Leverage models in professional services. Profitability vs. growth. Examples and measurements.

What is leverage in consulting business? How are agency growth and leverage correlated? How can you get rich by consulting? In what kind of agency are you?

In any professional service, there are three key benefits clients seek:

  1. Expertise (new solutions to new problems). "Hire us because we are smart."
  2. Experience (practise in solving this type of problems)."Hire us because we've been there before."
  3. Efficiency (well-known problems, performance efficiency). "Hire us because we are cost effective and fast."

Clients prioritize these values according to a problem:
  • Brain surgery requires frontier expertise, talent and innovation
  • Cosmetic surgery client looks for experience in particular aesthetic procedures
  • Teeth-whitening customer is interested in cost effectiveness, close location and sooner appointment
All types of projects could bring good business but only if staffing required by work matches the staffing an agency has.

The majority of consulting businesses start with few partners joining their forces. These partners have to balance the client and the people (employees) marketplaces to achieve planned economic goals.

In a partnership, the ultimate measure of a business's success is profit per partner, which is driven by three main factors:

  1. Profit margin
  2. Productivity (revenue per employee, or average hourly rate × utilization)
  3. Leverage
     
Leverage is the ratio of the "finders," "minders" and "grinders" in the firm organization.

1. Finders are senior-level staff (partners, VPs), people responsible for client relations and general services marketing. Senior employees billed under the highest rate bring new business and grow it.

2. Minders are middle-level employees responsible for day-to-day supervision and coordination of projects.

3. Grinders performs technical tasks necessary to complete the job (junior level in the organization).

Smaller companies could have just two levels of partners and associates. Large companies might distinguish between junior and senior partners.

Any employee can be well-paid, but the agency's business model relates to leverage as a mix of billing rate levels, target utilizations and billable hours quantity with a fixed overhead cost.

Here is the classic example of professional services organizational structure:
 
Level Quantity Target Utilization Hourly rate
Senior 3 70% $200
Middle 6 75% $100
Junior 14 90% $50
 
Overhead staff (non billable employees) cost is $30,000 per professional.
     
If a manager does not bring value that can be directly invoiced to a client as billable hours, he is considered overhead and not even a junior-level professional or consultant.

Grinder-level professional with a finder-level salary minimizes agency leverage.

One-level agency structure would mean an unleveraged business with some overhead cost.

Actual titles have nothing to do with leverage structure. For example, there could be a firm with 15 senior consultants (grinders or junior-level in leverage structure) and five managers who are more experienced than senior consultants (minders or middle-level) and three principles (owners or shareholders of the company).
Leverage mismatch — project is 100% covered by a leverage structure but might be too simple and not interesting
 
Project is too small for an agency
A project could be fully covered by a firm's expertise, experience and procedures, but the client is looking for the lowest price.

The firm's leverage structure does not account for a low fee, so the project might be not interesting for an agency.
 
Leverage mismatch — over expertise and not enough efficiency for the project
 
An agency has too much "brains" for a job
A project requires more procedural consultants than the agency has.

For example, the brain surgery can not be highly leveraged; the number of professionals is limited and their rates are high. Usually patients with a basic toothache don't go to neurosurgery specialists.
 
An agency does not have enough expertise for a job
 
An agency does not have enough expertise for a job
An agency could have enough experience and a good process, but if a client is looking for innovation and does not really care about the budget, there is a mismatch.

Leverage mismatch — project is 100% covered by a leverage structure but might be too simple and not interesting
 
Project is too small for an agency
A project could be fully covered by a firm's expertise, experience and procedures, but the client is looking for the lowest price.

The firm's leverage structure does not account for a low fee, so the project might be not interesting for an agency.How to measure leverage?
The Dupont formula of Return on Equity (ROE) for industrial companies could be used in professional services:
 
 

Calculate how leveraged is your firm

 
The simple formula is the relation of the number of partners to all other employees:
X – number of partners in your agency,
Y – number of consultants who are not overhead employees,
Leverage = Y/X

A more complex formula could be used to detect the leverage change overtime in all levels of the firm.
 
By leveraging its high-cost seniors with low-cost juniors, the professional firm can lower its effective hourly rate and thus reduce its cost to clients while simultaneously generating additional profit for the partners
 Managing the Professional Service Firm by David H. Maister
     
They leverage structure on average projects to influence economics and position the firm in the client and people markets.

It is usually more profitable for an agency to perform similar to previous projects with developed knowledge, expertise and approaches.

By providing reproducible services and standardized elements, the agency reduces risks and increases quality. But employees are not interested in doing the same project over and over. The solution is to utilize juniors for whom tasks would be new and challenging while promoting experienced people to the higher level to supervise and train juniors and eventually become partners of the firm.

It is important to understand that growth does not always mean higher profits. For example, let's compare the first and third year of an agency performance with the same cost and billable rates but different headcount.
 
Agency finances with 24 people
 
Agency finances with 40 people
 
 
This example shows that the agency has grown but per-partner profits have not increased. To solve that problem, the agency has to charge higher rates or deliver projects with less senior and more junior time.
     
Three factors drive profits in professional services: margin, productivity and leverage. Some firms can achieve their economic goals with modest leverage but high margins. Others agencies get equally high profit per partner with small margins, average productivity but a high leverage.

Only a few consulting companies use net profit per partner as their main method of regular reporting on the firm's performance. That is because the majority of reporting systems do not provide a convenient way to measure it. And if you never measure profitability per project, it's hard to reward partners properly.

A leveraged partner may deliver more cash into partnership profits than the unleveraged partner with high chargeability and realization (very smart and productive).

In Metric.ai profit per partner could be easily measured by simply adding a role "partner" (also could be a department or office) to reflect the connection between each project and a partner.
 
Editing projects in a custom "Partners" role so the Metric.ai can calculate profit per partner
 
Editing projects in a custom "Partners" role so the Metric.ai can calculate profit per partner
After a certain level, employee utilization cannot be increased or will be a bad influence on an agency. Growing by 20% and adding 20% more partners to maintain the same effective team structure is not increasing profit per partner. So the firm must have skill-building, specialization, innovation and value-added services that will make clients pay more for the services.
 
Only increased fee levels or leverage move the firm forward
— David Maister