As a service provider transitions from time and materials billing to an MSP model, one of the first key financial metrics that must be tracked is profitability per agreement. Basic as it may seem, there are several factors that must be taken into consideration in order to avoid under or overvaluing an agreement (impacting profit, margin, and cost). Specifically, you must look at the impact of effective rate, product bundling, and disparity in contract value.
Effective Rate = Total Amount Invoiced / # of Hours Against the Contract
In case it is new to you, effective rate is the total amount invoiced divided by the number of hours against the contract and defines what your billing rate would be if you were billing hourly, instead of under contract. While it ignores a number of important dependencies in and of itself, it is a good place to start understanding profitability.
Another MSP trend impacting the true profitability of an agreement is the bundling of many different items into a single contract. HaaS (Hardware as a Service), BDRs (Backup and Disaster Recovery Devices), SPLA (Service Provider License Agreement) licensing, SPAM services etc. are often now part of a single service agreement. Almost all of our core agreements have some elements of hard costs associated with them. If we do not take those costs out of the equation when looking at profitability we do not have an accurate picture of whether we are actually making money or losing money.
The other key issue impacting agreement profitability is disparity in total contract values. Often when determining agreement profitability, people will look at all agreements in total. While simpler, it hides the details within each agreement and skews the results. We have agreements as small as $1,000 per month and as large as $60,000 plus per month. If we are overpriced, not performing enough service, or not providing enough value on one single contract, we risk losing the customer on renewal. On the other hand, if we are servicing a customer that should be re-priced or let go, we are losing money, losing capacity, and jeopardizing other customer relationships.
These things are never seen when looking at agreements as a whole. You must look at each agreement on its own to understand your true profitability, but monitoring this can be a time consuming endeavor.
Labor Loaded Gross Margin % = Total Revenue from Contract —
All Product or Hard Costs – All Costs of Labor
This is where Labor Loaded Gross Margin Percentage (or LLGM %) comes in. Though the term sounds slightly scary if you aren’t familiar with it, the calculation is fairly simple. You start with the total revenue from a contract, subtract all product / hard costs, and subtract all of your actual costs of labor based on the resources who spent time against the contract.
This gives you your total true margin. You then divide the total margin by the total revenue to find out your percentage of margin. Over the last 30 years, we have found that you are doing well if you are in the 60% + range. If you are over 75% you are in danger of losing the customer, and if you are under 50% you are probably losing a lot of money. Your specific numbers may be slightly different but these provide good benchmarks that you can tweak to your own service delivery model.
All key metrics exercise the law of yin and yang – for every action there is an equal and opposite reaction. What does this mean for LLGM (or any profitability measure)? The easiest way to misrepresent the profitability of any contract is to not work on it, or misallocate the work. That is where balancing metrics like utilization by member and customer satisfaction come in which will be discussed in the coming weeks.
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