Knowing your effective rate is critical for understanding profitability. If you get it right, your chances of success improve dramatically. If you get it wrong, it could mean you’re closing the doors. In this episode, Summit CPA CEO Jody Grunden joins Jamie Nau to break down production metrics. Listen and learn precisely how service businesses and creative agencies can determine if they’re running a profitable operation.
“Measuring something and then consistently looking at it really helps you understand exactly how you’re doing.” - Jamie Nau
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Jamie Nau: Welcome to episode five I'm your host Jamie, and today I'm joined by Jody Grunden and we're going to dig into our next KPI: effective rate. So just before we get started I want to let everybody know effective rate has some formulas and definitions behind it. So we will have some notes in the show notes that will talk about how these formulas work. In case you want those as a guide as you're listening to this, but we will try to stay out of the formulas in too much detail and really talk about what the levers are in affecting these formulas. So welcome to the show Jody.
Jody Grunden: Thanks Jamie appreciate it. Definitely got that right. Effective rate is going to be a complicated formula. It's really simple actually kind of diving into it a little bit. Effective rates are your biggest rate of determination for any service based company. And so what it's going to be the all in rate. So we'll talk about a lot of different rates throughout and there may be many different definitions from many different accounting sources. And so we want to define what we call, effective rate, what we call standard rate, what we call average BOE rate, and some of the different things as we go through. So it's going to be really important that we make that distinction as we're going through the presentation. Would you agree Jamie?
Jamie Nau: I agree. Yeah we'll definitely go into them a little bit. Talk about how they work. But the actual numbers behind it we'll have the handout they'll really explain that in detail. So effective rate is a production metric Jody. That's what we call it on our side. When we talk through it with companies. Can you explain a little bit why it's a production metric and how a production metric differs from the other metrics?
Jody Gruden: Yeah sure. There's four metrics that we talk about a lot. One’s cash, the cash metric. One is net income metrics, a percentage of the net income. One is your pipeline metric, determining how much do you have in your pipeline versus capacity, and then the production metrics like the metric you actually determine your forecast. So what we're trying to do with the production metric is we're trying to determine the capacity of each of your individuals that you have on your team, production people. That's what I call production. It's on the top part of your financial statement. You have your revenue minus production or cost of sales and that future cost of sales which then to calculate your gross profit. So the production metrics can be really important for a service based company when that production metric typically to be right about 50 percent is what we find with most service based companies in the digital space especially so 50 percent the big all in thing. And as we go through and define how we come up with that production number we'll go ahead and define kind of really where that should all reside Regarding the financial statements.
Jamie Nau: So great thing about being a service based company is when you think about production metrics you know it's in the word there. So it's about your producers. So how effective are your producers performing. I mean I think it's another way to say it as well but I think the way you described is perfectly. It ties to the income statement, it ties your gross profit, and you want to see what is the driver. And for service based companies we really feel like the drivers or people or your producers know how much are they producing. And so definitely a very important thing to understand there is when you're looking at this metric and how it's performing it's telling you how your production team is performing or how the gross profits performing.
Jody Grunden: Yeah. And I would say a lot of times when you when you're looking at different stats and different type of ratios a lot of times you get kind of caught in the weeds. You don't really understand what the ratio typically means, and so with the production metrics we're going to break down the non-financial metrics. And the non-financial metrics are the drivers for your forecast, and that's the biggest thing or this is like the biggest metric really of all, this is the effective rate, and that's the big rate on the production metric that we're going to talk about in kind of show you how to get to it and the importance of it. Should we dive in Jamie?
Jamie Nau: Yeah let’s dive in. So just let's go through a couple of the formulas. They're going to help us make sense of this effective rate formula. So there's a couple that go into it and so if you want to start with utilization. Again just tell us what the formula is but more importantly tell us how to define utilization, what it means.
Jody Grunden: Yeah. So basically what utilization is, is just simply the number of hours that you're working divided by the number of hours that you're getting paid to work and such. That's what base with utilization is. So if you're looking at a utilization of one of your team members, you're looking about how productive are those team members, you know, how many hours during the year what was that percentage that they're actually able to work. So for instance if you're looking at an individual that has a regular workweek, a regular work year, you know, they're employed all year long. They work 40 hours a week, 52 weeks a year. Multiply that to come up with, two thousand eighty hours, so that's your denominator part of it. And then you look and see, well how many hours can they typically work. You've taken out all the holidays, the PTO, the admin time, vacations, you are taking out if you send them on an educational event, you know typically times they can't or you subtract that out of that number. And then once you come up with the number that you can actually bill for you, you divide that into the total number of hours available. So that’s the utilization. So basically what that’s doing is saying, hey with one person well I expect that person to bill for a period of a year, period of a month, period of a week—you know that type of thing.
Jamie Nau: So if you look at it on a year, that would give you a good estimate of what your utilization is. But to the point you just said, that utilization in one week, of seventy five percent, could be really good utilization, and other week 50 percent could be really good if you had some holidays happening during that time. Am I understanding that correctly?
Jody Grunden: Yeah it's really important to understand too because when we talk about utilization, a lot of times you'll say, well hey I want to have a 60 percent utilization. That's an all in utilization including all the PTO time and stuff. And so if you're looking at that on a month by month basis you're probably always going to be wrong. So you're going to be disappointed in some months and be really ecstatic and others. And the reason being is because utilization varies drastically from month to month because in certain months you get more holidays or more vacation time than you'll have another month. Typically we see November - December employees have low utilization because they're taking time off and they have high utilization maybe in the summer where they're not taking as much time off where they're really putting in the hours, that type of thing. So it's important to understand utilization overall for a period of time but it's also important to understand that it’s going to fluctuate from month to month. So it's important to understand what that utilization is for each of those months. So when you're looking at it you're saying, hey we're supposed to have a 70 percent utilization this month overall for the year it’s going to be 60 percent, 70 percent is what we are going to, and oh by the way we hit 80 percent high five, or if we had 60 percent in a month or so 70 percent well then, that's not a high five. That's like a oh no, you know what happened? Do we need to re-evaluate things? So it's important understand that month to month basis where you fall.
Jamie Nau: I think the important thing you said there is having that expectation. So I think that a lot of people focus, when they're focused on KPIs, they focus on the results. What did the number tell me this month? Having the expectation for the month is super important and that's for all the metrics we'll talk about in any podcast, you know, cash or net income ,it's really important to understand what the expectation is to know how you did. So that's a really important point there. So let's dive into the standard rate. So again this is the standard rate for how much we're billing. But if you want to go into the calculation there and then also the details behind it the definition.
Jody Grunden: Yeah sure. So standard rate is just your typical rate that you're going to invoice on. It’s what you’re going to figure your quotes on. So for instance, if you're looking at billing out at 200 dollars per hour, that's your standard rate. And so if you're looking to do a flat fee bill you back into it and let's say it's 5 million dollar job, or half a million dollar job, or five thousand dollar job, you're backing into the number of hours work that's your standard rate. So your standard rate is always going to be what's on the quote. That's completely different than what we call the average bill rate. If you're doing forecasting based on a standard rate you're going to be disappoint all the time because you've never had it. The average bill rates what you actually earn. So that's just simply taking the revenue divided by the number of hours worked. Pretty simple you can do that by the job, you can do that by the employee. You can do that really by the overall company for the year to find out what your average bill rate is . So the difference between the standard bill rate and the average bill rate two huge differences there. And so again if the standard bill rate is two hundred, and your average bill rate falls to about one seventy five, when you do your forecasts and everything, you’re going to go your forecasting based on that one seventy five which again is that average bill rate.
Jamie Nau: So Jody I'm a cost plus company here. So my average bill rate, my standard bill rate will always be the same, right? That's the question we get all the time. They'll always be exactly the same. Is that correct? Or is there ways that if I'm a cost plus company that I won't be always invoicing hours?
Jody Grunden: Oh well yeah, if you're perfect at invoicing every single hour that you work and your team doesn't lie to you at all, and they put down everything, then yeah you're truly going to be exactly right on. The problem is, that never happens. So when you're billing hourly there's always going to be times that hey, I feel like, you know, maybe I don't think you did a great job on that so I'm not going to bill as many hours I thought was going bill. I’m going to bill less on that. Or you'll get pushed back at the high end and you're billing at two thousand hours and you know the stakeholder on the other side is like, hey slow down a little bit. Well you still got to get the job done. And so you'll start eating time. And so it's very common that standard rate and average bill rate very rarely are going to equal each other. I mean it's a rare circumstance for a company where that that truly does happen.
Jamie Nau: Yeah I definitely agree. I think it's when we do onboarding with clients, a lot of times people will say, I'm a T&M client I'm never going to have any write ups because, that's the other term, that's a difference between the standard rate and the average bill rate, is those write downs the hours you're not getting paid for and that happens quite frequently. People come to us and say, oh I won't have any of those and then three months we'll have a conversation with them about some project that they aren't billing hours and I'm like, well you know we talked about write downs three months ago. That's exactly what just happened.
Jody Grunden: Jamie made a good distinction right now, and that's not bad, he's not talking about bad debt write downs, he's talking about what you can't truly bill for. And so he's saying, hey if you're going to bill if you have 100 hours plan then that project and you go over one hundred and ten, you can't bill for it, you're writing down that 10 hours. That's what he's talking about there. And what we typically see is when clients will come to us or we'll see, you know. what we're talking to people out at different conferences and they are like, yeah I'm just not profitable—you know five percent profitability. And we always tell people you need to be at least 15 percent. Twenty five percent is what you're striving for as a service based company. Anything more than that you're doing phenomenally great. High five, but you have to at least be 10 percent. They go, look I'm just saying I'm a 5 percent. You know, my standard rate is this, my utilization is this. And they're kind of going through all their numbers and where they typically see they fall down is that there's such a huge gap between that standard rate and the average rate. You know they write so much off or they and I don't know if it's a self-conscious thing or if it's just a time management thing or project management thing or coding thing there's a lot of different reasons for it. But anytime that we see that there is a great in the 10 percent gap in there that's a significant issue that needs be addressed like right away because we're giving time away. And that's where we typically see companies fail, is that gap between the standard bill rate and the average, it's typically not utilization, it's typically right there and it's very common for us to see clients or prospects all come in and say, yeah we find out like 30 percent difference or 25 percent or 40 percent or you know there's huge numbers there but you don't want to be greater than 10 percent, 10 percent fair. I mean it would be great if it's 5 percent, it would be great if it was 0, but 10 percent we can live at 10 percent. But 20 or 30 percent can't live with that on a long term basis.
Jamie Nau: It's important to put a dollar amount with that too, I think, again the percentage is great but I think oftentimes when you put a dollar amount associated with that you can tell people, hey if you add a bill every hour you work you would have an additional two hundred thousand dollars this year and then you just throw that right down to the bottom line and say, hey that 5 percent profit just turned into a 20 percent profit. If you're billing everything you work. I think a lot of people see that and go, OK that makes more sense other than just like, oh that's just an hour we didn't bill this week.
Jody Grunden: Yeah. So a lot of times what we see is you know we will and some of our clients put that right on the front of the financial statements they see it if it's not on the front of the financial statement it will be on one of the KPIs they're looking at so they can kind of see it there too. So it's going to be one or the other where they can visibly see that dollar amount because you're right. You know when you see that dollar it makes a lot of sense. But don't you ever think to give push back. Well I would never have sold that anyways. I never would have done that anyways. Sometimes some so you get that right.
Jamie Nau: A lot of times you'll do it for a reason, right? Like you'll go into a job like, we just want to get a client. We just want to get a job with client A. So we're willing to go in at a lower rate or at eat some hours because we know that client's going to lead to a lot more work. So there definitely is some strategic write downs that you're going to take. So you do get that conversation. But the important thing is having that conversation and understanding that write down on what makes it up
Jody Grunden: And even conveying that to the team. So again the leadership is seeing that and that's one thing but having the project managers see the same thing, that's a different thing, when they see you’re writing down a hundred grand on a project, or twenty five grand on a project, that's real money, and they start really kind of seeing the importance of making sure everything is done timely. And just because you hit that number doesn't necessarily mean you got that extra twenty five thousand dollars, doesn't mean you get an extra hundred thousand dollars, but what it does mean it means you've got more capacity to do additional work and that's the key thing. And that's what we're striving for. That's why I want that write down to be small.
Jamie Nau: Definitely. Okay. So the last metric ,and the one that this is all about, is the effective rate. So if you want to give us the definition of that and also the formulas.
Jody Grunden: Yeah sure. The effective rate is just simply the total revenue divided by the number of hours paid. So again we get back to that two thousand eighty hours we paid an individual for and we look at what kind of revenue does that person bill. And so you take that dollar revenue and you take the number of hours billed into each other and you come up with an effective rate. So that's the definition of effective rate. Another way of looking at effective rate is just simply taking your average bill rate which we determine again revenue divided by hours bill times your utilization. So you've got two ways of calculating the exact same number. And Jamie the difference is what
Jamie Nau: Yes the great thing is the first one like Jody said that's the definition. So if I look at the formula as being my total revenue divided by my total hours that's telling me how much revenue I am getting for every hour worked. Which tells me a lot. That's definitely very helpful especially when I'm looking at cost. I know how much I'm paying each employee per hour and how much revenue I'm making per hour. It's going to help me determine how productive I'm being. So that's kind of the definition formula.
The other formula helps me how do I fix it. Right. So if my average bill rate is low and I'm taking that times a high utilization it’s going to give me an effective rate of some number and I can go back at that and say, well if I just increase my average bill rate by 10 dollars that'll increase my effective rate by five dollars or six dollars depending on what utilization is. So it helps me figure out how I can fix a problem and that's a really important part of the definition for sure. That's again that's kind of why we walk through how they're all related.
Jamie Nau: So it's really important you understand utilization and average bill rate in order to understand effective rate and how to fix it. Let's go into that a little bit now. So if I set an expectation of utilization for a month, Jody, and I don't hit it. What are some things I may have done wrong and how can I possibly fix that next month?
Jody Grunden: So again, it's really important I understand again how to calculate it is really important and also understand that what that month's utilization rate should be. Again every month is going to be completely different. And so when you're doing your calculation and you do your forecasts, you’re forecasting based on capacity you should know you should be able to tell exactly how much utilization every single month that your team should be able to perform. And then when it actually does happen and you're off like Jamie is saying maybe you're under or over then you're looking for different things that you know, hey what are the one offs? You know the one offs could be that we have more vacation than that time that we're actually planning on because maybe we're planning vacations spreading equally throughout the year. And it just happened that everybody took vacation in April when we're looking in April. You know that could be a reason if that's the case then. Great. Good to know. Now we need to adjust the rest of the months to make sure that we pulled a vacation out of those other months so that we make modifications to that utilization going forward. It could be that we just didn’t have really anything for the team to do. So they went home or they didn't work something like that would always be the case. And if that's the case then that's a bigger problem right. That's like, okay now we've got to figure out how to keep our team busy maybe we have too many people. So there's a lot of different things that we're going to look at with that but the idea is not to whip people into shape or to lambast people or make them you know get them in order, the idea is, hey we want to be able to forecast effectively so we want to know if we missed this, did we miss this for a reason. You know are our expectations too high? Do we need to adjust our forecasting going forward based on that, or is there something more internal that we need to fix?
Jamie Nau: Yeah I think that's a great point there. I think a lot of people think of utilization as an individual problem. If my hours are low my utilization is low. What am I doing wrong? But it's actually not. And most times it's not an individual problem a lot of times it's there's just not enough work or I took some PTO that month, and it's stuff that we need to look at as an organization on the whole in our forecasting and making sure we're getting that right.
Jamie Nau: So then on the flip side we've talked about this a little bit but if my average bill rate was low other than write downs or other things that could possibly cause my average bill rate to be a little bit lower in a month that I should be working on those lower than expected?
Jody Grunden: If the average bill rate was low typically that maybe because utilization is really high. So there is usually an inverse relationship there. And so it could be that your team isn't putting all the time to the job that they should be. Maybe they're being bonus or incentivized based on how profitable their projects are. So one way would be is well I'm not going to build time to that project and we have more admin time. So you have to make sure that you're incentivizing your people correctly. That's a big thing. And watching the different levers that you're actually pulling. So if your average bill rate is not in line then you've got to kind of look and see what might be the reason. Are we putting way too much time in projects? You know maybe the business developments that communicate with the project manager and so they're coding jobs that the project management team is saying, hey there's no way we can get these jobs done in that time frame. So that maybe an issue, the communication gap. Maybe it's more of a you know, hey the project manager is not managing the team well enough and so the team is giving time away. You know there's a lot of different reasons why that the average bill rate can be lower than what is expected. So you have to kind of dig in and figure out what the root cause of the problem is. And again you're doing it so that as a training method, you know, so hey, if it's something that we can educate our team on, you know maybe you're looking at it based on the people and you find out that you know every job that Sally's on you know it's lower then Karen's, and Karen’s jobs are a lot higher. Well then you have to look at each one of them and say, hey is this a consistent thing? Is all Sally’s jobs low and Karen’s jobs high? And if that's the case what's Karen doing right and what is Sally doing wrong? Is she using all the tools that she should be using and using the processes that we've got in place. Is there something that we can educate or train her up so she her average bill rate up. Or maybe she just works slower, you know that type of thing. And so it's important to understand and know those things going in so that when we're giving you know jobs that are maybe that need to be turned around quickly. We don't give it to Sally we give it to Karen because Karen is much faster. We have to kind of be able to understand our people and understand what their average bill rates are on a consistent basis. So it's really important to dig it in on the jobs as you're going through it's also important to dig in you know take a look at that on the people that are actually working on those jobs that again you can look for those I guess obvious educational points where you can kind of you know really teach them you know what maybe what they're doing right and what they're doing wrong and kind of you know really build the team that way.
Jamie Nau: I think that’s the great thing about a lot of these metrics is you always get the high level look. So we've talked about how to calculate average bill rate for the company how to calculate utilization for the company and that that gives me where to look. That's kind of my math telling me where I need to look. So then I look at the jobs, then I look at the people, then I look at the teams and you can kind of analyze it, all those different levels to really tell you the story. So to Jody's point maybe it's just this one job that's really killing us and we're working every we've already built two hundred thousand dollars on it, but we've worked more than that already and every hour we work on that job doesn't count in work, we just keep building on it. So I think that's the thing that you'll see is that the more detail you look at the stuff the more answers they'll give you, and I think that's a very key point there.
Jody Gruden: Yeah and the other thing would be you know the more that you can actually make those corrective decisions you know if you're looking at it on a regular basis, not just at month end, not just a quarter end or year-end that type of thing, but you're looking at it job by job basis throughout the job, you can make those corrective actions during the project. If you've got a two month project you see it's going overboard, well then maybe there's something they’re not billing for. Or maybe there's something they're doing that they're not doing the right way, or doing a different direction that you had actually assume that they're going to do when you originally quoted the job out. So there's a lot of different things if you're doing it as you go you can make those corrective actions and you know it'll save you tons of money obviously in the long run, because you can make those actions now which you know when the job's done it's too late to make those corrections. To go back and ask for more money if that's the case, or it's too late to improve on a process that you've already completed the job. So I would recommend doing them as you go. Don't wait at the end you know and use them again as an education tool.
Jamie Nau: Yeah I definitely agree. I think it's something you learn early on, very early on when you're in a service based company. Don't procrastinate talking problems with the client. You know if you have a problem with the client and there's something going on. whether it's they're doing stuff out of scope. or things are taking longer than you think. If you go to them when it first happens it's a lot easier to get either more money or change the scope on other parts of the project. If you wait to the very end they're going to look at you and be like sorry. This project's over there's nothing we can do about it. So I think that's something you hear very early in your life as a service based employee.
Jamie Nau: So Jody any success stories? I know you work with a lot of clients. Any success stories where you feel like you've done a nice job in proving effective rate?
Jody Grunden: I'd say the coolest one that I had was when we had a business owner that wanted to build a building. I tell this at a lot of different events we go to. They wanted to build a building but they don't want to take a loan out. And so it was one of those deals that we had to think, what was the right size the building? All that kind of stuff. He decided it was going to be a four hundred thousand dollar building, is what he wanted to build. And then it was like, we;; how fast do you want to get this done? How long is it going to take for you to actually save enough money to build this building without having a loan? And so we went through the utilization, through the effective rate, went through all the numbers there, and we determined it was going to take about four years. It was one of those things he just kind of setback and he was, like four year? I was hoping to have this building done within about a year and a half two years. And I was like well I mean it can be done. Let's see if we can do it. And so we started playing with the numbers. And so again we're on this elaborate Excel spreadsheet playing with the numbers and we change utilization a little bit. We change the average bill rate a little bit. We didn't change the standard price. He didn’t want to increase his pricing at all, but he did want to get better between the average bill rate. He was at about 20 percent. We wanted to get him closer to that 10 percent mark. We wanted utilization, he's like, well my team typically works about 32 hours a week. You know if I give them incentive maybe they'll be interested and maybe I can get them to work 34 hours a week. He did. He's like, yeah they thought it was a great idea. Give him incentive builders and built that into the billing project into a goal for his team. So they added incentive there. And then you know we basically just kind of you know played the numbers a little bit until we came up and we reduced it from four years to about a year and a half. And so about 18 months. And so then it was like, okay great, we've got the map drawn out ,we've got the you know, we've got the goal here, now you have the work to do it. And so it was like, oh yeah I've got the work I can get the work and so now his goal was to really focus on the business development side, really focus on getting you know closing ratios down and getting all the different ratios that go into the sales side. And he was able to build a huge pipeline for it and he did. He exceeded his goal within a year and a half. He built a 400000 building paid in cash and did not take a loan. It was cool. It was really cool to basically see that because he went into the job with no idea how to do it. And just by kind of working through the math you know we figured it out. It's kind of funny because people do that all the time it's like you know if they don't have that you know that guide or the map you know they kind of wander around and they're like, well how do here? Why wasn't I profitable? I was so profitable. Where's my cash? You know all those different things that you know you just don't know because you didn't go to a Kelly Business School, or, a university to figure out how to do all this. And so as one of those things that you know it's kind of inherent for us is that we can help people to get to where they want to get. Help develop that roadmap. We can't do the work for them, but we can kind of give that guidance, and that's the cool thing about it. It was one of those things I felt just kind of as cool as what he felt. it was like you know even though I didn't have a building, it cool we actually succeeded. Put the roadmap together and succeeded in getting it because again once you have that plan in place it's kind of funny how people just gravitate towards it. The funny thing was you know to take two years to do it. That's been cool too, right. It took us a year and a half you know, it wasn't four years like originally planned, and it may never been ever had we not put the roadmap together to begin with. But we did it and we were able to accomplish his goal.
Jamie Nau: Yeah I think what you said there and I think it's great as measurement and consistency is huge. Right. Measuring something and then consistently looking at it really helps you understand exactly how you're doing. I think that's what a lot of times we first start working with people or start talking to people is they don't really know how well they're doing. Like they know how much money they have and they might know what their net income is. They don't know really how they're getting there. And so just to show every month to them this is your effective rate this month. It was low, what happened? And just having those discussions is a lot of times the most value you can get from having someone to talk to about it. So I definitely agree. Just knowing where that number needs to be, where it needs to be in order to hit your goals just really does tell a great story.
Jamie Nau: Jody any final points on effective rate that we didn't get across. We're getting close on time here?
Jody Grunden: Yeah I think the key is knowing what your effective rate is. That's the important thing, to go through the calculation figure, it out. I think we're attaching a guide which kind of goes through the some of the formulas. Take a stab at it. Figure out what each of your employees can do. Figure out what your team should be able to do, what your company is actually built to do based on the number of producers you have in there. Once you have that number then you know what that total revenue number is and you'll know what your total effective rate should be. And the key there is that everybody's effective rates can differ. So if you asked me what my effective rate was compared to your effective rate compared to somebody else's they're all going to differ because it's going to be really based on your effective cost meaning how much you actually pay your employees which is a completely different formula altogether. The key there is to know, hey when you're looking at it just because you have 100 effective rate I've got 80 that there's no difference there. I could be could be more profitable than you with that. So the important thing is just know what your effective rate is. Not what everybody else's is. But what yours is. Then once you know what it is and you can forecast going forward. And that's really the key. Using the effective rate for the forecast
Jamie Nau: We'll definitely spend a podcast talking about that. I think that's a really important topic that we can dig into a little bit further is how to lay that out. Go through the details of how that works and again today we've kind of talked about the measurement of it but I do think I'm setting up an extra podcast on actually how to the details of forecasting will be really important and that will be a big part of it. So I appreciate you taking the time today Jody and I think we covered a lot here and I think that's a wrap.