How do you assess the profitability of an IT Services business? Some of the performance parameters are the same as any other business in a different industry – Gross Margin, Operating Margin, Net Margin, EBITDA margin or EBIT margin.
But these are generic profitability parameters, uninformed of the structure of the IT Services business.
While not the only one, in most situations, the best profitability parameter to use is Billed Margin or Project Margin. This is the % profit from billed hours – revenue minus the direct cost of these billed hours.
I should quickly add that if you are an investor evaluating a company you should absolutely look at all the generic profitability parameters. You may not have a choice anyway because no public company reports Billed Margin, to my knowledge.
But if you run the company, Billed Margin is a very important way to assess the profitability of your services and accounts.
Billed Margin differs from Gross Margin in a crucial way – Bench Costs. Companies differ in how they compute Gross Margin, but Bench Costs always come before Gross Margin.
Billed Margin boils down the two most important aspects of an IT Service business – Prices and Wages – and the difference between the two. You could say that it captures the net effect of the two markets that the business operates in – the market for its services and the market for talent.
Why is it important that Bench Costs come after Billed Margin? For a couple of reasons.
Bench Costs, in an IT Services company, is the oil that greases the skids. It can help the company staff client projects faster than competition, enter a new account with a skill set that they desperately need, or even enter a new country.
Unfortunately most of the industry has seen Bench Costs as an undifferentiated blob of inefficiency – to be shrunk as much as possible. The same CFOs who hate missing quarterly estimates, treat Bench Costs like the plague. Which is ironic, because a healthy bench can make a huge difference within a quarter.
There is another important way in which Bench Costs can be strategic – in starting new services. Expanding the footprint of new services is essential to maintaining the company’s Billed Margins. For many years Enterprise Solutions played this role.
New services are always going to need creating a pool of resources before you can ramp up revenue from the service. You don’t want to assess the performance of a new service based on Gross Margin, because it is going to be low, even negative for a while. At the same time, you want to make sure that the business that is being built has the right price/wage relationship. Which is why Billed Margin makes sense.
Billed Margins are structurally ‘hard’. Prices and wages are difficult to change. If Billed Margins are going down, that is a sign of long-term decline in the fortunes of the business and must be addressed immediately. Unfortunately, the response to declining Billed Margins, or ‘commoditization’ in the industry has often been to cut Bench Costs, which has made it even harder to arrest the decline.
The truth is that you cannot build a Digital practice without a serious injection into bench costs. Many of these consultants will be onsite. And they will be expensive. You are not going to sell a whole lot of business to a CMO with resources trained in Java in a common bench in India.
My sense is that the big companies in the industry, which are giant lumbering public companies will find the shift very difficult. They will find it very difficult to invest in creating new higher margin services when margins in the core business are declining. Long-term planning can’t rely upon the decline in the rupee. They will have to acquire their way into new services.
The exception to this is of course, Cognizant, which among other things, has used its Bench Costs, and subsequently lower Operating Margins, as a strategic weapon. They are on the right path and have been for a while. That’s the company to beat.