Project Profitability

To run a successful business, you need to know where your profits are generated. It's possible to group outputs by product, customer, location, channel, or transaction. The first step is to allocate costs through a process known as costing. Once you know the cost per output unit, you can deduct it from its revenue, and you'll get the profit margin of a product, customer, location, channel, or transaction.

On its own, this information doesn't say much other than whether you're on the positive side of revenues or it is costing you more to produce a product than what you're gaining. However, managers can use this analysis to compare products, locations, and customers and decide to shut down the least profitable ones. Pruning the portfolio this way is necessary in times of crisis and recession, but it should be an ongoing activity.

When you have permanent employees, they need to be paid every month, regardless of whether you managed to successfully charge your clients or not.

When it comes to incomes, they are made of all the tracked billable hours multiplied by the hourly rate. This time it’s the hourly rate you charge your clients for each job type, and each job type has a different hourly rate.

Add to this sum all the billable expenses, and you’ll get the total amount of your income. Of course, you don’t need to add or subtract anything, as ActiveCollab does it all for you!

Finally, the difference between costs and incomes is what we call Profit! A quick summary of all this will be visible in the Project info.

To illustrate this in a simple way, here’s our magic formula:

[Tracked Billable Hours * (Job Type) Hourly Rate + Billable Expenses]

- [All Time Records * Internal Hourly Rate + Non-Billable Expenses]

= Profit

The same process can be applied to customers. The size of a client doesn't necessarily mean they're profitable. After establishing the revenue from each and subtracting how much they cost you, you'll be able to rank them by the profit they're bringing to the company.

Managers often miscalculate by valuing clients solely based on the revenue they bring, disregarding the expenses they generate. This way of thinking can bring the company to financial ruin. Including costs in the analysis means assessing customers realistically and trimming the client base efficiently.

You don't need a master's degree in economics to perform the profitability analysis. There are, however, some formulas and ratios you'll be implementing. The main ingredient you'll have to provide is data. Don't miss the opportunity to analyze potential projects, products, rates, markets, or clients in advance. It's useful to set a target profit margin, then compare the analyzed upcoming business venture with it and decide whether to give it a go or not.

There are plenty of financial and profitability ratios, and we've compiled a cheat sheet to guide you on how they're calculated. Here, we'll be more specific and review some metrics that will help you assess a project's profitability.

1. Net Present Value

NPV is based on the fact that with time, money loses value. So, in order to know what the future cash flow is worth today and to even out the value of all revenues, companies use the following formula:

Present Value = Payment / (1 + Discount Rate)^Number of Periods

The longer a project lasts and its revenues flow in, the lesser that money's value is. Once the analysis is completed, you should have a more realistic idea of a project's worth.

2. Internal Rate of Return

The IRR relies on the same principle and formula, except it reduces the NPV of a project to zero. This means IRR is the annual growth rate expected of an investment. It's used to determine which investment is the best—the higher the IRR, the more a project is worthwhile.

3. Payback Period

The name itself tells exactly what this measure is about—the time it takes for a project to bring back what's invested. The formula is quite simple: you divide the initial investment by the average cash flows. Generally speaking, the shorter this period is, the more attractive the project is. However, this metric is useless in some capital investments, such as construction.

It doesn't include the time value of money as in the previous two formulas, so combining the payback period with NPV and IRR is good.

The main ingredients of profit are income and costs. The most obvious methods to boost your profits and improve a project's profitability are to increase your revenues and lower your expenses.

There are several ways to do this, some of which are only acceptable in the short run. You could increase your rates, but bare in mind that this might make your services more expensive and therefore less desirable than the competition. Try to bring discounts to a minimum or eliminate them completely to secure your income.

Another option is to take on more projects. This means growing your business, which has to be done carefully. Growth also brings an increase in costs as you'll need more staff and resources to work on these projects.

The other side of the coin is decreasing your costs. You'll have to search for opportunities to cut expenses everywhere, perhaps reducing rent by closing an office space or even laying off some employees.