ServiceLine White Papers

The Art of Setting Financial Objectives

Setting realistic financial objectives for a professional service organization is obviously an important activity for the management team. For public companies, the result of this process is used to set shareholder expectations. More importantly, the assumptions created here can determine what bonuses get paid (or not paid) at the end of the year. If financial targets are too aggressive, variable compensation targets become meager and staff disenchanted. If targets are too easily achieved, variable compensation becomes excessive and profits suffer. So EVERY senior manager should be motivated to get this right. If so, why is the process of setting financial expectations for a professional service organization more art than science?

The Science of Setting Financial Objectives

To place more structure around the process of creating financial targets for a professional service organization, the management team should consider at least the following three variables:

1. The charter for the services organization.
2. The target financial business model.
3. The current service revenue run rate.

4. The size of the product install base.
5. The growth rate of product revenues.

Charter and Business Model

In the article The PS Charter, I introduced a framework management teams can use to clearly define why the company has created professional service capabilities. Without a clear charter in hand, it is extremely difficult for a management team to set appropriate growth and profit targets for the professional service organization. In the article The PS Business Model, I reviewed the importance for defining a business model that includes the investments in sales, marketing, and services engineering that will allow the professional service organization to sustain itself over time. If the target business model is not defined or well understood, the management team has a tendency to create financial objectives that become more difficult to achieve over time.

Current Base and Current Growth

When setting targets for the future, it obviously makes sense to understand where you are starting from. The current run rate of the professional service business, the size of the install base and the growth rate of product revenues all provide guidance when attempting to determine future service revenues. The larger these three variables are, the higher growth rate management could request from services.

For service organizations building around a core product portfolio, it is critical to understand the size and growth of product revenues. As an example, let’s assume the services organization is currently a twenty million dollar, break even cost center. Let’s also assume the following:

• There is $500M of product installed with customers;
• New product sales are expected to be $200M next year.

• Revenues from existing service offerings will stay steady next year at $20M;
• Using newly developed service offerings, we can go back into the existing product install base and capture 1% of past product sales in new service sales;
• Using newly developed service offerings, we can capture 1% of new product sales in service revenues.

Table 1: Growth Assumptions

By grounding themselves in the product growth rates, the management team can take a stab at one to three year financial targets for the business. Table 2: First Four Quarters provides an example of the financial objectives for the PS business over the next four quarters. The numbers show how the business will be grown 35% to meet the $27M revenue target. These four quarters also show investment to set up continued growth and scalability in years two and three.

Table 2: First Four Quarters

By using these five variables as guides, a management team has a better opportunity to define realistic growth rate targets for the services organization. If a management team is only considering one or two of these variables, there is a very real chance the financial targets will become destined to become another “management work of art”. One, unfortunately, that may not be well received by the critics of reality.

Realistic Financial Objectives

As we discuss the variables required to create financial objectives for a professional service organization, I want to comment on a common trend I witness in the PS business plans I review. Across the world, management teams are creating the perfect PS business in a workbook. They model what the business will look like over the next three years. Utilization rates for delivery staff will be high, bill rates will be high, load costs (overhead) will be low, and growth rates will be exponential. Of course, the business is profitable almost instantaneously. Figure 1: Typical PS Business Plan documents this optimistic view. How many of these plans are achieved?

Figure 1: Typical PS Business Plan

To help offset some of this unrealistic optimism, I would suggest a management team thinks in terms of three years, not three quarters. The general guidance is as follows:

• Year 1: Investment. Fix your hobbled business. Build out some of the infrastructure required to support this business. Invest in strategic capabilities such as Services Engineering and Services Marketing. Expect PS to lose money.
• Year 2: Break Even. Challenge PS to at least carry their own water as they continue to mature the business infrastructure.
• Year 3: Target Business Model. Challenge PS to meet its target business model, whatever that may be. By the way, it is probably not 40% gross margins and 20% in operating profits.

Growth Rates and Camel Humps

Philosophically, management teams typically agree that they should have a three year horizon. Emotionally, they don’t like it. They want to blow this PS thing out. “Hey, we are leaving money on the table. We have a huge opportunity here!”

Regardless of how fantastic your particular PS opportunity may be, I believe there are some natural limitations to how fast this human capital intensive business can be grown. Ingesting human capital takes time and energy. Even if you decide to acquire your way to growth, it takes time to assimilate service companies. You just can't grow this business exponentially. But how fast can you grow? I asked that very question to a group of senior service managers in the Fall of 2004 at one of the executive conferences I host at The Ohio State University. First, I asked the group of senior service managers what average growth rate they felt they could sustain in the PS organization for three years. Figure 2: Three Year Growth Rate for PS summarizes their responses. As can be seen, all of the forty–six managers that replied felt that the growth rate they could sustain for three years was 40% or lower.

Figure 2: Three Year Growth Rate for PS

I then asked this same group what is the maximum growth rate they could profitably achieve in a given year. Figure 3: Maximum Profitable Growth Rate documents their response. As shown, a majority of attendees felt PS could not grow profitably if at a growth rate greater than 60%.

Figure 3: Maximum Profitable Growth Rates

Yes, this is small data sample. However, the sentiment is strong and consistent. Complex, technology centered Professional Services are not easily scaled. When they are scaled aggressively, profitably suffers.

IBM, Cambridge Technology Partners, and Camel Humps

To help a management team set realistic growth expectations, let us look at two companies that aggressively grew their professional service capabilities in the late 90's: IBM and Cambridge Technology Partners. Table 3: Growth Rate Data provides an overview of each company.

Table 3: Growth Rate Data

Figure 4: Growth Rate Graph maps the year over year growth rate these companies experienced in their service business for a six year period. Once again, the IBM clock starts ticking in 1994, the CTP clock starts ticking in 1993. For just a moment, take yourself back to the late 1990's. In terms of technology based professional service activity, this was the perfect storm. Companies had to verify their computers would work in the year 2000. The internet craze began, and the overall economy was humming. Could any professional service firm hope for better conditions to grow their business?

Figure 4: Growth Rate Graph

There are two insights from the small sampling of data shown in Figure 4. First of all, even in a perfect storm, the highest year over year growth rate was 72%. Not 200%, not 100%, but 72%. The average growth rate for both companies during these heady times was 41%. The second insight involves the very visible “camel humps” that appear in both growth rate curves. I believe this is the direct result of the energy required to grow a human capital intensive business. You can only hire (or acquire) so many new consultants before you must pause and ingest them into the company. Notice the binge of revenue growth (and most likely hiring), followed by the decline in growth.

Now, let's play the optimistic PS business plan shown in Figure 4 against the real world. Figure 5: Desired PS Growth maps the anticipated growth rates from an optimistic plan against the real growth data of IBM and CTP. As can be seen, the first three years of a plan often strive for growth rates that are far beyond what these two example companies have experienced. Of course, if your PS business is $2M and you want to take it to $4M, that is 100% growth rate that makes sense. However, 90% of the companies I deal with have some run rate PS revenue that they want to aggressively build on top of. They are starting out with $15M to $25M and they want to take it to $100M or $250M. Wonderful, but don’t expect to get there by growing 150% to 200% a year.

Summary

Setting financial targets for a human capital intensive business is a tricky exercise. Especially when the business is based on complex, technology centered services that require unique skill sets. To help offset this challenge, management teams should answer two questions:

1. What are the variables that impact our ability to scale our professional service business?
2. Does historical data show any natural limitations to scaling this type of business?

By gathering information that helps answer these questions, a management team can begin applying more discipline to the art of setting financial expectations.