The battle to increase gross profit margin isn’t that complicated. By simply charging more you generate a higher top line with no change to delivery costs, thus increasing the bottom line. Battle won, right?
Not so fast.
While almost any firm can learn to increase their average prices across their client base by unlearning some bad habits and embracing a few simple rules about pricing, once accomplished, the battle shifts from an external one on the front lines with the client to an internal one that is even more fierce. It is rare that all the newly won gross margin survives the journey to the bottom line. The unfortunate norm is this margin won by business development through better pricing gets handed back by the delivery team through over servicing.
But this battle can be won.
First, Understand that Price is Not Cost
Cost and price are two different things but most creative firms conflate them and use their hourly rates as a vehicle for both.
Let’s look at how price and gross profit should be determined in the two main pricing approaches. In cost-based pricing, price equals cost plus profit. In value-based pricing, price minus profit equals cost.
Steps to Determining Price & Profit With
|Cost-Based Pricing||&||Value-Based Pricing|
|1. Scope solution||1. Set price|
|2. Determine cost||2. Deduct profit|
|3. Add profit||3. Arrive at cost|
|4. Arrive at price||4. Scope solution|
Regardless of the pricing approach, isolating gross profit on the job (adding it in cost-based and deducting it in value-based) is always part of the equation. But the typical creative firm never isolates profit at the job level. Because the hourly rate is seen as both a measure of cost and price, any excess margin obtained in the sale is converted to hours and therefore allocated as cost that the delivery team sees as available to them to use.
To illustrate, let’s say Tyler is working on a cost-plus basis to price service X for client Y and he determines it will take 100 hours at the blended rate of $225. The client signs off on the $22,500 statement of work (SOW) and those 100 hours are allocated to the delivery team and spent.
But let’s say Gina notes that the value created for client Y from service X is far greater than $22,500, so she intervenes before Tyler issues the SOW and convinces him to increase the price to $30,000. That’s $7,500 in profit added to whatever expectation of profit was built into the hourly rates.
That $7,500 should be allocated to profit even before the first hour is spent on the job. It should be taken off the table and away from the delivery team. But this rarely happens. Instead, the delivery team, taught to conflate price and cost, sees there is $30k in time to be spent, so they spend it. They don’t really see this extra $7,500 as profit—they don’t see anything as profit because gross profit is always hidden from them—so they rationalize the extra time (profit) spent as “an investment in the relationship.”
The first step in fighting this internal margin battle is to have everyone understand that hourly rates are internal tools that provide an estimate of cost, and that profit needs to be visibly added to that cost for every job (or deducted from price to arrive at cost when value pricing).
Pay Yourself First
The second step is to protect that profit by taking it off the table entirely and making it unavailable to the delivery team. The moment this gross profit is atomized into hours, or a higher effective hourly rate, it will disappear. In the mind of the delivery team such atomization turns that profit into cost available for them to spend.
Some firms routinely add a margin of error into their prices (ca. 5%-10%), but when the delivery team knows it’s there, it typically gets spent. Instead of “margin of error” that padding should be viewed as a different type of margin—“profit”—and it should be taken off the table. Tyler, after Gina’s intervention, should remove the $7,500 in profit and communicate to the delivery team that they have 100 hours to complete the job—a job that “cost” $22,500.
Align Any Incentives
While I’m not advocating either for or against commissions for business development or account people, or profit sharing for the broader team, if you do offer any such incentives consider taking those incentives from the pool of visible gross profit taken off the table. (A friend calls this the “POT stash” for Profit Off the Table.) Omit from the incentive pool any invisible profit that might accrue because of high utilization levels—the old source of profit that is entirely dependent on volume and efficiencies.
The Value of Making Profit Visible
In addition to creating a visible incentive pool that people can see and directly impact, isolating profit in every job also serves the function of begging the question, “Why is there no profit in this job?”
The honest answer might be “this is the best price we can get for this work from this client.” You may decide that is a tradeoff you are willing to make because of other, profitable work being done for the same client. But if you’re not evaluating profit on a project basis like this it becomes too easy to assume any project on which the delivery team spends all the allocated time is profitable. The equally incorrect follow-on assumption is the firm should continue to build a book of business exactly like this (unprofitable) work.
While this first assumption of profit built into time spent can be true, it is only true at high levels of utilization. And it is limiting. If profit is a measure of spending time, your relative profit will never increase beyond a certain, frustrating point and you will erroneously equate increasing your profit with increasing the size of the firm. You will be trapped in this narrow utilization band of say, 60% on the low end, below which you are unprofitable, and perhaps 75% on the high end above which you need to add more bodies and thus lower your profit ratio.* You will feel as though you are running a race on a treadmill; running faster, exhausting yourself, and no closer to your goal.
But if Gina’s $7,500 price increase was allocated to the POT stash, the firm could get off this treadmill and realize a dramatic increase in profit without adversely affecting delivery cost, headcount or utilization rates. This is the type of growth you want. This is the path to loosening the tethers of financial success from size, effort and efficiency.
Putting It All Together
Imagine a firm where your people on the front lines are Pricing Creativity masters. Where they easily increase prices where appropriate, with the client fully prepared to pay. Where it is understood by everyone that the hourly rates used are an internal measure of cost only. Where the pricers see themselves as having responsibility for gross profit by isolating it and taking it off the table so it cannot get spent. Where the higher value work you do delivers significantly higher profits. And where people can see their impact on the firm’s bottom line and perhaps are even incentivized to improve it.
This is possible.
Make the distinction between cost and price, isolate profit on each job and take it off the table so it cannot be spent, and align any incentives to increasing the POT stash, which should be viewed as the real profit generated by the delta between cost and price. Treat any “invisible” profit generated the old way, through volume and efficiencies, as a secondary source of profit derived from management acumen, but never prioritize it over visible profit.
Now the battle is won.
(*These figures are for example only. When David C. Baker and I discussed this topic in a recently-recorded 2Bobs podcast episode, he rightly pointed out that there are better sources for these numbers, and general operations advice, than me. Like him for example. I accept his admonition but the principle stands: limiting profit to a percentage of cost will create limited outcomes, no matter what prices you charge.)