The Service industry is geared to measure revenue generated from service contracts. This could be a facility management contract to manage a large office block, provide outsourcing services for local government or catering contract for an event.
The key measures are the expected revenue of the contract and the duration of the contract. The success of the contract is to measure the profitability of the contract by taking away the direct costs from the revenue generated. The Gross profitability margin will vary from the type of service, but a figure between 12 and 20% seems to be consistent across the full Service sector.
When analysing the operating margin (including overheads) the margin drops to between 5 and 8% which is a significant drop. It should be noted that the IT support and outsourcing markets have higher gross margins and operating margins with figures ranging from 20-30% for gross margin and 9 – 15% for operation margin.
What does a successful contact look like?
One of the key success criteria of a contract is its profitability. Quality, service delivered and the retention of the contract are just as important to the business as a whole, but in terms of financial performance the profitability is the key measure. Measuring the gross margin or gross profit of a contract is pretty easy to achieve. The total revenue (sales) of the contract minus the costs directly associated to the contract provides this measure. When a contract is sold the gross margin as a percentage is normally known and setting the correct percentage should lead to a profitability contract.
Where do overheads fit in?
The difference between gross profit and net profit is the inclusion of overheads (or indirect costs) into the net profit calculation. Indirect costs relate to costs that cannot be directly attributed to a contract and will be shared. Example of indirect costs include audit and legal fees, central costs such as rent and utilities, and IT services and support. As per my analysis, of some of the larger companies in the Service sector, overheads account for 7-12% of the revenue which is a significant contribution to the true profitability.
Net profit is easy to work out however, splitting these costs directly to a contract is slightly more challenging. Assuming that you cannot influence gross margin of a contract as the revenue will be fixed, to increase the true profitability a reduction in the indirect costs associated to the contract is a better approach. To counter that view, a potentially profitable contract at gross margin could be a loss making contract when the relevant indirect costs are allocated to the contract. Proceeding or extending with a contract which on the surface looks profitable (at gross margin) could be a poor decision if the net margin is either negative or lower than an acceptable margin.
How do you allocate indirect costs?
It should be clear by now; the better you allocate your indirect costs to your contracts, the better your measurement of true profitability will be. However at the same time it should be noted that there is no easy standard method to do this.
If we look at a particular indirect cost, audit and legal fees, this could be significant. Let’s say:
- The total annual cost is £10 million
- There are 50 active contracts that are being serviced
- There are two contracts out of the 50 to analyse
- Once of these contracts is worth £100 million revenue and the other is £1 million
This table shows three indirect cost allocation processes and the impact of the cost allocation of both of the contracts.
- Equal split
- Activity based costing
The equal split process. This allocates the same cost allocation to each of the 50 contracts. So this would mean both of the contracts would be allocated £200,000 each. As you can see, the smaller contract is seen to have made a loss as the gross profit of the contract prior to the cost allocation was £150,000 (15% of the revenue). Where there are large variances across the value of the contracts this method will penalise the smaller contract whereas the higher value contract is hardly impacted.
The pro-rata process. This allocates a cost based on the value of the contract which is based on the revenue of the contract. This is a common process and provides a level of accuracy however, the logic does not relate to the activities that incurred the cost.
Activity based costing. This allocates the cost based on a pre-defined activity. In relation to legal and audit fees, it could be that contracts are only audited at the end of their contract or once every two years. Therefore some contracts will not make use of the legal and audit fees and others might absorb a much higher amount than would be allocated via the pro-rata process. In the example we have 10% of the total cost was allocated to the lower value contract due to the recorded activities. This now has what was a profitable contract via the pro-rata process as a loss making contract through this process.
What does all of this mean?
It should now be clear that depending on the cost allocation method and process you select the net profit could vary dramatically. As a business you need to be comfortable with the method that you use and the impact this will have when making decisions based on the reported values.
Different types of costs may fit to an activity based costing process, and others might require pro-rata allocations. From a business point of view, making decisions to extend or bid for contracts should be done with the most accurate of data. The smaller contract in the example we have used is profitable from a gross profit point of view, however depending on the methodology used the contract moves from being profitable to loss making. A business would think again about extending a contract if it was known to be loss making, as it would be fair to assume that the loss would occur in the extended period. On the other side of this, if a contract is over allocated costs it may not meet the required net margin percentage and not be extended, but by using a different cost allocation method the net margin way exceed the required margin.
If you are managing service contracts you need to be sure you can fully report their true profitability. Having a robust process to capture and analyse indirect costs to contracts will provide the business with the correct level of insight to make the right decision at the right time. Time and effort needs to be invested to ensure the indirect cost allocation methodology is deemed fair and robust in order to support the rest of the business. Getting this wrong could be a very costly mistake.