The Top KPIs for Service-Based Businesses: The Metrics You Should Be Monitoring
A business’ greatest assets walk out the door every evening (or log off their computers in a remote-forward world). At some point in your life, you have probably heard this old business adage. For service-based businesses, this is not a metaphor; it’s the truth. So what does this mean when it comes to choosing KPIs for service-based businesses? Let’s dive deeper.
An employee’s knowledge is the actual asset by which a service-based business creates economic profit. Most service-based businesses choose to monetize this asset through some type of labor arbitrage, which is transacted based on a billable hour. In addition to a billable hour, service-based businesses can choose to charge clients many different ways. This includes on a product-type basis (e.g. audits website, blueprints, tax return), value-price basis (e.g. money saved, leads generated, AUM) or periodic basis (e.g. CFO services, subscriptions, memberships) among many other ways.
Although the way a business charges its clients for services provided differs dramatically based on industry, a common thread is that the action(s) of a person are needed to deliver the service. In contrast, product-based businesses can manufacture an inventory that can be stored and delivered over time. For example, a vacuum may be a physical asset of a cleaning company, but it is economically useless unless there is a person willing to perform the cleaning services contracted. You also can’t manufacture cleaning services and store for sale later.
Because service-based businesses vary greatly, addressing top Key Performance Indicators for all of them in one article would be daunting. Instead, I’ll focus on the top KPIs for service-based businesses, such as accounting and management consulting firms, law firms, architects, and the like.
Want to dive deeper in KPIs? Don’t miss finance expert Paul Barnhurst’s take on the finance KPIs every FP&A and finance controller should master. His article goes in-depth into each KPI formula, and there’s also a free webinar recording to watch, and a downloadable Excel file!
What should our finance KPIs be, and how many should we have?
Before diving into various KPIs, let’s step back from the trees to look at the forest. When researching what KPIs work best for your business, many look for articles or books to provide potential KPIs. Unfortunately, this often produces an extensive list of metrics that may have nothing to do with your business strategy and how it derives revenue and profit.
Identifying your business’ top KPIs begins with defining and understanding your organization’s strategy. Working backwards from strategy, what are the processes and procedures performed to deliver your services? This can start at a very high-level and then be driven down to a department level. The KPIs that drive profitability on a company basis may not be relevant or useful the farther down you go. That’s fine. The key is to provide people with a series of strategic metrics by which the total company will be able to measure its performance that will allow managers throughout the organization to look at the processes and procedures they manage and create relevant and effective KPIs to influence company growth.
More is not always better, especially when we’re looking at data. In today’s digitized world, there’s a tendency to overmeasure data. This can eventually lead to decision paralysis. That’s where leaders continue asking questions, but don’t make decisions out of fear of missing something. The optimal number of KPIs is 5-7. You could stretch this to 10, but beyond that, they lose their power in effective strategic decision making and management.
Common KPIs for service-based businesses
The most common KPIs for service-based businesses typically fall into the following categories:
- Efficiency and Effectiveness
- Operational Leadership Performance
- Pricing and Volume
1. Efficiency and Effectiveness KPIs
Since a professional services business’ assets are not machines, physical products, real estate or software, monitoring employee’s performance is key.
1.1. Billable Hours Leverage: Total Billed Hours / Partner Billed Hours.
Attaining Partner status in any firm comes through hard work, long days, and a trail of happy clients. They are also typically the most highly compensated individuals in the business. To make the economics work, they need to manage or generate more work than they can bill themselves. Tracking Billable Hours Leverage over time and by Partner can be a powerful tool to identify under and over-performance of Partners. For example, if a Partner has a relatively high bill rate and consistently bills most of the hours on the projects they manage, the Revenue generated may come in at a lower gross profit than if they were able to leverage downwards.
Utilization can be calculated in several ways, but here are the two most common:
- Total Billed Hours/ (Standard Hours – Leave Time). Standard hours will vary by business and is the number of billable hours expected over a time period. For example, an individual expected to have standard annual hours of 2080, would be working 5 days a week, 8 hours each day, for all 52 weeks in a year. I’m not aware of any business that holds their staff to that measure, but you get the idea.
- Total Billed Hours / Work hours In Period. This formula doesn’t take into account any haircuts that the firm may have to the 2080 potential billable hours in a year, PTO, training time, or any other time an employee may be productive but not billing a client. Calculating utilization this way is simpler and better correlates to generated revenue. However, holding a business to a certain utilization based on this calculation may lead to unintended consequences. For example, people don’t take PTO and get burned out. Or, even worse, they bill clients for time that they weren’t actually working on their account, so use with caution.
1.2. Realization: Total $ Billed To Clients / $ Work-In-Process (WIP) Generated.
Not all performed work gets billed to a client. There could be several reasons for this, including:
- Fixed price engagements: They agree to only charge a client X amount regardless of the hours worked on it.
- Client price sensitivity: In previous years, they may have had a resource to perform the work at a lower bill rate but this year a resource at that level was not available, so it had to be done by a more senior resource with a higher bill rate.
- Out of Scope services: In order to perform the contracted services on an engagement, work might be required to prep or filter data etc. Hours related to this should most often be billed to a client, but often it isn’t due to client-price sensitivity.
- Extra resources: Resources placed on the matter to perform the work were new or untrained causing a lot of re-work that needed to be done to produce the service at the quality the business demands.
1.3. Billable HC/Non-Billable HC: # of Billable Employees / # of non-Billable Employees
This is similar to the leverage ratio above but looks at head count and not hours. To provide a service, there will almost always be resources used to perform work that isn’t billed to a client. For example, in addition to SG&A related HC, filing and processing paperwork with government agencies, scheduling projects, researching complex technical issues, proposal development, and more.
2. Operational Leadership Performance KPIs
It is important that Partners focus most of their efforts on generating revenue and profits. The following metrics are ways to measure ongoing Partner performance.
2.1. Net Fee Revenue Per Partner And Net Non-Fee Revenue Per Partner
Net Fee Revenue is Revenue generated through billing time. Non-Fee Revenue is all other operational Revenue that is not Fee Revenue which can include but are not limited to admin fees, filing fees, T&E expenses, product, subscription or licensing fees.
2.2. Gross Profit by Partner
Not all Revenue is created equal. Some Revenue will generate larger gross profits then others. This helps to identify which areas leadership may want to deploy resources to, which will have the greatest impact on total company profitability. For example, a marketing agency may build a website for $100K, but due to the coding and effort required in the design, only generate a 20% gross profit margin. In contrast, a 1-year organic Search-Engine-Optimization (SEO) campaign for the same $100K, may generate a 70% gross profit.
2.3 Revenue and Profit per Matter/Service Line/Client/Industry
The ability to segregate the economics of a particular part of the business can be a very powerful metric that can be used to identify pockets of profitability or loss in any organization.
3. Pricing and Volume KPIs
All Revenue generated by a business is a function of price times quantity. The below metrics can aid leadership in measuring total company performance on an on-going trend basis. Typically, a one- or two-month spike or downturn in any of these metrics shouldn’t cause alarm, but if the pattern continues for three or more periods, action may need to be taken.
3.1. Average Gross Bill Rate: $ of WIP Generated / # of Hours To Produce the WIP
This assumes that 100% of the WIP that was generated would get billed.
3.2. Average Net Bill Rate: Gross Bill Rate * Realization %
This is the effective bill rate of the business. Of the WIP produced for a period, this is the rate that will be billed to a client.
3.3. Total Billable Hours: Sum of all billable hours for a period
This should show a seasonality pattern and may be best shown on a deseasonalize basis where the signal can more precisely be identified from the noise.
3.4. # of Active Billable Engagements: Sum of all active engagements for a period
An active engagement would be any engagement with at least 1 billable hour charged to it. Is this going up, down or sideways? Whatever the trend, there is a need to find out why.
3.5. Net New Engagements: Sum of new engagements for the period less lost or ending engagements
More new engagements then lost or ending engagements means there are more opportunities to generate future revenue.
4. Cash KPIs
Many professional services businesses operate on cash basis because they’re organized as pass-through entities. This makes cash-related metrics absolutely key in terms of KPIs for service-based businesses. The Partners will need to pay taxes on the profitability of the firm anyways, so at the end of the year, they take the cash that is left and pay bonuses. Track the below metrics to make sure that the cash pool at the end of the year is achieved and bonuses get paid.
4.1. $ Collections: The Sum of money collected
This is often compared with $ Billed for a period and on a rolling basis. It measures the quality of revenue generated. If a business is sending out invoices that aren’t being paid by their clients, this is a huge red flag to investigate.
4.2. Days Sales Outstanding (DSO): (Net A/R / Sum of 12-months of Net Revenue) * Sum of days in the year
DSO can be calculated over a 3-month period or any other relevant time frame that best suits the business. This metric can either include or exclude WIP as well.
4.3. Leverage Ratio: Net Debt / TTM EBITDA
This metric is only relevant if the business has any debt. Many professional services businesses use a bank line of credit, secured by A/R, to fund annual bonus payouts and then pay down the line of credit throughout the rest of the following year.
4.4. Total Liquidity: Unrestricted cash + availability on any bank line of credits.
This metric requires close attention. For asset-heavy businesses if they get in financial trouble, they may be able to negotiate with the lender for forbearance or some other relief, but in a professional services firm, if you can’t pay your employees you no longer have a business.
Final thoughts on KPIs for Service-Based Businesses
Choosing the right KPIs for service-based businesses can drive better decision making. The above is a small sample of some KPIs that may be relevant to you and help you drive increased performance throughout the enterprise.
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 For simplicity, this article will refer to all senior leaders whose primary responsibility is the delivery of services to clients as a Partner. In non-partnership organizations, a common title for a person with the same responsibility is a Managing Director or Senior Managing Director.
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