Would you rather have 100 percent of $80,000 or 90 percent of $100,000?
The answer would seem pretty self-evident: $90,000 is more than $80,000, so it’s hard to argue otherwise. However, it’s not uncommon for professional services firms to focus on the 100 percent rather than the $90,000. We’ll explain below why this happens and why you should think differently about realization on your time & materials projects.
Realization is usually calculated as the sum of the net revenue generated by the project, plus or minus any adjustments, divided by the net revenue. But net revenue is not as simple as you might think. Here’s why: Every hour recorded or budgeted by a professional services firm on a time & materials project is subject to four different rates, two for revenue and two for cost.
For now we’ll focus on revenue rates:
- One rate is the standard revenue rate. The standard revenue rate is your budgeted rate, list price, rack rate, stock rate — whatever benchmark hourly rate your firm uses for planning and budgeting.
- The other rate is the project revenue rate. The project revenue rate, negotiated rate or contract rate is the hourly rate your partners or your managers negotiate with a customer for a specific project.
When your firm is developing an annual budget, your finance team will use your benchmark rates as standard revenue rates. They are making assumptions about resource utilization, and the hourly standard revenue rates that apply to the different types of resources — partners, managers, staff, etc. All of these factors are weighed and compiled to produce the firm’s annual revenue plan.
Creating a specific time & materials project budget is not that dissimilar. The project manager should determine the appropriate mix of resources and, most important, use the same benchmark hourly rates that the firm used to create the firm’s budget. When your managers and partners create a project budget using a reduced and negotiated rate as a baseline, your managers have already agreed to a discount before the project is even started: They are focusing on realization at project revenue rates when they should be focusing on realization at standard revenue rates. This means your managers are focused on the 100 percent, not the $90,000.
RUNNING THE NUMBERS
Let’s look at a fairly common scenario at any professional services firm, with two similar time & materials projects, run by two different managers. (See the table at below.) Now let’s calculate our realization, but let’s expand the calculation methodologies to include two concepts, one familiar, and one perhaps not so familiar:
- Realization at project rates; and,
- Realization at standard rates
In our example, the manager on Project No. 2 agreed to a 20 percent discount from the firm’s standard rates. This upfront discount is often called a “planned adjustment” — the manager planned to give a discount from the beginning of the project. The project budget was $80,000, and the project net revenue was $80,000. This equates to a 100 percent realization rate when using project rates, but only an 80 percent realization rate when calculated against the firm’s benchmark or standard hourly revenue rates.
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On the other hand, the manager on Project No. 1 agreed to a smaller upfront discount, 10 percent from the firm’s standard rates, and at the end of the project made a $5,000 “unplanned” concession to the client. Project No. 1’s net revenue is $90,000. This equates to a 90 percent realization at standard rates, and a 95 percent realization rate using project rates.
Project manager No. 2 may have had a better project outcome relative to the specific plan, but Project manager No. 1 produced more net revenue for the firm and a better gross margin, both in percentage and money terms.
Let’s take our example above a step further. Let’s assume that the hourly project cost rate (we’ll leave out the discussion of what components belong in a cost rate for another time) for our resources on the project above is $120 per hour, and calculate a gross margin for each project (see table below).
On his next project, Project manager No. 2 realizes he’s been ignoring his firm’s standard rates and negotiates an increase in the project revenue rate to $168 per hour, from the previous rate of $160. That 5 percent increase in project rates improves the realization at project rates value to 84 percent. It also increases the project gross margin to $24,000. That $4,000 gain is a 20 percent gross margin increase on a 4 percent increase in realization at project revenue rates.
WHAT IT ALL MEANS
Ultimately, when any particular project is closed, billing is going to equal your project revenue plus any write-ups or less any write-offs. Nonetheless, realization calculations are useful tools:
- Realization is a valuable metric that combines both profitability and resource utilization concepts so that firms can evaluate which projects produce an appropriate profit margin.
- Realization gives managers and partners useful data for finance when setting a firm’s target rates. Unrealistic standard rates can result in heavy discounting by managers and partners when negotiating specific project contractual rates.
- Realization at standard rates tells you how the project did against the firm standards.
- Realization at project rates tells you how the project manager did against his project estimate.
Firms that budget time & materials projects using their standard revenue rates and strive to increase their project revenue rates will see that small increases in project realization rates mean big gains in gross margin percentage.
William Cornfield, CPA, is president, CEO and founder of WSG Systems Corp.
