The real cost to run a boutique professional service firm is hidden from most founders because many founders use the wrong cost measurement systems. Like an iceberg, they’re measuring what is visible above the surface of the water while the main portion of the iceberg is actually lurking beneath. The visible portion they end up measuring are the costs at the firm, client, or project level.

However, founders are only measuring their firm by the 20% easily visible when they take this approach.

At the firm level, founders use a P&L which will express costs as a percentage of revenue for items such as labor expenses, overhead, business development, and taxes. At the client level, founders measure costs as an input into the client profitability calculation. And at the project level, founders measure project margin in the aggregate as revenue – project expense = project margin. These cost measures hide a lot and are inadequate. And this is why many boutique professional service firms run at skinny margins unnecessarily.

The common math problem that costs firms a lot of money

An analyst might be paid an annual salary of $100,000 and provide 2,000 hours of capacity per year. This implies a per-hour internal cost of $50 (note: to keep this simple, I have not used the fully loaded cost of an employee as they vary from shop to shop). When this analyst spends 100 hours on a project, the project gets charged $5,000. Seems straightforward, so what is the problem?

We have to consider how much an employee really costs and which employee should be completing the project. What if an associate could have performed the same activities as the analyst? The project charge gets cut in half. An associate only earns $50,000 in annual salary and has an internal cost of $25/hour, in our hypothetical example. It was incorrectly assumed that this project required an analyst when an associate would have been fine. This mistake gets made too often and costs firms a lot of money.

To see the full scale of the iceberg, founders need to measure costs at the activity level, not at the firm, client, or project level. When they do so, they will uncover bloated expenses ripe for cuts. The way to measure costs at the activity level is called time-driven activity-based costing. It was made popular by authors Robert S. Kaplan and Steven R. Anderson in their book “Time-Driven Activity-Based Costing,” published in 2007. Quite technical, but I recommend reading it.

Understanding how to measure the activity level of your firm to locate hidden costs of running a business

What is an activity? Activities are narrower than functions. They are what create value for the client and costs for the service provider. The difference between value (what a client gets/pays for the activity) and what it costs to deliver the service (activities) determines profit. Therefore, to track true profitability, a small service firm must track activities. Failure to do so will result in hidden costs and low margins.

How can a firm locate hidden costs through activity-based costing for services? This is a big question that goes beyond the scope of a short blog post. I will do my best to provide an overview here. If you want more details, read Kaplan and Anderson.

1. Document the activities required to deliver a service to a client.

This produces a level of effort for each activity. For example, factoring in the number of hours and required skill level to complete each activity (20 hours of a junior resource, 100 hours of a senior resource, etc.).

2. Calculate the internal hourly cost for each employee in the firm. 

This produces a $/hr for each employee. For example, Sue costs us $65/hour, and Bob costs us $40/hour.

3. Assign costs to each activity. 

This is simply the number of hours and $/hr for each activity. For example, it takes five hours to interview a client during week one of an engagement. It takes two hours of prep by a junior associate at an internal cost of $20/hr; one hour for the interview performed by a partner at an internal cost of $100/hr; and two hours of post-interview analysis, assigned to a mid-level analyst at an internal cost of $50/hr. Therefore, the total internal cost to interview a client during week one of an engagement is $240. This is the activity cost.

4. Diagnose the cost behavior for each activity. 

Senior resources cost more than junior resources. If a senior resource is performing an activity, it will cost more than if a junior resource performed it. In the client interview example above, the activity is cheap because only one of the five hours was consumed by a partner. Ask yourself, “What causes the cost of this activity to go up or down?”

5. Control the cost drivers. 

Armed with all the knowledge of hidden costs, make smart work assignments. For example, do not assign any senior people to perform junior activities.

6. Reconfigure how activities are performed. 

Aggressively pursue cost reduction in activities that do not influence firm differentiation. For example, substitute technology for labor where possible.

7. Capture the proprietary learning. 

Most small service firms do not use time-driven activity-based cost systems and don’t know how to. Mastering this capability will allow you to earn industry-leading margins and become the leader in your niche. This becomes part of your secret sauce. Keep it a secret.

Once you start measuring your firm’s costs by activity level, you’ll start to see where your margins were suffering and where the real hidden costs of running a business were hiding. Just as it’s important as a founder to delegate tasks to a trusted executive team to spread out the leadership role, it’s important that tasks are being assigned appropriately within your teams. You wouldn’t give just any task to your C-suite members, so think of your more senior employees the same way.