In business, revenue growth often takes center stage, celebrated as the ultimate indicator of success. It’s an easy figure to understand and companies proudly announce their rising sales figures and growth, fueling that perception. However, there is an underrated metric that underpins that revenue growth, one that holds the key to sustained success and long-term growth: gross margin.
High gross margins create cash flow, which can be reinvested in sales, IP, operations support, all of which can boost revenue growth, driving a virtuous circle.
High gross margins create cash flow, which can be reinvested in sales, IP, operations support, all of which can boost revenue growth, driving a virtuous circle.
The opposite also holds true. It is extremely difficult to maintain high revenue growth with low gross margins, at least sustainably.
This is why acquirers and investors pay such close attention to a company’s gross margin profile. Savvy acquirers and investors in technology services understand that gross margins are a measure of a firm’s delivery efficiency, pricing power and market fit. Higher than average margins signal a strong competitive advantage and a certain level of operational rigor. Conversely, gross margins that are below peers signal that something in a business might be off.
So what does good look like for IT services firms?
Different types of firms may have different gross margin profiles. However, good gross margins for systems integrators are considered to be above 40%. Great margins are in the 50s. We see some world-class technology and AI-enabled services firms in the 60s.
Achieving margins like these requires a strong focus on the fundamentals, along with strategies that set you apart, such as unique pricing models, packaged accelerators and IP, and differentiated talent models.
In this two-part series, we’ll first explore the fundamentals necessary to achieve solid gross margins. Then, in the second part, we’ll delve into strategies to push margins even higher.
The Deceptive Complexity of Gross Margins
On the surface, gross margins are simple to calculate:
Gross margin = (Revenue-Cost of Goods Sold)/Revenue
For an IT services firm, there are three fundamental levers that impact this equation – bill rate, resource costs, and utilization. So the gross margin equation can be simplified as:
Gross margin = (Bill Rate – (Resource Cost Rate / Utilization)) / Bill Rate
However, that is where the simplicity ends and the complexity starts. Performance across all these levers can be affected by a myriad of factors across almost every functional area of the organization:
- Service Delivery: Delivery quality, accurate project forecasting, and setting reasonable client expectations can all affect gross margins.
- Leadership Policies: Decisions on utilization targets, onshoring versus offshoring, and contractor usage can influence margins, often in indirect ways.
- Talent Management: Compensation costs, hiring triggers, supply-demand alignment, and staffing decisions, such as using contractors, can impact margins.
- Sales Team: Effective communication with prospects around expectations, effective pricing and ensuring realistic project scopes are crucial for maintaining margins.
- Financial Management: Incentive plans, rate cards, and margin expectations can act as margin levers, sometimes with unintended consequences.
To truly optimize gross margins you must acknowledge this complexity and engage the entire firm in improving performance.
To truly optimize gross margins you must acknowledge this complexity and engage the entire firm in improving performance. It requires working across the business to determine which of these three fundamental levers may need the most help, and then putting a plan in place to make those improvements.
Whose Job Is It To Optimize Gross Margins
As with most business imperatives, expanding gross margins requires visibility and accountability across the organization. The first step is ensuring leaders across different groups know what great looks like. Then they need to empower their teams with the right targets, and ensure they have the resources and capabilities to reach those targets.
Often this requires implementing more disciplined processes and structures. For example, many firms will institute process checkpoints to control performance. This might include checkpoints to review project scope, resourcing requirements and project margin estimates before the sales team submits proposals. Those that promise too much to close the big deal may boost revenue (and their compensation) in the near term, but end up hurting gross margins and company profitability in the long term.
Another firm that was looking to lift gross margins instituted a biweekly gross margin “huddle” with leaders. During this meeting, they reviewed performance, and forecast versus plan data on KPIs that affect gross margins, such as resource costs, utilization, bill rates and staffing. The huddle updates managers on initiatives intended to improve KPIs. As a result of this initiative, this organization saw a pretty significant improvement in its overall resource cost.
That said, as with any internal process there’s always a balance that must be struck between speed and control. Establishing the right level of process, and clarity around when to allow exceptions, can help ensure checkpoints like this don’t create more harm than good.
As with any internal process there’s always a balance that must be struck between speed and control.
To succeed, you will also need to engage next-level leaders, for whom gross margins may typically not be top of mind. Delivery leaders may naturally be laser-focused on their specific portfolio of projects, but giving them a more holistic view of how performance across projects can impact the firm might mean they put more energy into standardizing delivery and finding synergies through processes and technology.
Aligning Incentives and KPIs
Once you understand the dynamics that affect your firm’s gross margin, you can design compensation packages to incentivize the right behavior. This requires careful analysis and planning to ensure that you are focusing the right people on the right levers that they can most directly control. For example, delivery consultants and managers can more directly influence utilization; whereas project managers may have a more direct influence over as-delivered margin.
One firm we know tied its delivery team’s bonus pay to goodwill, customer satisfaction and utilization (corporate and practice), and it found a material change in behavior. Previously, when a skills gap arose the team’s leaders tended to hire a new employee to address it. With compensation tied to utilization, the team became more careful, knowing that if the new employee’s utilization was low it would affect their bonus as well. This firm began to focus more on cross and upskilling their team, which in turn improved employee engagement.
For an incentive to be effective, it should unambiguously support firm-wide margin health. It should be simple, easy to understand, and based on a small number of KPIs that an employee can affect.
For an incentive to be effective, it should unambiguously support firm-wide margin health. It should be simple, easy to understand, and based on a small number of KPIs that an employee can affect. If bonuses are based on more than four equally weighted KPIs, it’s unlikely that any of them will matter enough to serve as a strong motivator.
Quarterly or semi-annual payouts for meeting KPIs, and even extra bonuses for significantly exceeding them, can help keep employees motivated. A quarterly cadence establishes more near term focus and creates a continuous payout, thereby discouraging people from leaving after a large bonus payout. Yet businesses are cyclical, which can also make it tougher to directly impact measures for some quarters. In some cases, this can create a potential disincentive.
Establishing the right KPIs by role, and the right payout timeline, requires both art and a science. Having great advisors around you can help.
Establishing the right KPIs by role, and the right payout timeline, requires both art and a science. Having great advisors around you can help.
Mastering the Fundamentals
Improving gross margins requires an unwavering focus on the fundamentals. It isn’t easy, but the benefits of unlocking higher margins are worth it – more cash to invest in fueling growth.
With these fundamentals mastered, we’ve found firms can get to great gross margins. But if you want to be world class, it might be time to explore advanced strategies that push margins even further. This is a topic that we’ll be exploring in part 2 of this blog series.
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