Starting a Professional Services Firm: Income Statement Targets

There has never been a successful professional services firm that was not also financially successful. Remember that we compete in two markets; the one for our services and the one for the talent required to deliver those services.

Attracting and retaining top talent is only possible if you have the financial resources to offer competitive compensation. That means running a good business.

I remember that feeling when I first saw my standard billing rate as a brand-new consultant. It was five times my salary. I was embarrassed to tell my parents. They might think that I was doing something illegal. Well, thirty years later I understand the economics of the industry a little better and have spent years working to improve the financial models we use in professional services.

The Ideal Financial Model

Gross margins on services are critical, especially if you operate a project-based model where your resources are not always working on client engagements. In a growing firm, you are likely to always be investing as you hire your team in advance of having paid engagements for them to start on day one.

My advice is to create an operating model that enables you to target spending 40% of revenue on the fully loaded salaries of your client service team.

That doesn’t mean charging 2.5 times costs for your work. Doing so leaves you with no allowance for unutilized time. My first firm set standard rates at five times costs but also only targeted a 70% utilization rate at the firm level. After an allowance for discounting standard rates by 30% (which is the realization rate), they made the math work at scale.

70% utilization times 70% rate realization produced approximately 50% of standard rates in revenue, or 2.5 times cost (I know that 70% times 70% is actually 49%, but we’re talking big numbers here.)

You can play with these variables any way you want if the formula produces the right answer. Run the firm hot at higher rates of utilization and you can have lower rates. Eliminate discounting and you may be able to carry a larger team through the inevitable periods of slack demand. There are several strategies to consider when deciding how you want to run the firm, but the constant is the need to produce good gross margins from your work.

Planning for Expenses: Income Statement Targets

With these numbers in place, you can think about how to budget and plan for your expenses, like support staff, non-reimbursable travel, and overhead.

In general, client service staff employment costs should be around 40% of revenue.

When it comes to support staff, my suggestion is to limit your investment in non-client service personnel to 5% of revenue. There will always be loud voices calling for more controllers, marketing, talent management, and administrative assistants. The rationale for each of these requests will be rock solid. Your non-client service support team can be an incredible source of value, but you must grow into that investment by growing the top line. I think the best way to manage this is to put a cap on the percent of revenue the firm will spend on these resources.

In pre-pandemic days, we also budgeted 5% of revenue to cover the cost of non-client service travel and living expenses. Think of this as both an investment in sales (traveling to meet with prospective clients) and an investment in people and culture development (occasionally getting a distributed workforce together to reinforce values and facilitate collaboration.)

That leaves another 10% of revenue to cover all other overhead including the hard costs of marketing (target 1.5 – 2.0% of revenue), insurance, technology, phones, rent (small offices and big houses), taxes, recruiting, legal, accounting and banking fees, and all the other stuff that comes at you with an annoying regularity.

So to recap, that’s 40% of revenue for client service employment costs, 5% for non-client service employment costs, 5% for unreimbursed travel and living costs, and 10% for all other overhead.

If you’ve done all of that right, you should be left with 40% of revenue to compensate your partner team, and how you do that is the subject of a whole other blog post. Remember that they are the engine that drives the business and allows you to scale. When the income statement is working right, you should have plenty of margin at the bottom line to compete for top partner talent. If margins are compressed, you will struggle to keep the partner team engaged and actively helping you win in the marketplace.