A company Acme INC achieved quarterly revenues of $282.000 while cost amounts to $228.000 and net profit $55.000.
Is this a good result or not? Both cases raise the question if it could have been better, and how to improve profitability.
The first step is to identify the units that make up the profit. In other words, you need to identify the projects that contribute to profitability. So, based on the standard financial report, we have the information about the total profit but can’t access that profit’s structure.
To understand profitability optimization you need to first understand profit structure – where the profit is coming from and where it’s going.
Let’s look at the profit per project of the company Acme INC. We can see that some projects generate a loss, and others a very small gain:
What does the picture tell us?
The biggest profit was made on project 10, even though that project has the biggest sales income.
For example, there was a loss on project 5.
There was a very small profit on project 2, but the effort and expenses invested into it were significant.
So, on average, on the company level, Acme INC gained the target profit, but there were some projects that generated losses or small profits continuously. Knowing this, the company can reconsider its strategy regarding low-performing projects.
On the other hand, if the company has the information about its most profitable projects, it is clear where it should focus its efforts.
That is why it is necessary to track profit per project, to get to business decisions that will optimize profitability on each individual project level as soon as possible.
How to calculate profit per project?
According to the estimations, over 70% of professional service companies don’t have records of how much profit each project or service line brings.
Given the fact that profit is the difference between the revenue and the costs, project revenue is a known category and can be found in the accounting records.
So, we have the basic formula:
Project profit = Project revenues – Total project costs
In contrast, companies have trouble allocating costs per project. The cause for this is the fact that some employees work on multiple projects, and that some general expenses exist, and are difficult to allocate per project.
How to allocate the costs?
A professional service company sells its time, or, better put, its employees’ time. that is why time is the key element in allocating costs.
Let’s start with the basic project cost formula:
Total project costs = Labor costs + Overhead costs
Using project hours tracking tools and all employees logging their time per project is a very simple way to get a record of the number of hours per project. The software then multiplies the hours spent on a project by the pay rate of the employees who were engaged on that project to calculate the direct costs related to a specific project.
So, labor costs are connected to the employee hourly rate.
How should you allocate overhead expenses? These are the general expenses, including Utilization, rent, administration costs, office costs, internet costs, phone and postal costs, etc.?
You can do this by assessing the overhead cost hourly rate. So, the total overhead costs for a specific period are divided by the number of work hours in that period. Once we multiply the overhead cost hourly rate by the number of hours per project we will get the cost of allocated indirect costs per project.
When we add labor costs and overhead costs, we will get the total costs of each individual project.
However, this calculation can be complicated.
To simplify the process, we have the option of doing the entire calculation in two steps:
Firstly, we calculate the total employee rate through the following formula:
Total cost rate = Pay rate + Overhead hourly rate
Secondly, we enter that rate into the time tracking software, and the software will generate the total expenses per project by multiplying the total number of hours per project with the total cost rate of individual employees working on the project.
When we have calculated project costs we can easily determine the margins and profit by subtracting the costs from the income, which is a known category due to the invoicing process.
Observing the structure of profit per project or service line is the key factor in optimizing and increasing profit. Once you have this data you can make strategic decisions regarding future projects.
Without time tracking it’s impossible to accurately determine project costs, which are a key category in calculating project profit. A time tracking tool allows knowing project costs in real-time in a very simple way.
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