By Harmony PSA's Steve Duckworth

Peter Drucker, the inventor of modern business management, adapted Socrates’ “Know thyself” mandate to today’s marketplace: “If you can’t measure it, you can’t manage it.”

Yet business owners regularly chug along without really understanding which products and which customers are the most profitable. So they have little understanding of what changes could be made to their business to make it even more profitable.

To be fair, there’s good reason for this widespread lack of understanding: It’s not an easy thing to do.

In this first of several pieces designed to explain what it takes to better understand your business, we will explain how to determine how much money your business is actually making. The second part will help you better understand your staffing costs. The third part will put these two pieces of data together to help you get to the bottom of your profitability.

Step-by-Step Process

The first step in the process is determining how much money you’re actually making.

While this activity may sound trivial, the reality is that it’s becoming more and more complex. For example, repayment terms and availability of extended funding mean that revenue can stretch beyond a month, even to perpetuity. From an accounting perspective, this means you need to care about deferred revenue, and only recognizing revenue on the basis of earning in the correct period.

To fully analyze your business, you need to ensure your period accounting — the time covered by your financial statements in the reporting period — is correct.

Most businesses will split their accounting systems between two platforms: an invoice engine and an accounting system. Neither of these will ever provide you with the capability to analyze your business in the way you need. For example, your billing engine doesn’t care about period accounting — it only cares about invoices. Meanwhile, your accounting system will index costs by supplier, but not against sales or split by contracts and projects.

To get your period accounting right, you need to ensure you are correctly deferring revenue and recognizing any associated costs automatically. If you’re running a big project on a fixed price that includes purchases and claim 30% progress, you need to make sure you have also claimed 30% of the costs. Failing to do this will cause a spike in your profit and loss (P&L) accounts, and all your analysis of the performance of a project will go out the window. To do this more accurately and efficiently, you need a solid cost recognition architecture, which is more likely provided by a PSA tool.

Your PSA tool can act as a key differentiator from a period accounting perspective. It should enforce period accounting, but also provide indexes on each journal, allowing true multidimensional analysis of your business.

The reason for this capability is that your PSA tool will offer additional indexing capabilities that your accounting system doesn’t.

The second step in your business analysis is the indexation, or a system to connect prices and asset values to inflation, of all your financial transactions.

Your accounting package will enable you to index costs against suppliers, but it will not allow you to cross-index against the customer or project on which you have incurred those costs. This means you can’t achieve customer margins unless you have a system that effectively connects the dots of billing and purchasing.

You not only need to be able to index costs against contracts, projects and suppliers, but you also need to …

… understand all the underpinning complexity of the contribution each employee is making to each project. On top of this ability, you need to do it quickly and continue to revisit it as the project rolls on.

Your PSA tool can help you capture and control business processes. Alongside that core capability, it can also trigger accounting events that are critical to getting a full picture of your company profitability – and these also need to end up in your accounting system.

Depending on how complex your business is and how tightly you want PSA actions to drive accounting processes, there are many ways you can make these systems talk to each other to help you analyze your business:

For many monthly-cycle professional services companies, the balance sheet is only used for AP/AR and deferred revenue isn’t seen as important. However, the balance sheet has a big part to play in monthly performance metrics and business analysis. And to get that right (plus automate as much as possible) you need to be able to use the product features to drive revenue and cost recognition.

Once a product billing behavior reaches outside the month the invoice is released, you must reinforce cost and revenue recognition to ensure the period is correctly accounted for. While this can be achieved manually for large amounts, achieving 100% coverage systemically, through system-driven structured processes, is something only a PSA system can achieve. Try to do it manually and you will waste time only to achieve a poor, often inaccurate, result.

Get these core numbers wrong and everything thereafter is built on sand. Analyzing bad numbers doesn’t improve them.

Next time, we’ll take a look at how to account for the largest fixed-budget cost for technology and professional services business: staffing.

In a career that began in offshore engineering, migrated into investment banking and ended up with the co-founding of a software company 10 years ago, Steve Duckworth, CEO of Harmony PSA, has devoted his career to developing solutions solving project, accounting and business process problems. Follow him on LinkedIn or @HarmonyPSA.