Project profitability--plan for it and keep it!

Abstract

Most project managers are familiar with the budget allocated to their projects. But do they understand the profitability built into those budget figures? While projects are undertaken to solve problems, they may also represent profit to certain organizations. Maintaining the level of profit built into the budget may be critical for continued success of the organization. However, if the project manager does not participate in pricing the project and understand the level of profit expected from the project, success may be elusive. Completing the project to the satisfaction of the client is one thing; completing the project to the satisfaction of the organization may be something else entirely.

Completing the project on-time and within budget is the goal of every project manager. It should also be a goal to complete the project profitably. Every organization is entitled to make a reasonable profit on its business endeavors. This same belief holds true for projects, as well. This paper will investigate the methods of planning for profit and maintaining profitability throughout the project.

Introduction

Before we discuss the issues related to project profitability, we must first define what we mean by it. In his book, Quantitative Methods in Project Management, John Goodpasture (Goodpasture, 2004, p. 1) states: “Successful projects return value to the business.” The question, then, is “What is value?”

The team and the customer both seek project value, but their perspectives are sometimes the same, sometimes different, and these differences are sources of conflict. We can define “value” in common terms

Using these issues, we can now define “Project Profitability” from both perspectives:

Proper financial management of a project is critical to an organization’s stability. Clients and management are constantly inquiring as to the budget status of the project. Clients expect timely answers to their financial questions in order to understand the status of the project and, ultimately, the cost of the project. Management expects the profitability originally budgeted will be realized in order for the organization to maintain operations. A project manager prepared to answer these questions (positively) increases management’s confidence in his/her performance, builds client satisfaction, increases repeat work and has numerous other positive results.

If projects are the primary business of the organization (such as in consulting), maintaining operations depends upon the successful completion of projects as they are outlined in the scope of work (SOW) and realizing the profit planned (or more). There are a number of variables that must be considered when pricing a project to ensure profitability. For example, the profit realized from a project that was executed under a fixed price contract, will probably be entirely different from a project that uses time and materials pricing. The reason for different profit margins in these two contract types is risk. The greater the risk involved, the higher the expected profit. Understanding how these elements work together is crucial for a project manager to successfully execute the project. By successful execution we mean, on time, at the specified price (including profit), and with the quality expected by the client.

Therefore, one of the first things a project manager needs to understand about the project is how the project was priced and the profit the organization expects to realize at its conclusion. Understanding this will help the project manager make decisions throughout the life of the project that will not adversely impact the bottom line.

As previously mentioned, risk associated with different contract types affects the profit expectation. With fixed price contracts, the risk is borne by the seller, therefore, the seller may add ‘contingency’ for the unknowns. If the project runs exactly as planned and the contingency is not needed, then profit is increased. However, if the project runs into trouble, costs associated with solving problems may use up the contingency and deplete the anticipated profit margin. Using a time and materials contract can produce acceptable profits if they are properly built into labor category rates. In fact, profits may even be increased if the labor categories have multiple salaries. For example, if all the Engineers were priced at a fully burdened rate of $120 per hour to the client, but the individuals’ salaries ranged from $30 - $40 per hour, using the $30 per hour individual would increase profit. Of course, this is not always an option and it only works if they are comparable in expertise (usually not) and available when needed.

Developing a price to meet cost and profit expectations based on labor and material estimates may be easy, but executing the project exactly as the SOW and cost estimates were developed is an entirely different thing. There are a number of factors that will affect the outcome of any project, and ultimately, the profitability. The project manager must now manage the scope and the resources to deliver the profit to his/her own organization while delivering the product to a satisfied client.

But experience tells us that 99.9% of projects change somewhere between initiation and closeout. How does a project manager handle these changes to maximize profits? To begin, the project manager must ensure that all changes are beneficial to the project. Even those that are requested by the client should be evaluated for their contribution to project success. Every change should be subject to impact analysis, particularly cost and schedule. When analyzing the ‘cost’ of a change, the PM should include the same rate of profit originally planned in the contract price. If the price to the client included a 10% fee, then all changes should include a 10% fee. Often, when a change is requested, the PM prices the change and neglects to include a profit margin. Or, even worse, a small change may be requested and no change in price or schedule is made to accommodate the additional work. These small, insidious changes will eat away at the profit margin.

Another factor that can affect the outcome for both the project team and the customer is quality. An effective project quality program will pay for itself, but the basic question is “Where does it stop?” As A Guide to the Project Management Body of Knowledge (PMBOK^® Guide). states in chapter 8: “Quality planning must consider cost-benefits tradeoffs” (PMI, 2004, p. 185). Is there a point where the team achieves the maximum effective level of quality? Probably.

The quality programs of any organization should be implemented in the order of most effective to least effective. Graphically, it can look line this:

Exhibit 1 Cost/Benefit comparison of quality improvement efforts

Once the optimal point is reached, the cost of increased quality programs far outweighs the incremental benefit realized.

However, achieving quality and profitability goals without customer satisfaction are not worthy objectives. Clients demand that project managers deliver quality solutions on time and within budget. Dissatisfied clients often lead to overrun projects, little or no profit, and little opportunity for repeat business.

Goodpasture (2004, p. 8ff) presents a model of customer satisfaction / dissatisfaction and product functionality. Essentially, there are four quadrants:

Figure 2 Comparison of Functionality and Customer Satisfaction

Quadrant		Characteristic	Implications
Q1		Customer is happy when informed of functionality	Adding new requirements here may present high risk
Q2		Customer is unhappy with the service provided, regardless of the actual functionality.	The PM must address this issue. Adding resources to resolve the issue may compete with the Q1 successes
Q3		Customer is unhappy, due to poor or missing functionality.	MUST fix. Allocation of resources will compete with the right side of the chart.
Q4		Customer is unaware of the missing functionality.	No need to invest, but doing so will strengthen Q1 and customer satisfaction.

There are two lines worth noting. First, the 45° line could be called “More is Better,” meaning that customer satisfaction is directly related to the degree of functionality. Computer memory is an example.

The second line is the horizontal axis. This is the line for Customer Indifference. There is no impact on customer satisfaction, provided the minimum required functionality is met. Regulatory compliance would fit in this category.

What are the implications for project profitability? In Quadrant 1, the customer is aware of the functionality and depends on it. There is a high expectation of delivery. Any addition or deletion here adds a significant risk element: identified additions must meet expectations or customer satisfaction will suffer. Deletions, such as “descoping” to a future delivery for risk avoidance, will likely have the same effect or will reduce customer valuation of the product (more about this later).

In Quadrant 2, the customer is dissatisfied for some reason, even though the actual functionality satisfies requirements. This dissatisfaction may or may not affect the valuation of the product, but will likely affect the project’s profitability because investment is required to determine and resolve the underlying issue(s) and this will reduce profitability. Additionally, if the issues are not resolved, the likelihood of future work is greatly reduced.

In Quadrant 3, there is real dissatisfaction based on a true lack of functionality. This demands attention! In this case, maintaining profitability may be impossible, especially if the contract is fixed price.

In Quadrant 4, missing or reduced functionality may have no detrimental effect on customer satisfaction. In this case, though, the addition of the incremental functionality MAY significantly affect customer satisfaction positively. If analysis shows this to be the case, investment here may increase both the project’s real profitability and the customer’s perceived value.

Another factor affecting profitability is scheduling. Different techniques can have significant effects on project profitability, both positively and negatively. First, the good news. Rolling Wave Planning can reduce project risk by reducing the uncertainty inherent in the schedule. With this process, deliverables to be created in the near future are decomposed down to the final level and those farther out in time are decomposed to a higher level; once detailed information is available for the distant deliverables, their decomposition is carried out to the final, low level. If the project is decomposed fully from the outset, there is high likelihood that the logic and durations associated with the activities in the (project) distant future would require significant revision as the detailed information became available. Rolling Wave Planning imparts an “if, then, else” determination which can be made only after other outcomes have become fully known.

One phenomenon that increases schedule risk and therefore reduces profitability is path convergence. The basic concept is quite straightforward and uses simple math:

Exhibit 2

If activities A, B and C have the same total float and (for example) a 75% chance of finishing on time, the odds of the test activity starting on time is less than 50/50 (actually, 42%, calculated as (3/4)³).

That is the basic path convergence calculation, which assumes that each of the three predecessors is independent of each other. However, if two of the activities share common resources, then there is an additional factor which is added to the mix: the likelihood that an activity is completed on time given that the other activity sharing the resource also finishes on time. Whether or not this increases or decreases the odds depends on the quality of the resources, etc., but the point is that it increases the variability of the result, and increased variability equals increased risk which may result in reduced profitability.

Resources and their availability are another important aspect of the project that contributes to its profitability. As mentioned earlier, time and materials contracts using labor category rates can be made more profitable by using lower-end staff on the project. Conversely, if they are not available and higher-end staff must be substituted, then profit margins decline.

A further impact to profitability that project managers often neglect to monitor is billing and collecting. Project managers are often uncomfortable discussing money with clients. It is a PM’s job to ensure all allowable charges are billed accurately to the client and that invoices are paid promptly. The project manager must understand the billing procedures in his/her own organization as well as the payment procedures of the client. If the client has special invoicing requirements, the PM should know this in advance so that invoices are not returned because of format issues. The longer an invoice remains unpaid, the bigger the impact on the profitability of the project, since the cost of money increases as time extends.

Conclusions

To maintain profit levels as originally estimated, project managers need to:

1. Participate in developing the pricing structure of the project
2. Take the time to develop a SOW that thoroughly and clearly defines the requirements of the project and the individual deliverables the seller is to produce
3. Ensure that changes to the original SOW include the same margins as the original pricing
4. Beware of scope creep
5. Adjust the price of the project in accordance with the risk associated with successful completion of the project
6. Understand what satisfies the ultimate customer
7. Recognize continuous improvement methods become increasingly more cost effective to implement and the quality improvement efforts should be re-examined routinely.
8. Have the right people with the right talents working on the project.

Following these guidelines will help ensure projects will maintain the profitability planned for and expected by management. Remember, the organization that depends upon project profitability for survival can be severely affected by how well the Project Manager maintains the profit originally planned.