Detailed Investigation of a Simple Growth Strategy
My last post on professional service firms ended with a little game designed to test your entrepreneurial skills. The key objective of the game was to make your PSF grow and reach a given cash target within two years. This post analyses some simple growth strategies that will not only help you to find a solution to the challenge but will also provide some real-world learnings.
To save you from having to click back and forth, let’s take a quick look at the game and the underlying assumptions: every month you receive the current figures regarding your current project backlog, your headcount and the cash you have at your disposal. You have to decide how many new people to hire and how to allocate your current staff between business development and project delivery.
The challenge is to increase your cash and up with at least EUR 26 Mio. at the beginning of month 24.
Its not as easy as it sounds, in fact it is quite difficult to end up with more cash then if you had done nothing at all.
And once you’ve reached your first cash target, try and reach EUR 42 Mio. of cash at the beginning of month 42 – you will probably find that the tactic you use to achieve the first cash target will not help you to reach the second target.
Here are the assumptions underlying the game – essentially we are just quantifying all the elements from the conceptual model we developed in my last Make Your PSF Grow post:
- The average project volume is 16 person-months
- The average project duration is 2 months, i.e. 8 project delivery staff are involved for 2 months.
- The prospecting effort to generate a lead and write a proposal is 4 months.
- The project acquisition duration is 6 months, i.e. it takes 6 months between generating the initial lead before a newly acquired project starts.
- Market conditions are perfect, i.e. both the prospecting and acquisition success rates are at 100%.
- The project delivery fee is EUR 17,600 per person-month, i.e. the daily rate per consultant is at EUR 880.
- Projects are charged on a monthly basis.
- The collection duration is 2 months, i.e. it takes 2 months after revenue is collected and arrives in the bank.
- The workplace cost per staff member is at EUR 1000 per month (rent, laptop, software licenses and services, …).
- The company has overhead cost of EUR 306.000 per month (administrative cost, …).
- The average salary per staff member is at EUR 100,000 per year.
- The hiring duration for new staff is 3 months
- The initial cash is at EUR 1,000,000.
- The company initially has 200 professional staff members, 20% of which are assigned to business development. At this setting, the company is stable.
- The initial backlog of project weeks is 320 person-months, and the initial number of prospective projects/proposals in the sales pipeline is also 320 person-months.
Before you read on, please try the challenge for yourself: first test the stable setting at 20% business development and zero hires and just “click the game through”. Make sure you understand what the graphs mean. Then hire some people in the first months and see what happens to your staff level. Can you explain why the graphs change when they do? Can you see the dynamic we depicted in our conceptual model? Once you have understood the basic dynamics, start experimenting and try to solve the challenges – don’t be ashamed to use pencil and paper to make a few calculations, you will most likely need too!
OK – so how can we go about finding the right growth strategy? What is the maximum we can achieve given the conditions defined above?
First of all, I think it is worth noting something about the challenge itself – don’t forget we have developed a very clear conceptual model of how our business works and we even have full information regarding the quantities involved. Yet the problem still isn’t easy to solve – and of course a real business is even more complex.
So one important learning is that even if you have a good conceptual understanding of how your business works, this understanding alone still doesn’t mean you will be able to make better decisions.
In this case, you need to go a step further and use what I like to call “computational thinking” … this involves taking all the parameters we identified in our conceptual model, quantifying them and relating them to each other using simple equations. Once you have a feeling for the numbers, you can start working out a solution.
Ultimately, the best thing to do is to keep all the figures and calculations in a small spreadsheet model – in fact, we’re in the process of preparing some tutorials that will show you how to do this in quite some detail. But for now we want to focus on the calculations, so I’m providing you with an interactive simulation that will let you test all the scenarios we discuss and will show you the results both as charts and in tabular format.
But whatever kind of situation I am prototyping, once I have a conceptual model and some concrete quantities for the elements in the model I first like to write down the key equations and crunch the numbers using pencil and paper – that gives me a good sense of where the difficult issues lie. Once I have figured those out, I can then build a more sophisticated model using a spreadsheet or some other modelling tool if necessary.
It doesn’t really matter which tool you use, what is important is that you actually do some computation because this will give you some feeling for the numbers involved.
In practice, quantifying your model may take some time because you will have to do some data mining first to arrive at the quantities you need (e.g. answering questions such as “how much effort do we spend on business development vs. project delivery, on average?”) – I mostly work with educated guess for the figures I don’t know, that way I can start building and testing the quantitative model while the data mining work is going on.
In this concrete case we’re lucky, because the quantification has already been provided for us by the instructions for the game, so we can dive right and crunch some numbers.
Let’s do a few quick calculations to make sure we understand the underlying assumptions … the company has 200 professional staff members, 20% of which are assigned to business development. This means that 160 persons are continuously working on projects. The initial project backlog has 320 months in absolute terms, i.e. the backlog relative to the number of project staff is 2 months into the future. This backlog will remain constant in the steady state “base case” scenario – I’ve plotted this below and you can recreate this curve in the game if you set the number of people you hire to 0 and the percentage of staff allocated to business development to 20%.
Hiring people always costs money, in our case the wages and extra workplace cost. To make the right hiring decisions we therefore need to know how much money we can spend on new hires. To work that out we need to look at the PSFs cash flow.
Let’s look at the revenue side first. Initially, the PSF is fully booked and working at a rate of 160 person months per month, so the company is making EUR 160*17600=2,816,000 per month of revenue from projects.
The cost side is a little more intricate: each staff member costs EUR 100000/12=8333 on salaries and an extra EUR 1000 workplace cost, i.e. EUR 9333. At 200 persons in the company, this sums to EUR 414,615 in staff cost. We also have overhead cost of EUR 306,000 per month, so the total cost is at EUR 1,839,333.
Putting all these figures together leads to a cash inflow of EUR 976,667 per month. I’ve summarised these figures in the table below:
Note that these are monthly figures – so, if these figures remain stable, then after 2 years, at the beginning of month 24, the company will have cash equal to the initial EUR 1 Mio. plus 23*976,667 which amounts to EUR 23.463 Mio.
You can check this for yourself in the simulation – note that the charts and tables shows beginning balances, i.e. the figures at the beginning of each month. I’ve also plotted the graph below for your convenience – you can see that we get fairly close to the easy target cash level but we do not quite get there.
Here are the precise figures, tabulated in spreadsheet format.
Given that a project typically occupies 8 persons for 2 months, the business development staff has to generate 160/8=20 projects every two months. The effort required to acquire a project is 4 person-months, so the company has to invest 4*20=80 months every two months or 40 person months per month. So the company needs 40 business development staff for 160 project delivery staff, the ratio of business development staff to professional service staff is 1 to 4. This of course is equivalent to the ratio of 16 person months per project to 4 months of acquisition effort.
Two things are worth noting here from a business perspective:
- It is irrelevant whether the acquisition success rate is 100% or less – what counts is how many project months you generate per month of business acquisition. In reality this figure will not be constant, but experience shows that it doesn’t fluctuate wildly either. It will also depend on the kind of services you offer and you may have to work with different figures for different services.
- The “acquisition” overhead is quite high at 25% – typically we would like to see an overhead that is closer to 10%. But as we are assuming a 100% success rate, the figures are actually quite realistic as a whole.
Now what happens if we make the PSF grow by hiring people more professional staff?
Let’s think through what will happen if we hire one person first, again you can test this scenario in the game.
Clearly if we hire a new consultant we need to assign her to business development at first, because otherwise there will not be enough projects to keep all the project delivery staff fully occupied – so the allocation of staff to business development will no longer be 20% (40/200) but actually 41/201, once the new hire is on board.
The curve below shows what happens to the headcount and to the project backlog if we decide to hire somebody in month 1.
Don’t forget it takes 3 months before a new hire finally comes on board, so she doesn’t arrive until month 5, and then another 6 months before the new business developer acquires her first project, hence the project backlog doesn’t start building up until the beginning of month 12. I’ve tabulated the data in the spreadsheet below.
Don’t forget that each project acquired feeds 8 project delivery staff – so we need to ensure that 8 project delivery persons is on board by week 39, so we need to hire those people in week 26 and adjust the staff allocation to 4100/209 in week 39.
What about the project backlog? We now have 41 business developers that generate 41*16/4=164 months of projects per month. As we have 168 project delivery staff, this means that our backlog will decrease by 4 weeks per month and this will continue until the backlog reaches a level of 164 months. The only way to avoid this is either to hire 2 business developers (matching the 1:4 ratio or to hire just 4 project developers, in which case we would have to stretch the delivery of one of the projects from two months to four months.
Now what about our finances? Well in the short run, because we make more revenue with more people in the 9 person scenario, our revenue increases. Our cash level decreases slightly at first and ends up being slightly above the amount we had in the base case. But we’re still way of our target of EUR 26 Mio.
So how many people do we need to employ in order to generate excess cash of 30 Mio.? Well given the figures we worked out above we know that this means we need to make an extra EUR 6.53 Mio compared to the base case (30 Mio – 23.46 Mio).
Which costs do we need to account for?
Well if we hire
newBusinessDevelopmentStaff amount of business developers straight away, they will arrive in month 5. So we will have to carry the business developer cost for 24-4=20 months.
We also need to remember that our new project development staff will arrive in month 11 – so we will need to carry 24-10=14 weeks of their staff cost.
On the other hand, we will be making EUR 17,600 for 14 months, for each of our new project delivery staff.
We also know we have
4*newBusinessDevelopmentStaff of project delivery staff.
So we can write the following equation:
Solving this for
newBusinessDevelopmentStaff we arrive at 28.4 new business developers. This rounds to 29 new business developers and thus 116 new project delivery staff and total of 145 new staff. Try implementing this strategy in the game and see whether this helps you to achieve the easy target cash level (you will have to round the allocation percentages to the nearest integer, because the game doesn’t allow fractions).
I’ve added the graph for this scenario bellow and I’ve also tabulated the precise figures:
Summary and Learnings
Great, we’ve found a simple solution for the easy cash target and we did so using brain power and not just through trial and error.
But what are the learnings for “real life PSFs”?
The first key learning is that just a few factors have a strong impact on how your firm will grow: the ratio of business development effort to delivery effort, the average headcount in projects, how long it takes to acquire projects and the cost of your resources. Even if we assume a very stable environment (as we do in the game), it is still quite difficult to make the right growth decisions.
Quite a few questions arise that you – as a manger of a PSF – should be able to answer:
- Can you quantify these parameters for your firm?
- How do they differ between services, customers and industries?
- Are they fairly stable or to they change over time?
- If they change, what does the change depend on, e.g. your staff expertise, market conditions,…?
The second key learning is that your growth rate is directly influenced by the average headcount in your projects. So if your projects typically are staffed with eight people (e.g. management consulting), you will grow in chunks of 8 people, if your projects are staffed with 40 people (e.g. IT services), then you will grow in chunks of 40 people. So how you staff your projects will have a big effect on your growth pattern – to put it simply, if you want to grow faster, it is better to deploy larger project teams (and hence shorten the duration of your projects). Of course this will in part depend on your customer situation, but it is worth bearing in mind when you design your services and staff your projects.
Again there are a few questions for you to ponder:
- What does the staff size in your projects depend on?
- Could you design your services such that you can work in parallel better (and thus deliver results faster)?
In our next post, we will tackle the expert cash target.
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