A well-managed consulting firm with consistent profits in excess of 20% pa could achieve a valuation close to 2 x sales revenues if market conditions are good. However if you achieve 10% margins or less, then it could make the difference of between 2 times and 1 times sales revenues or less to your valuation. If your financial performance is closer to 10% than 20%, then our free Gross Margin Modeller download could make a difference of Millions of £’s to your personal wealth!

Delivering average or ‘above average’ profits from your consulting firm is one of the main factors that drives up equity value. Many firm owners don’t realise that it is GROSS MARGIN that savvy trade buyers look closely at when assessing the worth of a consulting firm. As it is quite a common experience for us to look at a set of consulting accounts for the first time and see NO MENTION of Gross Margin, we felt it worthwhile to explain the real importance of focussing on this measure.

Our free Gross Margin Modeller is built in MS Excel, and it's there to help you understand the factors that drive this key performance indicator in the right direction. Read this article first then download the modeller and learn how to drive up your gross margins. Let’s define the measure.

Gross Margin (GM) or Gross Profit is what’s left out of sales revenue when you’ve subtracted all direct consulting delivery costs. These delivery costs don’t usually include business development time but do include under-utilised time costs (and re-billable expenses if your sales revenue line also includes billed expenses). For healthy firms the GM should be in excess of 50% in order to create sufficient profit to pay for marketing, sales, admin, finance, service development, etc, etc and of course to have something left to create value for shareholders! That’s you today of course and what’s left will fund working capital/investment and pay bonuses or dividends to key staff. In the future what’s left will be another factor that determines the value of your firm… but more about that another day!

So why is gross margin so important, particularly to trade buyers? Firstly let’s look at the obvious attraction.

If your trade buyer wants to buy your service and/or client competence, experience and contacts in order to integrate you into an existing similar business then they are probably not at all interested in your overhead structure. They may wish to leverage further their own overheads structure and so yours becomes surplus to requirements. In these circumstances it is your GM, not Net Profit that is attractive to them. Effectively your GM will flow straight down to a much-improved Net Profit for them, making their firm even more valuable than the price they have paid for you. This is a real win-win for both parties (except of course those staff in your overhead structure!) and is often the reason a trade sale is successful.

Now let’s look at what else a strong GM says about your firm, irrespective of the type of buyer. To do this we have to answer the question “what factors affect GM?” The most important factors are:

1.Your Sales Value Proposition. Are you selling services that are scarce, high value to the client and in ‘fashion’ or have your products been commoditised? For example, 10 years ago it was possible to command £2000+ a day for process re-engineering work. It was ‘in vogue’ and every corporate wanted skills in this area. Today you’d be lucky to get half that rate. On the assumption that the costs to deliver this service haven’t similarly reduced by 50% it is likely that if you are still providing the same service as 10 years ago then your GM has been cut substantially and/or demand is sporadic, also reducing GM through poor utilisation. Keeping your value proposition at the cutting edge is one of the best ways of maintaining a healthy GM. Some of that is linked to client value and inevitably some of it is about keeping pace with what is ‘in fashion’ in the market! Sales propositions should be reviewed quarterly and the average fee rate achieved from innovative propositions in the market as compared to the competition is one of the best ways of judging the value growth potential of a firm.

2.Size of Project. In my old firm, WCI Group, we were suffering at one stage with reducing margins. We introduced a number of measures to correct this and one of them which was very effective was to track and drive up the average size of project sold by the firm. Many commentators in the industry talk about the consulting ‘leverage’ structure ie the ratio of partners to consultants as the key to high margins and of course this is true. However, improved leverage is an effect, not a cause and just recruiting more junior staff without developing propositions that can use larger numbers of junior staff is a recipe for junior consultants sat ‘on the bench’ – this is unlikely to drive margins up! Aiming to sell larger projects forces you to think about the nature of your proposition and the size of consulting team it drives.

3.Consultant Utilisation. Whilst undoubtedly this is also an effect, getting this wrong can seriously damage your wealth! Lots of small projects make achieving high levels of utilisation very difficult so again the sales proposition and size of project are causes of poor utilisation. A ‘feast or famine’ sales pipeline that looks more like the Himalayas than the ski slope we’d all like to see is also a cause of poor utilisation. The wrong mix of full-time consultant employees and associate staff can also contribute to a bad result here. Are we making use of the many services that can provide short-term resources to smooth out peaks in demand and avoid too many costly troughs? Of course just sloppy management can badly effect your utilisation if it doesn’t get the focus it deserves. Make sure you don’t leak profits and value this way!

4.Long-term Contracts. Most of us don’t enjoy the luxury of having 50% or more of our workload booked for the year ahead. 3 months is more typical and I’ve seen a few weeks! Are there ways of structuring your proposals so that projects extend to many years? This doesn’t necessarily mean that you have to go down the Accenture and others’ outsourcing path to achieve this end. Finding client value that can be delivered continuously or periodically over many years can achieve the same objective. Contingent fee structures often provide the opportunity to deliver benefits and fees over the long-term rather than a short-term intensive engagement. Use of audits and benchmarking on a regular basis provide similar opportunities. Embedding monitoring software and tools in your client to measure and feedback on performance improvements often creates long-term contract opportunities. Apart from the beneficial effect on utilisation this can have, the ‘quality’ of your revenue profile will improve and this is a major factor in determining the ‘profit multiple’ that is used to value your firm by external investors. £1 of profit from a 3 year contract is worth more equity value than that same £1 of profit from a 3 month assignment!

So now we understand a little more about the importance of a healthy GM and some of the factors that influence GM, it’s time to have a go modelling your current business and running some hypothetical scenarios to see the effect that it has on your profit. Download the Gross Margin Modeller and enter the data that best reflects your current firm. You can input numbers of consultants, fee rates, utilisation %, consulting costs etc and all variable by level of consultant. The model works out the resultant GM that you should expect from this current structure. If you know your current reported GM, fine tune the data to reflect the actual result achieved today. You can then use the scenario sheets to model ‘what-if’s’. For example, “what if we managed to increase our value proposition to clients and achieve an extra average £200 per consultant-day in fees?”; “what if we were capable of selling projects that drove an extra 3 junior consultants in the team?”; “what if we managed to increase average utilisation by 10% due to a better mix of larger projects and using more associate consultants?”.

You get the point, I’m sure. Try many different scenarios and watch the effect on the GM. If currently your GM is below 50%, choose the scenarios that achieve a minimum of 50% and that have the greatest chance of being achieved. Then make them happen of course!

If your interest is increasing your bonus/dividend or achieving a higher equity valuation on your business, then increasing GM has a large impact on your Net Margin % as well as the absolute amount of cash that the firm generates. All of which is good news for the owners of Consulting firms!

This exercise is best done with your management team in a one-day workshop, away from the pressures of clients and staff. If you’d like some facilitation we can provide you with an ex-consulting Operations Director (who also developed the model!) to run the session and make sure there is an actionable plan at the end of the day.

Happy modelling!............

Download the Consulting Firm Gross Margin Modeller (be patient, it is a 1mb MS Excel file).

In the past few months I have seen far too many firms who are working very hard at full utilisation but struggling to build any real equity value. That's not to say that they're not growing. Often revenue growth looks good but profit margins are in single digits or even worse. A quick analysis of their financials almost always shows the same root cause. Gross Margin (GM) ie the difference between what you charge a client and what you pay consultants is way too low.

What do I mean by 'low Gross Margin'?

Well if your GM is less than 60% on a project and less than 50% at the company level, it is unlikely that you will be creating the funds for growth at the same time as delivering a net margin that will drive equity value. For a firm to have intrinsic equity value, not only does it need to produce a good net profit, year on year, but it needs to be able to grow that profit in absolute terms each year. So let's investigate why GM's are so low.

Fortunately we don't have to look too far for the symptoms even if the remedies are more complex!

Take a look at your 'blended fee rate'. This is the weighted average, taking into account the quantity of different skills at different rates, that you charge your clients.

For most firms in most sectors in today' market, if your blended rate is less than £750 then you are in the 'busy fool' trap! There are always exceptions to this rule of course depending on the type of work you are doing and the type of client. We all know that SME's and local government don't pay good rates. Moving to sectors that do might be an answer! But for most of us a good test of whether you are charging enough for your services is to go out to the contract or associate consultant market and find out how much per day you would need to pay to get the skill level required for your client.

If you are not charging twice as much, i.e. a GM of 50%, to the client for this work then you are probably selling yourself short.

"Why would a client pay twice as much for my firm to do the work as opposed to employing a contractor to do the same at half the price?", I hear you say! The answer to this question is a large part of the solution to how you build equity value in your firm and it all revolves the Unique Value Proposition that you present to prospective clients.  If you are selling individual technical skills then don't expect to make much of a margin on each consultant - employed or contract - that you provide to the client. If on the other hand; you help the client diagnose their problem, you craft a solution to that problem with them, you commit to solve that problem at a fixed price with a well thought through ROI and maybe even put some of your fees at risk to demonstrate your commitment and confidence, you programme and project manage the delivery of the solution and have case studies and testimonials to prove your worth. 

If you do some or all of this then 50% plus GM's are achievable

If you're already do some of this and are not charging for it, well maybe there is a problem with either your marketing or sales approach or it just could be that you haven't tried. Remember it's easy to sell a £10 note for £5! Getting full value for your services takes more effort and occasionally you will fail but that's good because you will know then just how much your services are valued. Of course it could be that you really just do sell bodies and that's fine so long as you realise that the path to equity wealth will be a tough one!