By Jason Parks, Director – Strategic Advisory Services, Equiteq.
Gross margin is an important metric in consulting organizations. It can be the difference between steady growth, and running to keep the lights on. It’s also one of the key metrics potential consulting firm buyers focus on as they look to acquire firms with strong profitability.
We recommend that gross margin should represent 50% of a firm’s revenue. If it’s less than that then you’re unlikely to be generating the funds needed for growth or delivering a net margin that will drive equity value.
The challenge with improving gross margins lies in the fact that they rarely have a singular root cause.
There are three main areas to focus on to improve profitability in a consulting or professional services firm, and they are all intertwined:
- Increase revenues generated by the business by selling higher value work
- Improve the leverage structure of the delivery organization (i.e., people, IP, QA)
- Optimize overheads
It’s difficult to generate higher profits with a sales pipeline loaded with lower value opportunities, and you can’t build a strong pipeline without the people, IP and processes to scope, deliver and sell the work.
Ultimately, low consulting margins are the result of failures across a system of causes which will need to be addressed both tactically and strategically to create sustainable margin improvement.
Consider some common causes for low margins that we see in the field:
- Lack of a benefits-driven value proposition to support higher fees, leaving clients questioning why they should pay a premium price for your services
- Excessive amount of revenue from staff augmentation (body shopping)
- Internal misalignment on the firm’s value proposition and ideal client, leading to unfocused sales efforts
- Missed opportunities to use idle capital (non-billable time) for revenue generating projects
- Top-heavy pyramids in the organization where knowledge is concentrated in the upper layer of the firm, stifling growth
- Under developed intellectual property (IP) that would help the firm to scale by enabling more junior consultants to deliver work
- Lack of market/competitive research to inform the leadership of the need to pivot or cut service lines and target client base
- Wasted sales effort spent in transactional accounts, taking the focus from key and strategic clients and missing opportunities for sustained growth
- An ineffective sales engine not delivering new clients, which are fertile ground for higher fees
This list is far from exhaustive, and many firms are likely to have at least two of these problems. Pulling the strings apart to find the underlying people, process or product issues can make it incredibly difficult to even know where to start.
That’s because levers to help resolve problems are obvious – revenue and cost. But it’s the combination of activities required in consulting and professional services firms that make margin improvement so difficult.
Margin improvement is about change
Business controls are important, but they are only part of the solution. You’ll need to make margin improvement part of the leadership team’s mindset for sustainable margin improvement to be successful.
To do that, you’ll need to get some crisp communications and success measures in place and start integrating the tactical activities (e.g., margin exception reporting, resource management, and utilization forecasting) into the regular business cadence.
Once the team aligns to a shared understanding of what success looks like, you can begin to layer in strategic work streams (e.g. market expansion, IP development) and make people accountable.
Remember: change is an ongoing process, and it’s best accepted when delivered one bite at a time.
We will be exploring specific steps consulting firms can take to address low margins with a view to one day being acquired in future posts.
Topics will include how to establish financial transparency and empower practice leaders, how to define both tactical and strategic improvements, why cutting costs isn’t always the answer, and how to best put idle capital to work to generate value.
If you are preparing to sell your consulting firm and would like to discuss your plans, please get in touch.
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