• Revenue: Revenues specifically related to the client and /or project are separately identified in the accounting system.
• Direct labor: In general, direct labor costs ref lect the value of time spent on the client or project. Direct labor costs are computed by taking the number of hours recorded on each person’s timesheet for each client and multiplying it by his or her per hour salary cost. In some cases, the salary cost may include a factor to cover related benefit costs as well. Further, some firms choose to use a standard hour factor other than 2,080 (52 weeks x 40 hours per week) as the denominator for the total number of hours in a year because not all of those hours will be chargeable due to vacations, sick time, and administrative time. The actual denominator used is subject to management discretion based on actual experience and may fall as low as 1,500.
• Direct expenses: Direct expenses include all out-of-pocket expenses incurred by the firm in conjunction with the client’s assignment that are not reimbursable by the client.
• Indirect labor overhead: Rarely is every hour of every employee in a firm chargeable to clients. The value of the time not charged out
to clients is normally assigned to an indirect labor overhead account.
In simple form, it represents the salary cost of staff time spent on
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administrative functions, including vacations and sick time. The total cost to the firm may be allocated among all of the firm’s clients for cost accounting purposes in a number of different ways, the most popular of which is as a percentage of total direct labor or revenue.
• Overhead: All other costs not listed in the preceding category are grouped into an overhead category and are allocated among all the
firm’s clients in a manner similar to that described for indirect labor.
Costs in this category include rent, taxes, insurance, office supplies, administrative travel and entertainment costs, utilities, IT expenses, and depreciation and amortization.
Once all costs have been allocated among the firm’s clients and their respective projects, management can then evaluate historical performance in terms of each project’s relative profitability. Doing so for the past is helpful, but using that information to evaluate and price future projects properly is vital to the firm’s long-term existence. When evaluating the results of a cost accounting analysis, management must be conscious of the difference between marginal and fully loaded costs when determining if a project was good for, or well managed by, the firm.
Projects that show a loss on a fully loaded basis (i.e., with all labor, direct, and overhead costs included) may contribute positively to the firm’s profit if revenue exceeded the marginal costs of performing the work. In the long run, a firm cannot remain profitable if all its projects are priced to cover only its variable or marginal costs, but in the short term, squeezing in a project that covers only its marginal labor and direct out-of-pocket costs may help increase the firm’s overall profitability. In the very short term, even projects that do not cover their direct labor costs may still be profitable for the firm if it could not have avoided those labor costs otherwise because the staff that worked on the project was able to squeeze it into their normal schedule.
Client Compensation Contract Negotiations
Compensation contract negotiations with the firm’s clients are one of the most critical factors in determining the firm’s profitability. At the outset of a relationship, these negotiations form the foundation from which the firm will live, possibly for many years to come. Because of the long-term precedent-setting nature of these discussions, it is important that the firm negotiate the best terms possible. Often this may mean taking several months to negotiate in the case of a long-term relationship, but that upfront investment of time will, if done well, pay dividends for many years to come.
Most contracts include two main types of issues: financial and nonfinancial terms and conditions, including the scope of work. Getting the most favorable financial terms may not be best for the firm if it does not negotiate reasonable nonfinancial terms and conditions as well.
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SETTING THE PRICE.
Establishing the rate of compensation and the
methodology to be used is the most basic and yet critical point in the negotiations. Regardless of compensation methodology used, the firm would be well advised to understand its projected costs by estimating the total number of hours by each type of staff required to complete the project. This analysis allows management to determine, a priori, the break point at which the firm will walk away from the negotiations. Compensation methodologies can take many forms and include:
• Time and materials: Under this type of agreement, the client agrees to pay the firm for its actual time and all out-of-pocket expenses. Normally, this type of arrangement is applicable to situations where the client recognizes that the scope of work is difficult to determine and thus it would not be fair to force the firm to commit to performance of a project that cannot be well defined. Sometimes the firm is able to negotiate prices to be at its “standard” hourly rates. Alternatively, rates for each level of staff may be negotiated separately. In some instances, the rate may be a simple f lat rate irrespective of the level of staff (e.g., $250 per hour no matter who works on the project).
• Fixed price: In situations where the scope of work can be fairly well defined, it may be appropriate to negotiate a fixed price arrangement.
This gives the client the comfort to know that the firm cannot exceed its budget without prior approval (assuming such a provision is negotiated), and it gives the firm a virtual guarantee of revenue. To negotiate this type of deal, the firm should first confirm the scope of work; then it can estimate the total number of hours required to complete the project and multiply those hours by standard hourly rates for each person or class of staff to participate in the project. It is important for the firm to recognize that it will be obligated to deliver the project in its totality even if it takes more time to complete than estimated originally, so it should ensure that it can in fact deliver within the time allotted; otherwise, it could face a significant financial liability.
• Commissions: Depending on the nature of the services to be rendered, it may be appropriate for the client to pay the firm as a percentage of the project’s total costs. This method has been used for decades in the construction management and advertising industries. Depending on the
volatility of a client’s spending level, this method may provide potential for significantly increased or decreased revenues as compared to a labor-related cost-based approach.
• Hybrids: Depending on the specific circumstances of the client and the work assigned to the firm, some combination of the basic compensation plans mentioned earlier may be appropriate. For example, a time and
materials contract may include a provision that the fees will not exceed a certain dollar level. A commission arrangement may guarantee the
firm a certain minimum compensation level to ensure that it can provide
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the staff necessary to support the client’s assignment. Also, the client may agree to add in a bonus component to the base compensation structure to incent the firm to achieve certain performance standards. In some cases, these standards may be objective and quantifiable whereas in other situations, criteria for payment may be more subjective.
• When to reject a client’s “ best offer” for compensation: In many cases, a client’s budget will not be sufficient to cover the firm’s initial cost estimate and the two sides must then negotiate a mutually beneficial fee.
At some point, the firm must walk away from the assignment if the financial terms and conditions are not sufficient to meet its requirements to properly service the account. Determining that point is very difficult and involves both objective and subjective factors. Short-term projects that can be squeezed into the firm’s normal schedule with its existing staff can, and probably should, be accepted if the revenue is anywhere near its direct labor cost, irrespective of its overhead component.
Longer term or large-scale projects should be accepted as long as all of its direct and indirect costs, including overhead and a minimally acceptable profit margin, are covered. In some circumstances, there may be valid strategic reasons to accept an assignment that does not provide sufficient net income to the owners and may not even cover all fixed overhead allocations. Senior management should sign off on any client contract that is below the firm’s guidelines for profitability. Acceptable profit margins vary by industry, but it is not unusual for professional services firm targets to exceed 15 percent to 20 percent of gross revenue.