Cutting costs with a scalpel, not a chainsaw
The United States economy has always fluctuated over the years. From 1945 to 1965, the financial market moved upward. It then moved sideways until about 1982, and up again until 2000. Right now, we are engaged in another great sideways movement that could continue for another decade or so. The last year or so, America has faced a recession that caused businesses to fail and members of congress to pound their fists. In such times, it is natural to fear for the future.
These types of fears can be especially dangerous for businesses. Managers often makes unwise business decisions out of panic. For example, they might cut valuable employees or reduce spending on various programs that are actually good for the company. As a result, many companies that slash costs in response to an economic recession find themselves unable to achieve top-line growth when the recession ends. Their method of survival today will cost them dearly tomorrow, but they cannot see that through all of the uncertainty.
Yet what if you could know where your company is profitable and where it is not, and then figure out a way to do more of the profitable work? In other words, what if you got rid of unprofitable customers instead of loyal, productive employees? Fortunately, all of this is possible and easier to accomplish than you might think.
The arbitrary cutting of people and projects can be avoided, or at the very least, it can be performed with more intelligent precision. All that is required to handle such problems the right way are per-person per-project profitability metrics.
How to Cut Costs with Precision
Understanding costs is the first step towards understanding profitability. Most managers know how profitable the company is in general, but few of them know how profitable it is on a per-customer or per-project basis. Yet this level of understanding is necessary in order to develop and implement the right growth strategy as well as cut costs in the right places. Think of it as the difference between performing surgery with a scalpel and performing it with a chainsaw.
So how can you possibly know where you should cut and where you should not? It is actually rather simple once you have the right data. As it stands today, do all of the executives at your company know which of your past projects were successful? How many employees worked on these projects? How much time and how many resources were allocated to them? Do you know which of your clients are profitable and which ones cause you to lose money?
If you don't know your costs on a per-project basis, then you have no way to validate future project estimates. How can you know, for example, if your previous project estimate was accurate (both in scope for time and budget) or completely unrealistic? Which processes are working for you and which need to be improved? There is no way to answer these questions unless you are tracking time on projects, and not knowing these answers is especially dangerous during a recession.
Below is a five-step process (see Exhibit 1) that will show you where you are spending most of your resource time and money, as well as where the return on investment (ROI) is really coming from.
Phases of P5 Maturity
Where to Begin
The first step to improvement is to identify the current state of your organization. Are you constantly overcommitting, taking on projects you just cannot complete? Are these projects being abandoned in crisis? When a project is successful, are you able to isolate the key factors involved and use them to repeat the success in the future? If you are unable to gauge potential project outcomes or repeat past successes, you might be in the chaos state. Many organizations are currently characterized by chaos and may not even realize it.
If your organization is in “chaos” mode, get your employees to track their time on a per-project basis. Yes, everyone hates timesheets, but they can make an enormous difference to the success of your business, especially when the economy is down. The time data you collect will alert you much earlier to when projects are in trouble, giving you the opportunity to do something about it before it is too late. Contrary to what you might think, 100% compliance is not necessary to gain significant insight into project progress, profitability, and adherence to estimates.
Once your company is consistently tracking time to projects, you will need to add labor rates to the data. The time of one employee can cost the company more than the time of another, and those costs add up on major projects. If nothing else, visibility into these costs can help you with more effective, profitable resource allocation and project prioritization.
The basic time-tracking data you obtain from this system will surprise you. You can figure out, for example, which projects are consuming more labor hours than you thought, or which of your customers are cheap to service. What many project managers don't realize is that the noisiest customers are often the ones who pay you the most. While they are often labeled “problem customers,” they may account for much of your revenue. A simple basic level of employee project time utilization data can give you insight into the profitability of each customer, so you don't have to wonder anymore. Imagine if your engineers, developers, services team, and salespeople all knew which of your customers were making money for you and which were not. Wouldn't this information alter their behavior in ways that would make you more money? For example, in recessionary times, you can choose to “fire” unprofitable customers and “kiss up” to the profitable ones.
It is also important to track all expenses associated with your various projects. For instance, some projects and customers use up more travel expense than others. Collecting all these data on a per-project basis can help you understand true direct per-project cost, giving management better insight into how to cut costs with precision.
Now is also the time to aim for nearly 100% compliance on time and expense data collection so that management will have better insight into how to cut costs without a chainsaw.
It is also necessary to allocate indirect costs in order to paint the full picture of where your company spends money. There are two types of indirect costs: general indirect costs, such as rent, that need to be allocated across every project in the company, and semi-indirect costs, such as customer relationship management, which should be applied to all projects for the customer in question. For general indirect costs, you will need to create an allocation formula for each type: marketing, legal fees, office rent, and electricity, etc. For semi-indirect costs, there is a different process. If you have a large customer for whom you do multiple projects, there are usually some costs that apply to those projects as a group, but not against any particular one of them. In this case, you might allocate these semi-indirect costs by revenue or direct cost over those projects.
Another thing to note is that input from all of the managers involved is not only useful, but necessary. You may want to alter these allocation formulas over time if they are generally perceived as inaccurate, unfair, or leading to bad decisions.
Once you have allocated indirect and semi-indirect costs across all projects, you will be fully aware of what your complete per-project costs are. Whether or not you are facing a recession, you will have a very precise tool for making intelligent changes to company resource utilization and direction that are likely to lead to increased profits.
At this stage, you can choose to integrate all of your time and project data with your CRM or accounting systems. This will give you a true understanding of what each project costs and how to bill your clients, for example.
Billability (often termed “utilization rate”) is the percentage of time in a given period during which employees are working in a revenue-producing capacity. If you have employees performing billable services directly for your clients, for example, this applies to you. You must therefore configure your timesheet system to track whether work is considered billable or not. Once you have this information, utilization for any period, group, or person is found by the formula B divided by T, where:
B = billable hours for the employee/group in the period
T = all hours worked for the employee/group in the period
Most organizations try to keep their utilization rate above 70% or so. With this kind of insight into utilization, you can easily focus your people on more billable work, therefore increasing revenue without hiring any staff. Let's say that this system adds three additional billable hours per consultant per month to your organization. If your average hourly internal bill rate is, for example, US$85, then for 50 consultants, you would add US$150,000 of profit to your bottom line each year. The more billable employees you have, the greater the profit will be, just by understanding the availability of each employee and how their time is spent (Exhibit 2).
Only Profitable Projects
Consider British Petroleum (BP), one of the world's largest energy companies, and their experiences in drilling for oil. They created a strategic vision for their company which they termed “no dry holes.” Drilling for oil and not finding it is expensive. Rather than try to make up for all the dry holes by finding an occasional gusher, BP decided to try to never have a dry hole in the first place. Changing the attitude that dry holes were an inevitable cost of doing business fundamentally changed their culture in very positive ways.
Other types of businesses also have dry holes: projects that cause them to lose money. Due to an inadequate understanding of costs, many of these go unnoticed. If you set a strategic goal for your company of “no unprofitable projects,” it will change the nature of discussions in your business. For example, it empowers frontline employees to legitimately push back when a project is being taken on for political reasons. Conversely, having the attitude that the winners will make up for the losers doesn't do this.
Once you have the data on both costs and ROI, you can try to maximize the number of profitable projects you work on.
Anyone can tell the manager of a large department to cut 10%, yet that manager can only do it intelligently if he or she is enabled with the right data. The solution might be as simple as canceling one large project, or it may take more finesse than that. Regardless of which course to take, time data is a necessary component to making the right decision.
Once you understand per-customer per-project profitability, you will have a significant advantage over your competitors, not only during a recession, but during good times as well. They don't know where their profits come from but you do, so when you have to make cuts, you can easily calculate ROI on various projects and isolate the unprofitable work. Regardless of the economic climate, knowing where you are profitable and where you are not is the only way to thrive in a competitive business environment.
© 2009, Curt Finch
Published as a part of 2009 PMI Global Congress Proceedings – Orlando, Florida