The Basics of Professional Services Accounting

What are professional services, and why do we need to account for them differently than a product-based business? Simply put, a business selling billable hours in exchange for labor is a "service" business. From an accountant's perspective, this means you need to proactively address a slew of items to understand how you can grow and maintain profitability. Typically, this will be your rate and rate structure, time management, and any general and administrative (G&A) costs against each project or client.

Examples of service based businesses include #marketing agencies, construction companies, #architects, video production companies, #solopreneur types, and more. Service-based businesses have their own, unique accounting considerations. They need to constantly be answering the question, "How much should I charge to make money?"

There is a lot more to figuring out the magic formula that answers that question, once you dive into the details. Follow up questions to ask range from; "How much should I charge?" to "How many clients do I need?" to "How many hours should I actually pay for each hour billed to the client?"

For the service business owner ready to maximize their efficiency and margins, it helps to dive into the overall concepts to consider in any calculations first.

Let’s take a look at the basic elements of professional services accounting.

How to Spend Labor Hours Efficiently

A good starting point for understanding professional services accounting is understanding this: as an owner, your biggest spend will be labor.

Labor not just associated with doing direct tasks for the client, but other types of labor; from administrative functions to marketing to internal time for training, days off, etc. This is a great place to start.

From the #accounting perspective, you will need to understand how to spend these precious labor hours in an efficient manner and be able to understand where your labor hours go. This is where the key to profitability for a service business lies. You will need to identify which labor hours fall into the overhead category, and which fall under the directly billed category, then establish the return on the investment of each.

Knowing how profitable the time spent per client is may dictate the following; if you should bill per hour or as a retainer/set fee-type set up.

Your “Inventory” Is Billable Hours

Sometimes it seems a bit more straightforward when you think of professional services in terms of a product-based business. You have a product, you have a price and you sell it for said price to ultimately cover the costs of that item and leave some extra for profit.

For the service business, the “inventory” is its billable hours. In simple terms, if you are charging $100/hour for a service, you will be giving the client an hour of your time. Inside of that time is where the analyzing begins and the efficiencies need to be established.

Generally, we think of a full time employee as one who works 40 hours per week, 52 weeks a year. That is not an accurate starting point for calculating your labor cost against your billable hours. It’s not as simple as “I bill for three hours, Joe Employee does the service for three hours”.

Inside that 40 hour work week needs to be a buffer to consider the other hours you are paying for that are not directly billable to the client. This includes internal items such as meetings, training, lunch time (if you include this on the clock), and holiday or vacation time.

Realistically, you're likely getting about 32 hours a week on average that are directly related to the client task. This may equate to about 80% of their hourly cost being directly billed to the client. You must analyze this time first, to drill down the actual numbers. While many employees aren’t too keen on literally writing down their time and segmenting it by client or task, there are a ton of modern time keeping and project management systems out there that help make this easier.

Remember, the key is to understand your return on investment by each hour spent. Meetings and training sessions are well spent if they make your team better at their job and more efficient in meeting client needs, so they shouldn't be neglected entirely in an attempt to squeeze the most juice out of each employee.

Your “Cost of Goods Sold” is Your General/Administrative Labor

Outside of your client facing employees, are the meat and potatoes of every business; the general and administrative part of the business. You have your owner(s), administrative assistants, your human resources team, your marketing and sales team, and more. These are essential team members to keep a business growing and humming along, but share the profits of the billable hours. This (again) is where understanding your ROI and analyzing where their time goes, becomes an important part of your business accounting.

If the billable hours are your “inventory”, these essential pieces are your “cost of goods sold”.

Like the time spent on direct client needs, you will need to have an understanding of where your other functions benefit the business, as well as the costs associated with each.

Quality benefits, time off, in house activities on the clock–these are all important parts of keeping up good morale and a quality workforce. Marketing efforts (should) speak for themselves as a return on their investment, through better outreach to the industry, a solid brand voice, and gaining more opportunities for the business. It makes sense to build these into your business pricing to build a solid foundation to your success.

The Bottom Line For Establishing Good Service-Based Business Accounting

The basic equation for the service based business profit is Rate (what you bill your client) - Cost (Labor cost for your employees and overhead expenses).

The first step into understanding your biggest spend: labor.

Then, you will need to drill down what those labor costs are, how many hours you will pay for “per billable hour”, and how best to maximize your number of hours, so that you stay within the threshold of being profitable.

In doing this, you will need to have a good sense of where your time is spent and the return on investment of your indirect hours, such as marketing and administrative tasks. By identifying each aspect of your business–directly billable to the client and overhead, you can start to have an understanding of where your profitability can continue to flourish or improve. Once your labor dollar efficiency is headed in the right direction, your business will be in a better position to be at its most profitable.

Make sense? Let me know your thoughts, tips and tricks in the comments! ??