Imagine you’ve taken on a year-long project with a client and agreed to a fixed price at the start.
But, since then, things have changed — maybe a couple of team members changed departments, or the software you purchased now costs more, or your chosen freelancers have increased their rates.
Cue the question: are you still making a profit on this project?
The easiest way to tell is by running a profitability analysis. Here’s a guide to what exactly a profitability analysis is and why it’s crucial for agencies and professional service businesses.
In simple words, profitability analysis is a way of using financial metrics to measure a project's financial health.
A profitability analysis report answers questions like:
Businesses of all kinds make profitability reports, especially during economic downturns, to analyze profits.
Professional services businesses and agencies have more cost variables to consider than any other type of company.
Let’s take a look at this in action. For example, if a client is outsourcing a content creation project to you, their costs might look like this:
However, to keep track of the same project, you (as the agency) will need to consider the following costs:
Eventually, keeping track of all these cost variables becomes difficult, and you need to conduct a profitability analysis to determine if you’re making a profit, where you can optimize your processes, and what you actually need to charge the client.
The one mistake most businesses make is limiting profitability reports to every quarter, or worse, once a year.
Agency owners and professional service businesses can’t afford to make that mistake because they deal with multiple client projects every quarter/year.
Imagine you’re in the red on projects A and B. You can either stay in blissful ignorance or you can run a profitability report before you start projects X and Y so you don’t make the same mistake.
This is a proactive way of conducting profitability analysis where you measure how much you make per project, as opposed to waiting for the year-end to analyze project health—when it’s likely way too late.
There are several ways you can perform profitability analysis. However, the most common profitability analysis technique is the profitability ratio, followed by techniques like customer profitability analysis and qualitative analysis.
Profitability ratios measure how much a company has earned in sales in a specific timeframe and what its costs are.
This ratio also helps measure the company’s overall growth, cash flow, stock prices, how much to give back to shareholders, and how to increase profits.
Profitability ratios can also be further divided into three categories: Gross profit margin ratios, Net profit margin ratios, and Operating profit margin (also known as EBIT ratio).
Some companies also calculate revenue ratios under profitability ratios, which account for return on assets and equity.
Customer profitability analysis provides more insights into how much profit each customer is bringing to the company.
You’ll need data on your revenue, gross margin, direct and indirect costs, marketing costs, sales costs, customer service costs, and the number of products your customer purchases from you (plus the prices of these products) to create a customer profitability analysis.
Knowing more about customer profitability analysis also allows you to employ marketing techniques and project management methods like account-based marketing (ABM) and enterprise resource planning (ERP) effectively.
Qualitative analysis analyzes customer dialogue, purchase patterns, response to marketing campaigns, etc., to know how to make the right investment decisions to impact their future profitability.
At Harvest Dashboard, we suggest a different profitability analysis method for our agency and professional service customers where certain roles are tasked with managing the profitability of their own activities.
The project manager measures the project's financial health and the account head measures the sales revenue customer accounts are making. Each profitability analysis sits with a specific role in a department, and the overall agency profitability (or the company’s financial health) sits with the operations director
In an agency environment, everyone has their own slice of responsibility. And when all these profitability ratios come together from different department heads, you get a more accurate picture of whether you’re making or losing money.
Let’s calculate profitability based on the different methodologies mentioned above.
We can calculate profitability ratios in three key ways:
For example, Gross Profit Margin Ratio: (1000 - 800) / 1000 x 100 = 20%
For example, Net Profit Margin Ratio: 150 / 1000 x 100 = 15%
For example, Operating Margin: 600 / 1000 x 100 = 60%.
The gross profit margin ratio helps you analyze how much money you make before taxes, the net profit margin ratio determines how much money you make after taxes, and the operating margin shows you your ability to manage indirect costs.
To conduct a customer profit analysis, you’ll have to run a couple of calculations to get the number you’re looking for.
Here’s what the calculation might look like:
Find out how much money the customer is spending on your business. Here, you’ll need to calculate the customer-specific revenue.
Revenue = Quantity of Products x Price
For example, Revenue: 10 x 100 = 1000
Identify your Cost of Goods Sold (COGS). This accounts for both direct costs (such as fixed costs, labor, materials, manufacturing, packaging, etc.) and indirect costs (such as overhead, technologies, office supplies, etc.).
COGS: Direct Costs + Indirect Costs
For example, COGS: 120 + 40 = 160
Identify your gross margin.
Gross Margin: Revenue - Cost of Goods Sold
For example, Gross Margin: 1000 - 160 = 840
Take all costs into consideration that result in your customer knowing more about your product or having a better experience with it.
Servicing Costs: Marketing Costs + Customer Support Costs + Sales Acquisition Cost
For example, Servicing Costs: 10 + 30 + 5 = 45
Find out what your net profit is. This is basically what you’re earning minus all the servicing costs.
Net Profit: Gross Margin - Servicing Costs
For example, Net Profit: 840 - 45 = 795
This is the final step in your calculation. Here, you need to find out your customer's lifetime value (aka, how much you expect a customer to spend over the years they do business with you).
Customer Lifetimes are usually a data-backed guesstimate, so feel free to analyze your previous customer accounts to see how long they worked with you to make this decision.
Customer Lifetime Value (CLV): Customer Lifetime x Net Profit
For example, Customer Lifetime Value: 5 x 795 = 3975
So, as per our calculations, all costs and expenses considered, this specific customer can provide you with a profit of $3975.
There are no formulas for qualitative analysis, but you can look into areas like customer behavior, purchase patterns, responses to your communication, analytics from social media channels, etc., to do qualitative analysis.
Role-level analysis depends on specific KPIs the department heads or responsible roles consider important variables.
We’ve shown above how project managers can calculate project-level profitability using ratios, but here’s what a pared-back profitability analysis might look like for, say, the head of operations:
Alternatively, if the account manager is analyzing the profitability of customer accounts, then here’s what we can expect the customer profit analysis to look like:
Side Note: Another way for agencies and professional services businesses to get a better handle on their costs is to create a direct comparison between cost rate and bill rate.
We say this because you might be working with multiple freelancers and in-house employees, all of whom might adhere to different payment terms.
For example, some of the common pricing methods agency heads see are per word, value-based, per project, hourly, etc. For in-house folks, you might be looking at salaried employees or hourly employees (plus bonuses).
To ensure you’re pricing your projects correctly and are actually making profits in a sustainable way, know what your bill rate is. To know what your bill rate is, find out what the cost rate of all your resources is.
For example, if you’re paying an employee $80,000/year over an average of 48 weeks per year at 40 hours a week (taking deductions for PTO, vacation time, sick time, holidays, etc., into account), you’re looking at a cost rate of $41.7.
Imagine you’re working on a website design project for a client. Here’s an example of what a project-based profitability analysis can look like:
For example, let’s say the project requires 40 hours of writing. The bill rate for your designated writer is $150 an hour and the cost rate is $100 an hour. 40 hours costs you $4,000, which you price at $6,000 for the end client, leading to a profit of $2,000 or 33%.
You can use this table to analyze the profitability on a task level, day level, and the project as a whole.
If you’re creating a typical profitability analysis report, you might measure the overall profits you made during a quarter or a year for multiple projects, instead of specific projects.
You also need to decide if you want to do company profitability analysis, customer profitability analysis, or product profitability analysis (however, most agencies and professional services businesses don’t create product profitability analysis since they mainly provide services).
Depending on what you decide, the KPIs for calculation might change. If you stick with a project profitability analysis report, here's what your report might end up looking like:
If you wish to make a more detailed report, then you can use this template instead:
You can create profitability reports on a spreadsheet or you can use a sophisticated, automated solution.
The analysis report is typically only a page or so long unless you're creating a report for multiple clients and projects at once.
Profitability analysis usually relies on past data and current research, so if you’ve noticed X, Y, and Z issues by creating a profitability analysis report and have implemented changes to address these issues — keep track of the results you’ve achieved.
If you’ve received positive results, chances are, the profitability report guided you in the right direction.
With Harvest Dashboard is you gain instant access to real-time profitability data for your Harvest projects and clients. Make informed financial decisions, keep projects on track, and watch your profit margins soar
Learn more about Harvest Dashboard and explore what Harvest Dashboard can do for you and your business!
