than money as to why it exists, but remember if the firm isn’t profitable, then it won’t survive. If you think of the firm’s purpose as the body, then profit and cash are the oxygen and blood that keeps it going.
A strong, focused, and aligned partnership, working towards a common goal, will endure and produce amazing results.
On-Demand Webinar: Ensure Your Firm’s Survival
Interested to learn more? Watch our recorded webinar to further drill down on the implications for your firm. This webinar looks at how today’s response can position your business to thrive tomorrow.
Our webinars are an opportunity to tap into our knowledge and challenge your thinking.