How to Deal with the 4 Problems That Cause Margin Erosion

Have your company ever won a job and finalized a statement of work (SOW) where everything appears to be in order until, suddenly, nothing adds up? Margin erosion is a term used to define loss of margin dollars that occur once a job has been won. More simply, it is a gradual reduction in gross profits over time. Savvy professional service firms are acutely aware of the threat posed by the erosion of profit margins. In fact, when Harvard Business Review conducted a global study of 1,471 IT change initiative projects, they found that the average cost overrun per project was 27%.

Many things can erode margins on projects. Some are harder to control than others, but by putting a few project management processes in place, your company can realize greater financial return from projects.

There are 4 primary categories that encompass many of the problems that lead to margin erosion including bad estimates, scope creep, poor resource management and issues with clients. Here are some tips for closing the gaps:

Establish repeatable processes for providing accurate cost estimating.

Good estimates are the critical first step in assuring that your projects will be successful. And, knowing and anticipating a project’s expenses correctly provides a definite advantage when competing for a contract. However, even under the best of these circumstances, cost estimating is difficult. It requires both quality data and judgment.

Developing a good cost estimate requires:

• An accurate project scope. As a project manager, you’ll use a scope of work (SOW) to make sure expectations are clear and agreed-upon with the customer. An SOW should include:
  • Project Objective
  • Schedule/Milestones
  • Individual Tasks—this may also include the personnel who will be conducting the tasks
  • Deliverables—these need to be clearly defined, especially if it’s a service
  • Payment information
  • Terms, conditions and requirements—this may be were lawyers get involved

• Access to detailed documentation and historical data. Information from past projects like man-hours per activity and cost of materials make estimating more accurate. Having a system where this information is recorded and easily accessed cuts the estimating time and increases accuracy.

• Standard processes and work break down structures to ensure that no portions of the estimate are omitted and to make it easier to make comparisons to similar projects.
• A risk and uncertainty analysis that allows a contingency for unknown costs, and an independent review by and experienced project manager to establish confidence in the estimate.

A project’s approved cost estimate is a critical component in creating a project budget.

Proactively manage the change order process.

Out-of-scope requests can kill project profits. The way a firm manages with out-of-scope requests can go a long way in determining project profitability.

Change orders usually originate from a few common issues, including:

• Miscommunication between the members of the project team
• Accepting scope changes from the client without fully understanding the financial ramifications of the changes.

Addressing these issues proactively can help minimize the effects of change orders on project profitability.

Provide visibility and effective coordination of resources.

Teamwork and personal productivity are critical in the services industry. People are a professional services firm’s greatest asset and by keeping them busy on the right projects is absolutely critical to your profitability. Key metrics like utilization rate and percentage of billable employees must be monitored to maximize your effectiveness in this area.

Arm yourself with information necessary to proactively respond to cases of margin erosion.

Project managers and principals need the tools to budget effectively, closely monitor actual time spent versus budget, adjust their planning based on the required changes and be armed with the information necessary to proactively respond to cases of margin erosion.

The solutions for avoiding project margin erosion all involve a combination of people, processes and tools. When it comes to technology, it is critical for professional firms to have solutions that support the effective collection and analysis of data to provide for better decision making and actionable, strategic reporting and key performance indicators at both the project and firm level. Together, these functions give firms the knowledge they need to achieve their profitability goals.

To learn more about preventing margin erosion, download the white paper on process improvements.