Council Post: It’s All About Unit Economics For Professional Service Firms

By Russell Benaroya, co-owner at Stride, a virtual bookkeeping and accounting firm servicing organizations in North America

In 2005, I was raising money for my first startup, a healthcare service business that operated clinics to diagnose and treat people with sleep disorders. I remember a meeting I had with a well-known angel investor in Seattle. We went into his office. He threw me a pen, pointed to the whiteboard and said, “Help me understand the unit economics of each facility.” I fumbled through it with a little bit of sweat and a whole lot of anxiety.

It took me a while to really appreciate why he wanted to base his investment on this concept. I get it now. There may be nothing more important in the financial analysis of a company than understanding unit economics.

What are unit economics?

Unit economics represent the revenue and direct costs associated with delivering your product or service. Forget about all the overhead that you are investing to “run your business,” such as your rent, executive salaries, insurance, sales costs, etc. Strip it all down and look at how profitable each unit or service that you sell is; that’s the critical measure. Direct costs often include labor and materials costs. They can also include some allocation of indirect overhead.

Business leaders who understand their unit economics have a powerful advantage because they know deeply the value of the “thing” they sell. If you don’t understand your unit economics, you can’t optimize for profitability.

Who should care about unit economics?

Professional service companies that generate revenue on a project or engagement basis should be maniacal about unit economics. A good example would be marketing agencies that do projects for clients. How profitable are these client projects? Should we do more of these? Are we successful serving clients in this industry and with this project type? How could we change our pricing so that we have more attractive margins in the future? These are all fundamental questions you can answer when you understand unit economics.

How can you calculate your unit economics?

The definition of unit economics is not that hard to grasp. But, isolating that data can be pretty difficult. Let’s look at small- to mid-sized professional service firms that run lean without big, expensive financial systems. Their data may reside in a general ledger, time-tracking system, customer relationship management (CRM) system and project management. Bringing all of that data together into a single database is not easy.

The most important action that a professional service firm can take is to have people start tracking time by using applications such as Harvest or TSheets. Why? Labor is typically the single largest cost in professional service organizations and understanding how your labor is being allocated is essential. Many CEOs are turned off by time tracking, but if you want to know unit economics, track time.

How can you improve your unit economics?

When a business owner understands the unit economics of their projects or engagement, they can start to make strategic decisions to optimize for it. Here are some things to think about:

1. Review your pricing for your client engagements.

You may be undercharging and losing money on certain engagements. With good data, you can speak to your client during the engagement and revisit the engagement from a data-driven perspective. Frankly, it might be a great vehicle to terminate a client relationship if it’s not additive to your organization.

2. Review your costs of delivery and look for efficiencies.

If you have detailed time-tracking data, you can analyze engagements at an individual level to better understand how your people are performing. You can look at labor efficiency across clients and lines of business, too. Direct materials costs can be reviewed for efficiencies and cost reduction.

3. Plan your capacity.

If you take on a new client, do you have the existing capacity to serve them? If you know your unit economics and labor inputs required to serve a client, you can run scenarios looking at who is available to take on that client or whether you have to hire ahead of expected demand.

Unit economics represent the most widely desired but most elusive set of data for most professional service firms, and that’s OK for a while, until the CEO instinct becomes a liability. At a point, it’s not sustainable to work based on an inclination that one client is losing money and others aren’t. The better companies are at surfacing unit economics transparently for everyone in the company to understand, the higher the likelihood that the business will generate more cash flow and profitability. And in times like today, that matters.