Professional Services Guide

Billing your clients and managing profitability

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Billing your clients and managing profitability

Setting up project accounting, billing, and invoicing clients is one of the most important parts of running a professional service business—otherwise, you don’t get paid.

In fact, according to research from the Federation of Small Businesses, 30% of small business owners in Q4 2021 said late payment of invoices had increased in the previous three months. Not getting paid on time has resulted in hundreds of thousands of businesses teetering on the brink of survival. So it’s important to get it right to avoid the same fate.

On the other hand, if your invoicing process is too confusing or unnecessarily difficult, you’ll likely find yourself suffering from customer churn—losing clients and what could be profitable business relationships.

In this section, we’re going to look at the main different types of billing models, the difference between billable and non-billable hours, how to invoice clients and what to expect, as well as measuring and managing profitability.

What are the main billing models?

The type of billing model that works best largely depends on the type of professional service business you run. Personal stylists are likely to have a different billing style compared to hiring builders to restructure a home. So what are the most popular billing models?

  • Hourly/Daily rate. One of the most common methods for billing is hourly or daily rate charges. The basic idea is that you or your employees charge the client based on how many hours or days it took to complete the project. Therefore, time-tracking is an essential tool for businesses that prefer this billing method.

    The types of businesses that work well with hourly/daily rates are knowledge-based, e.g. accountants, consultants, and lawyers.

  • Fixed-rate/Project-based. The other most common billing method is having a fixed rate based on project completion. This means that a project fee is pre-agreed before starting, and that’s how much you charge the client by the end of the project.

    This billing method works well for businesses that don’t have many fluctuating costs or those who tend to work fast and won’t benefit from an hourly rate.

  • Unit-based. Slightly less popular, but still significant in particular verticals is unit-based billing. This billing method involves billing for producing work by the unit. For example, it’s a common practice for journalists and other writers to charge per word for articles written rather than an overall cost.

    The reason for going with a unit-based approach is similar to fixed-rate—if you work fast you don’t benefit from hourly billing, but this method is more flexible. So if your service produces materials, unit-based is another good option.

  • Milestone-based. If you prefer to spread out your income across the span of a project instead of getting (or asking for) a lump sum at the end, milestone billing might be the approach for your business. This method ensures you get paid when pre-agreed milestones have been reached.

    This billing method works well for projects that last for a long period and have definable steps towards completion. You can also use this approach for new clients to ensure you get paid for work you do, rather than risk the client “ghosting” when payment is due.

  • Materials and labor-based. The final common billing approach is to create a materials and time-based contract. This type of contract means you’ll bill the client according to the costs of materials and the amount of labor that was used to complete the project.

    This type of billing is most common in verticals where materials and supply costs fluctuate a lot, e.g. construction and architecture. Being able to reasonably accurate with quoting for jobs with this billing method is essential to ensure clients don’t get unwanted surprised at the end.

These are the main types of billing methods used by existing professional service businesses. However, the billing method that’s best for your business can also vary on whether the client is hiring your business for a one-off project or on an ongoing retainer basis.

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What are billable and non-billable hours?

The most basic explanation of billable versus non-billable hours is that the former means you get paid for time worked, and the latter means you don’t get paid for time worked.

After knowing that, you might think, “why would I (or my employees) do work that’s not getting paid for?” Well, that’s where it gets a little more complicated.

For hours worked to be considered “billable”, you need to be doing work that advances the client project forward or is necessary for the project to finish, such as client-specific admin, marketing, design, or research.

On the other hand, businesses can’t reasonably expect clients to be invoiced for time spent entertaining them, training employees, or marketing activities that aren’t for that client.

Beyond using accurate time-tracking software, such as the feature provided by Cloud Coach, you can also have an in-depth section of the project scope or the client contract detailing what is and isn’t considered billable work.

The software you choose can help you calculate how much you should invoice the client based on the billable hours multiplied by the agreed rate. If you’re working with a fixed or project-based billing method, you can also use the concept of billable hours (and calculations) to figure out if you’re charging the right amount for the whole project and adjust future projects if not.

Invoicing clients and what to expect

Once you’ve worked out what is and isn’t billable hours, and you’ve done work for the client, you’ll need to send them an invoice to get paid.

An invoice is a formal document that details what work has been provided, how much you’re charging the client for that work, as well as how and by what date they need to pay the invoice.

Depending on where in the world you do your business, you might have specific laws to adhere to regarding what information must go on an invoice. However, there are a few best practices of what to include that cover most requirements:

  • Both your business name and address as well as the clients.
  • Contact details such as an email or phone number.
  • Date of the invoice and payment due date or payment terms.
  • Unique invoice number.
  • Description of services and a cost breakdown/itemization.
  • Your business bank details (where to send the money).
  • Other business information as required by local laws or business structure (such as a registered company number or tax numbers like VAT in the U.K).

Once you’ve sent a client an invoice, you can expect them to pay within the agreed payment terms. Some of the more common payment terms are a 7, 14, 21, or 30-day payment deadline or a fixed payment date for small businesses or contractors. For larger corporations and big projects, having a 60 or 90-day payment deadline is also fairly common.

To avoid late payments, it’s essential to make sure invoices get to clients error-free. However, you can also help to avoid late payments by stipulating late-payment fees in your client contract (and including a reminder of such fees on the invoice).

Invoicing clients and what to expect

Project profitability is also an important element of running a professional services business. The profitability of the projects you take on decides whether your approach is sustainable, and also helps you find areas to make your work more efficient.

While it’s great to have solid figures on the profitability of a past project, it’s better to have a good idea of what the profitability of a project is going to be. That way, you stand a better chance of making sure you don’t stretch your organization’s profit margin too thin. So what is project profitability, and how do you measure it?

What is project profitability?

Project profitability is the metric that describes the potential financial profit gain or loss for the organization as a result of taking on the project.

Of course, you’ll very rarely want to take on a project that you know nets a financial loss. The times that you do would likely be for a charitable cause or at least a guaranteed increase in reputation or brand awareness.

In terms of profit gain, just because a project would demand a high price doesn’t mean it’s profitable. Projects with big scopes normally require a higher amount of time and resources to complete—all of which eat into your profit margin.

The balance of project profitability is in knowing how much of those resources a potential project is going to take, then after factoring in for any surprises, deciding whether the project is worth taking on.

How to manage and measure project profitability

Newer businesses or businesses with fewer clients might struggle with “guessing” project profitability (saying yes to every project that comes isn’t always a good idea). However, there is a better way forward: using a profitability index (otherwise known as profit investment ratio or value investment ratio).

A profitability index indicates whether or not projects are profitable using a simple formula:

Index = present value of future cash flows / initial project investment

As a general rule, if the result is higher than 1, that means the project will generate value and it’s a good idea to take on the project. If the result is less than 1 it means the project will likely net a loss and you shouldn’t go ahead with it. If the result is equal to 1 or very close to it, it’s more likely the project is going to break even and those are best avoided.

Here’s a quick example:

Project A is five years long and requires an investment of $150,000, which is calculated from material costs, employee or contractor pay, equipment costs etc. The project is estimated to yield annual cash flows of:

  • $15,000 in Year 1
  • $30,000 in Year 2
  • $50,000 in Year 3
  • $20,000 in Year 4
  • $60,000 in Year 5

Totaled up that’s $175,000. Putting those figures in our formula results in a PI of 1.16 rounded down—a profitable project.

On the other hand, if your client’s projects are quicker-paced, another example would simply be:

Project B is a one-off, fixed-rate of $1,500. It’ll take approximately 20 hours to complete. You estimate that your minimum “hourly rate” is $75 to meet your business and personal needs. So total project investment (based on time worked) is $1,500. In this scenario, the PI is exactly 1, breaking even.

For Project B, your business could try to negotiate a higher project fee to make the project profitable.

With all that being said, you can also use software solutions such as Cloud Coach’s Project Portfolio Management features to help you automatically calculate if a project would be profitable, and to keep a running PI score for existing or ongoing projects.

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