Why You Should Cost Projects with Gross Margin
Today I’m getting into the managerial accounting weeds and talking about project profitability.
When you shop for ERP or PSA software, they’re always hawking “project insights!!” but there’s a lot to think about when you are trying to get from a basic costing spreadsheet to the rich dashboard insights of your dreams.
One of the biggest decisions you’ll make when implementing this kind of software is how project profitability gets calculated, and there’s no right or wrong way. We recommend costing your projects on Gross Margin, but first let’s cover the basics.
Project Profitability vs Business Profitability
Business profitability is measured down to the penny and becomes the basis for everything from cashflow planning to tax returns. It even has a standard format: the profit and loss statement.
Project profitability is just what it sounds like: how profitable your individual projects are. Unlike business profitability, there’s no universal rule for how to measure this and project profitability usually is a “soft” metric, meant to be used as a reference point. It’s not a method for allocating every single penny your business spent on a project (not the way it’s usually done in a service business). Project profitability helps answer questions like “How are we doing on that flamingo-care service we’re offering?” and “Should we be hiring?”
Gross Profit vs Net Profit, Indirect vs Indirect Costs
Before we go on, let’s do a quick definition: the Profit & Loss Statement (see above) is usually separated into four sections:
Cost of Sales (also Cost of Goods Sold or COS/COGS)
Operating Expenses (OPEX)
Financing Activities (income and expenses from financial activities outside of business operations)
The COS includes your variable costs, like freelancers, ad buys, etc. These are called “direct costs,” because they are directly related to your income and can easily and accurately be allocated to projects.
OPEX are typically fixed and account for overhead like rent, utilities, salaries, and advertising. Sometimes it's helpful to categorize the salaries of billable employees as COS, and the back-office staff salaries into OPEX, but this isn’t strictly necessary. These are considered “indirect costs,” because they are not directly related to your project operations.
When you subtract Cost of Sales from Income, this is your Gross Profit, or when expressed as a percentage, Gross Margin.
When you subtract Operating Expenses (and whatever Financing Activities come out to) from Gross Profit, that’s your Net Profit. Net Profit is “the bottom line.”
Calculating Project Profitability
While pricing might be complicated, calculating project revenue (or income) is straightforward: fees (hourly or otherwise) plus items sold plus expenses billed = project income.
When you’re considering how you want to figure out your project profitability, what you’re really doing is deciding what expenses you want to allocate against your project income.
I think everyone would agree that what is critical is capturing your variable direct costs: freelancers, project materials, ad buys, anything whose cost scales up or down with the amount of work you’re doing.
I believe you should also include the salaries and IT costs of the people delivering the services, since they are a fixed cost but still directly related to the services delivered. How to allocate this is open to some interpretation.
It’s always helpful to have line-item cost data, but keep in mind that project managers and others will have visibility of the costs in the ERP system. Using someone’s actual salary (even if it’s weighted for other costs) is not a good idea.
We recommend using a generic cost based on seniority. For example, if we’re billing $150 per hour for a mid-level creative director, we might generically calculate an internal cost like this, regardless of how much the creative director in question actually makes:
$120,000 base salary x 30% fringes & IT costs / 1800 billable hours per year = $87 internal cost per mid-level hour
This is a fake number but it’s a relevant fake number!
What’s open to more debate is what else is included.
Activity-Based Costing (and why it’s dumb)
If you talk to a “general business” accountant (which I don’t recommend), they are likely to tell you about something called Activity-Based Costing, or ABC. Among other things, ABC supports the idea that all costs, direct or indirect, should be allocated precisely to all business activities (remember 9th grade science and the difference between precision and accuracy?). The logic goes, because flamingo-care constitutes 20% of your sales, you MUST assign 20% of your phone bill to your flamingo-care projects.
When you’re trying to calculate hourly rates or other variable fees, the logic of ABC starts to fall apart quickly. The phone bill is the same whether you sell $10,000 in flamingo-care or $50,000. Here are the major issues with ABC:
It’s complex and time-consuming, and often leads to inaccurate results.
No matter how good your underlying cost data is, it’s frozen in time and quickly irrelevant.
ABC is subjective and open to interpretation, giving misleading results
ABC is simply not suited to project accounting, which requires accurate and timely information.
There is no relationship between indirect costs and project revenue. Allocating a fixed cost to dynamic revenue results in a meaningless study of profitability.
Practically, ABC makes bad years look better and good years look worse. Think of this:
If you’re having a great year and you sell 110% of planned hours, what happens to OPEX you’re allocating by ABC? It’s overstated by 10%. Your project profitability looks worse because of this meaningless allocation. The reverse is true: If you’re slow and come in 10% under planned hours, you haven’t shown 100% of your OPEX.
What’s the alternative?
We advocate costing your projects with only direct costs, which I extend to the salaries of billable employees and their variable IT costs: in 2023 the vig on a knowledge workers’ salary should include their hardware and software. Those Adobe seats add up!
Figure out what your gross margin should be and make sure your projects are hitting that number to cover your fixed operating costs and your target profit, just like you do at the business level.