Case Study: Incremental Approach
A client asked me to help redesign their cost rate model for their project management (PM) services business. Their existing model implied they had to either charge exorbitant rates to meet target margins or accept poor margins when offering market-competitive rates. This dilemma manifested itself in poor pricing decisions where pricing varied wildly based on whether a client should be charged a "marketable" or "profitable" rate, which felt like a false choice (and often is).
The most important problem we keyed on was that the company's current cost rate model applied a traditional "cover your total company costs plus a margin" approach. This approach works fine when your services business is mature with relatively predictable bookings, revenues, profitability, and headcount. For rapidly growing companies not yet profitable, however, these models work poorly because they burden your new projects with the impossible responsibility of making your current book of business suddenly profitable.
So we redesigned the model to answer two key questions:
what incremental cost per hour does each new project and employee add to the business?
what price levels ensure new projects and hires progressively increase the company's profitability towards its margin targets?
This "incremental" cost rate model only included the types of cost the business would actually incur per each new hire:
Bonus plan applicable to the role
Line management (if you hired 20 more people in that role, you would have to hire more line managers)
Remote office stipend
We then excluded cost types that the business did not have to incur more of just because it hired more direct staff:
Executives- hiring more project leads does not mean you hire a second CEO or CFO (unless you're Salesforce)
Sales & Marketing- selling a new project does not require you to spend more on S&M
R&D- this particular company also sold a SaaS product and allocated a portion of that R&D to its PM business, even though its product R&D spend was not correlated in any manner to its PM revenues or headcount.
The company now has a far more accurate picture of the degree to which ongoing projects are net profitable and what profitability could be expected from new projects. Services are sold on a fare more consistent basis now that the false choice or "marketable" versus "profitable" rates no longer exists. The CEO and CFO can approve new hires knowing what levels of pricing those hires' services need to be charged for the business to meet and beat its margin targets during its growth stage.
Given the business will likely need more outside capital over time while the product side progresses towards profitability, it can now demonstrate to current and potential investors how growth in its PM business can help the overall business achieve profitability more rapidly than was previously thought possible.
Bottom line- while models are just tools and results are what truly matters, problems in your models will manifest in your results if your models don't give you accurate information for decision making.