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The Professional Services Business Model - Fighting the 40/20 Myth
- by Thomas E. Lah, author of Mastering Professional Services
Many Professional Services Organizations focus on increasing bill rates, increasing utilization,
and reducing load costs to meet profitability targets. While it's important to track such metrics,
oftentimes, the senior management team has not yet defined a target business model for their Professional Services team. The lack of a clearly defined business model can lead to poor decisions.
Business Model Definition
In a previous article, The Professional Services Charter - Beyond Financial Targets, I argued that a clear and prioritized charter is critical for the long-term success of the Professional Services organization. However, a clear charter is only half of the battle when it comes to setting revenue objectives for the services function. The executive management team must also discuss and document the financial business model for services. Of course, this financial model should be 100% aligned with the charter.
When people think of the term “business model”, several items come to mind:
- Target Markets
- Target Customers
- Product Offerings
- Distribution Channels
- Margins
- Profits
A sound business model considers all of these items. In essence, a business model demonstrates how a company will
manage all of these parameters to grow and make money on a sustainable basis. If you don’t have a business model that eventually makes money, you don’t have a sustainable business model.
A financial business model reflects the realities of your overall business model. Ideally, a financial business model accurately defines the costs, investments, and profits required for the business to succeed long term. The financial business model should be realistic and sustainable. A successful model allocates the appropriate amount of investment in sales, research, and administration to achieve market success and hit target profitability.
A financial business model is not simply a financial report. A financial report summarizes anticipated revenues and expenses to show profitability. You could have extremely accurate financial reporting but have no idea what your target financial business model should be.
A sample financial business model is shown in Table 1.
Table 1: Sample Financial Business Model
| Category |
Common Abbreviation |
Description |
Target |
| Revenue |
|
Total revenues expected to the company from services. |
100% |
| Cost of Services Sold |
COS |
Cost of materials and human resources required to deliver the services to customers. |
70% |
| Gross Margin |
GM |
The difference between what customers paid for the services and what it cost the company to deliver those services. |
30% |
| Sales Costs |
|
The total cost of all selling efforts. Includes salaries, expense accounts,
and commissions for sales management, sales people and sales support. |
5% |
| General & Administration Costs |
G&A |
The general expenses not captured in COS, sales, marketing or R&D. |
8% |
| Research & Development Costs |
R&D |
Investments mad to improve service methodologies and delivery tools. |
2% |
| Marketing |
|
Investments made to market the service portfolio. |
2% |
| Operating Profit |
|
The profit generated by services. Also known as the operating margin. Operation Profit= Revenue - COS - Sales Cost - G&A - R&D - Marketing |
13% |
The example financial business model in Table 1 shows that the management team of this business believes
at least 4% of revenues needs to be invested into marketing and R&D to sustain the business. If these investments are not made, future revenues and margins could be compromised.
Business Model Examples
Before you attempt to document a viable financial business model for your services business, it is helpful to understand what models already exist in the marketplace. Let us begin this review by looking at Accenture Consulting. Accenture is a global
consulting firm with over 75,000 employees in 47 countries. They perform the type of high-end technology and business consulting
that many companies wish they could deliver. Table 2 shows the financial results for Accenture in 1998 and 20021.
Table 2: Accenture Financial Results
| |
Accenture 1998 |
Accenture 2002 |
Sample Business Model |
| Revenue |
$9,511 |
100% |
$13,105 |
100% |
100% |
| COGs |
$5,996 |
63% |
$8,428 |
64% |
63% |
| GM |
|
37% |
|
36% |
37% |
| Sales & Marketing |
$696 |
7% |
$1,566 |
12% |
8% |
| R&D |
|
|
|
|
2% |
| G&A |
$1,036 |
11% |
$1,616 |
12% |
8% |
| Operating Income |
$1,783 |
19% |
$1,385 |
11% |
19% |
In the far right hand column, I have reverse engineered a financial business model Accenture could be using. Accenture targets services that will bring in decent gross margins. However, they need to invest heavily in sales and marketing to maintain their brand and land large engagements. I make the assumption that some of Accenture’s G&A expenditures are actually R&D dollars invested in delivery methodologies.
A second sample model to review is that of IBM, a stellar example of PS within a product company.
Table 3 shows IBM Global Services results for 19982 and 2003. In 2003, IBM Global services represented 48% of total company revenues. What is amazing is how significantly different the IBM services business model appears to be from Accenture’s. IBM only brings in an average gross margin of 26% on the service business. After the COS, I had to allocate G&A and Sales costs to the services business based on the percentage of total revenues services represented.
Table 3: IBM Service Revenues
| |
IBM 1998 |
IBM 2003 |
Sample Business Model |
| Service Revenue |
$28,916 |
100% |
$42,635 |
100% |
100% |
| COGs |
$21,125 |
73% |
$31,803 |
75% |
73% |
| GM |
|
27% |
|
25% |
26% |
| Selling, G&A |
$3,470 |
12% |
$5,116 |
12% |
12% |
| R&D |
|
|
|
|
2% |
| Marketing |
|
|
|
|
4% |
| Operating Income |
$1,959 |
7% |
$4,263 |
10% |
8% |
Even with the gross assumptions I am making, the sample business model I have reverse engineered in the far right column of Table 3 is significantly different than the one Accenture is possibly operating under.
Finally, let’s consider the point where most product companies are starting from: a Support Services financial model. A traditional support services business often commands fat margins with minimal investment in sales and marketing. This is due to the fact that support services are a natural attachment to the product sales cycle. Table 4 summarizes a sample financial business model for a traditional support services business.
Table 4: Support Services Financial Business Model
| |
Support Services at a Product Company |
| Service Revenues |
100% |
| COS |
50% |
| GM |
50% |
| G&A |
8% |
| Selling |
5% |
| R&D |
2% |
| Marketing |
2% |
| Operating Income |
33% |
The 40/20 Myth
So there are three sample financial business models for services organizations. It is important to notice how wide the variations are, with gross margins ranging from 50% to 26% and operating profits ranging from 8% to 33%.
When I first work with organizations on their PS strategy, the senior management team has a common assumption 80% of the time: PS is a fat business. How fat? Executives consistently tell me they are looking for gross margins around 40% and operating profits around 20%. What are these expectations based on? It is unclear. Do you currently get 40/20 from your PS business? No. Have you historically achieved 40/20 from your PS business? No. Do you have hard data that other companies are sustaining 40/20? No. Then where do these expectations come from?
Industry Results
I believe this 40/20 myth is a function of how companies currently report their service revenues. Recently, I reviewed the 10-Q’s of 30 publicly traded companies. Ninety-seven percent of them blend support services revenues with professional service revenues.
Figure 1 documents the gross margin these companies report for “services”. Oracle is the one company on the list that explicitly reports the gross margin for their consulting services. As you can see, this gross margin is significantly lower than the blended numbers. Interestingly enough, the average gross margin reported on services for these thirty companies is 41.2%. This represents the forty of the 40/20 myth. Unfortunately, 97% of these companies are not reporting the operating profit achieved by their PS business. So it is very unclear where the twenty portion of the myth is coming from. My assumption is that executives look at the results of independent consulting firms like Accenture, see the high operating profit as shown in Table 2, and assume that should be the target for their PS business.
Mix Matters
Another insight provided by Figure 1 is the impact of service revenue mix. Six of the listed companies do break out how much top line revenue is coming from support services vs. professional services. This data supports my premise that a mature service revenue mix with lots of PS drives down the blended gross margin.
 Figure 1: Service Gross Margin %
To prove the point, Figure 2 documents the revenue mix for Novell services.
As shown, the mix is heavily weighted in support services. This helps Novell report an overall service gross margin of a healthy 52%!
 Figure 2: Novell Service Mix
Unisys, however, has a very mature service revenue mix which includes professional, outsourced, and managed services as shown in Figure 3. Revenue from support services represents less than 15% of total service revenues. This reality drives the blended service gross margins for Unisys down to 21%. In summary, Professional Services activities appear to drag down total service gross margins. This substantiates the premise that PS is not a 40/20 business. But what does the business model look like?
 Figure 3: Unisys Revenue Mix
Setting the Boundaries
We have reviewed example business models for service organizations. I have made the argument that Professional Services is not likely the 40/20 business many executives feel it should be. Now, for the million dollar question - what does a sustainable
business model look like for professional services?
First, we should discuss the individual line items of the financial business model. Table 5 provides
target boundaries for each line item. The table also provides rationale for the boundaries.
Table 5: PS Line Items
| Line Item |
Recommended Boundaries |
Rationale |
| Gross Margin |
15% < Target < 40% |
If less than 15%, PS can not sustain itself. No money left to invest.
Difficult to consistently exceed 40% when asked to pull products or invest in critical company accounts. |
| G&A |
5% < Target < 8% |
If less than 5%, required infrastructure for PS is not created and maintained.
Greater than 8% is a sign critical operational processes are not defined or are not being followed. |
| Sales |
5% < Target < 8% |
If less than 5%, service capabilities are not aggressively being sold to customers and channels. |
| R&D |
2% < Target < 5% |
If less than 2%, intellectual property is not being documented and leveraged to improve profitability. |
| Marketing |
2% < Target < 5% |
If less than 2%, service portfolio is not being positioned to the marketplace. Sales representatives are forced to do general awareness and initial demand generation. |
| Operating Profit |
5% < Target < 12% |
Within this range, PS is being asked to carry its own water. However, the organization is not being tasked to sustain unachievable profits. |
With these boundaries in mind, what overall financial model is realistic for the professional services organization at your
company? Table 6 provides a range of possible values for the key financial variables that need to be set.
If you create a business model with values from the left side of the table, you risk setting financial objectives that cannot be
sustained by PS. For example, having a gross margin target of 50% will be difficult for the professional services organization
to maintain. On the other hand, setting the financial business model with values from the right side of the table will make it
difficult to keep the services organization alive. If Services continually brings in low gross margins, no investment is made in
sales, marketing, or R&D, and operating profits are non-existent, then senior management may have little patience for the business. Even if services are considered a strategic investment, a business model weighted toward the right will be difficult to maintain. There is not enough investment in the business to help it grow. The anemic return will eventually make it unpalatable.
Table 6: PS Business Models
| |
Can Not Sustain |
|
Can Not Maintain |
| GM |
55% |
50% |
45% |
40% |
35% |
30% |
25% |
20% |
15% |
10% |
| G&A |
13% |
12% |
11% |
10% |
9% |
8% |
7% |
6% |
6% |
6% |
| Selling |
10% |
9% |
8% |
7% |
6% |
5% |
4% |
3% |
3% |
3% |
| R&D |
8% |
7% |
6% |
5% |
4% |
3% |
2% |
2% |
0% |
0% |
| Marketing |
8% |
7% |
6% |
5% |
4% |
3% |
2% |
2% |
0% |
0% |
| Operating Income |
16% |
15% |
14% |
13% |
12% |
11% |
10% |
7% |
6% |
1% |
Using the range table for guidance, the management team should be able to draft a viable target financial model for the services organization. The key point here is alignment. The target financial business model should be aligned with the charter thatwas created for the professional services organization. Looking at Table 6 again, we can see that financial targets from the middle to the left supports a service charter that is focused on revenue, margins, and profits. However, if a services organization has a charter of product sales enablement, the financial targets from the center to the right will make much more sense.
Stake Your Ground
Defining a sustainable business model is a critical step for any business. This reality applies to the professional service
business. However, senior managers often focus on bill rates and utilization targets, without ever stepping back to identify what financial business model makes sense for PS. This lack of abstraction is denying PS required investment and crippling the function long term. If the management team does want to create a business model, they often start with the incorrect assumptions that PS will maintain significant margins (40% or higher) and require minimal investment. This behavior must stop if PS is to flourish as a function.
To move the conversation in the right direction, I believe a management team can take these four important steps:
- Acknowledge that operating a business function with no defined business model handicaps the function.
- Based on actual financial data, reverse engineer the financial business model PS is currently operating under.
- Understand what the PS business model truly looks like in your industry today.
- Determine how PS will move the current business model to a sustainable one that makes sense for your industry.
If a senior management team takes these four steps, they will dramatically improve the ability of PS to succeed long term. If the business model remains undefined, PS management will continue to focus all their energies on pushing staff to bill more hours at higher rates-until those employees bail in frustration.
Thomas E. Lah
is the Executive Director of The Technology Professional Services
Association (TPSA), author of Mastering Professional Services and Building Professional Services: A Siren's Song,
and currently consults with companies to establish or improve their professional services organization. Thomas is actively engaged with The Ohio State University to host an executive education program focused on frameworks and strategies to successfully build professional services at product-centric companies.
He received an undergraduate degree in Information Systems and holds an MBA from the Fisher College of Business at The Ohio State University. |
1Source: Accenture's 10-k report for fiscal year ending August 31,
2002, Page 27.
2Source: IBM's 2000 Annual Report. Consolidated Statement of Earnings, Page 64.
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