I’ve spent a tremendous amount of time evaluating technology consulting businesses over the last 20 years and doing so involves examining a large number of qualitative and quantitative factors. These include things such as revenue, revenue growth rate, client revenue concentration, average bill rate, utilization rates, EBITDA, mix of employees vs. contractors, percentage of revenue in sales expense, sales production by account rep, mix of internally vs. partner-generated lead flow, voluntary employee turnover level, backlog, probability-weighted pipeline, etc. These all fill in gaps in the business puzzle, but this list excludes the piece I would choose if I could select only one: services gross margin percentage. This will no doubt come as a surprise to many consultancy leaders. It’s not even tracked by a fair number of firms. But from my experience, it provides the best bang for the metric buck in terms of presenting lots of important information in one simple two digit percentage.
How Is It Calculated?
Gross margin percentage is the percentage of revenue left after deducting the direct costs of all billable resources. This sounds simple enough on the face of things but there is some complexity in application, particularly around the questions of how to define “revenue,” “direct costs” and “billable resources.”
1. Revenue–because we’re talking about “services gross margin,” the revenue number must include only services revenue (i.e. it must exclude product re-sale, proprietary product licensing, etc.).
2. Direct Costs—these expenses include salaries, bonuses, benefits, payroll taxes and project delivery-related travel expenses (pre-sales or project pursuit travel expenses are excluded) for employees and contractors. Note that bench time IS included in direct costs but general costs such as office lease, marketing, sales commissions and overhead support expenses are not.
3. Billable Resources—this is where things get tricky and there is some legitimate variance in practice within the industry. The easy part is that billable resources exclude all SG&A functions (e.g. sales, general management, marketing, accounting, HR administration, recruiting, etc.) and proprietary product development/support teams and include employees and contractors who focus entirely on billable work. The challenge comes with hybrid roles such as a practice leader who has 50% target billability and 50% sales/practice management/employee mentoring/etc. responsibility and a consultant with 75% target billability and 25% internal product development responsibility. There are two primary methods for handling these hybrids. Some firms split the individual’s expenses between direct costs and SG&A based on the billability vs. non-billability splits. Others opt for an easier approach and allocate 100% of the individual’s expenses to direct costs if he/she is more than 50% billable and 100% to SG&A is he/she is not. In practice, the difference between these approaches is rarely significant enough to materially impact the analysis.
What Does It Tell You?
Services gross margin percentage reveals a number of things about a consultancy:
1. Value proposition—all else being equal, a low gross margin signals a firm that does not have much value add between its consultants and its clients. The firm that is a pure body shop conduit between independent contractors and clients may have gross margins less than 20%. The firm that can charge premium prices based on its brand power, delivery expertise, etc. while attracting top flight employees willing to sacrifice higher potential contractor compensation for job security, training, career development and a sales channel that produces interesting work may have gross margins north of 40%. This value proposition, as reflected in gross margin, is the true source of enterprise value.
2. Delivery excellence—excellent gross margins require not only a strong value proposition but also delivery excellence. Overruns on fixed price or quasi-fixed price engagements adversely impact gross margins. Similarly, write-offs of receivables due to collectability problems with unsatisfied clients drive down the margin.
3. Utilization management—a firm can have a nice value proposition and excellent delivery management skills but it must also effectively manage utilization levels to generate outstanding gross margins. Poor discipline around bench time can quickly drive down margins which would otherwise be above average.
This is not to say that strong services gross margins automatically indicate a firm with lots of enterprise value. The firm with 5 people doing $1.5m in revenue has some valuable individuals but not enterprise value. The company with 90% of its revenue in a single client carries concentration risk that craters enterprise value. I’ll talk about some of those other metrics in future posts. However, services gross margin is a powerful single metric that packages together nicely a number of business quality measures. Every consulting business should be measuring it, tracking it across time and evaluating the levers that drive it.