P&L, Project Margin, Gross Margin
P&L, Project Margin, Gross Margin
(Originally published on my blogspot space)
Financial Management is a broad topic and forms the core for any business. However, I will bring some of the terms here in simplistic way for persons taking up project management role or aspiring to do so from a technical career stream. As in most of my writing in these series, my language, terminologies may be found to be more closely aligned with IT project management, more specifically from an IT Service provider delivering projects /services for its clients.
Companies do business to make profit either for the founding members or for the investors who expect good return. What does an IT project manager need to do to manage profit and margin? Does he/she have an element of control? In most cases, the finance department publishes a certain template or the same is part of an enterprise application for PMs to manage the financials of the project. Depending on the size of the organization, and the layers involved, the PMs mostly get a thin line of control to manage their profit margin at a target level, as the constraints in getting the resources (team members) and the timeline, criticality of project deliverables generally takes the margin downwards.
Given the thin line of control, it is important for PMs to understand certain basic terminologies and financial concepts behind the calculations. So, let’s get to some basic accounting terms.
Most understand profit involved in selling a product or service as the amount earned over and above the cost involved in developing and delivering the product or service.
Profit = Selling Price — Cost Price = Revenue — Cost
Profit is a number in the currency being used.
Margin is expressed in percentage of profit over sales.
Margin = [Selling Price — Cost Price] *100 / [ Selling Price]
Margin = [Revenue — Cost] * 100 / [ Revenue ]
For example, let’s assume you have 10 persons in a team working for a project, and are billable on T&M basis (Time & Material). The amount charged to client, assuming different rates for different roles charged to the client, and a period of 10 months, with 8 hours per day and an average of 20 working days in a month would be as follows.
So, the cost projected to client is $ 392,200 and for the IT service provider, it is the projected revenue. How do we get the cost of the resources to calculate the margin? In most organizations, the cost (salary) of resources are confidential and managed by finance team through a financial system. In such organizations, the resource names and rates are fed into the system along with other project parameters. In smaller organization, the PM is aware of the salary and can compute the cost. For instance, in the above example, if we consider the following salary structure (assuming the team is offshore and are paid annually in INR), we can calculate the cost and hence the margin.
The profit in the above example is $392,000 — $163,095 = $228,905 and the project gross margin is $228,905 / $392,000 = 58.4%
I am using basic terms and definitions of cost, revenue to help understand the difference between profit and margin. Each of these terms can further be defined as per the costing philosophies and models used in the organization and the accounting standards followed. There could be other costs in executing a project, not related to the resource’s costs, which we did not consider in the above example.
Why do we measure margin and not profit?
There are some good financial reasons for the same to help understand the performance of the company and for comparison with others in the same business. It is a good indicator of both the costs of operation and the selling rate and justify the margin. Increasing margin, can also indicate lower cost of operation with respect to a competitive pricing model determined by market dynamics. In my view, when the economy is in growing phase and market itself is expanding globally, with a competitive environment governed fairly for the benefits to spread across society, margins are a much better indicator of business growth. But when the economy reaches certain limit, and due to constraint imposed on the business operations either externally or internally, margins may not be an indicator of business growth, but just a financial stability indicator. Rather too much focus on margins can indicate that business might be falling apart and may follow certain predicted lifecycle model of organizations. (Refer Adizes Methodology lifecycle model). As a side note, I have my own philosophical thought on why ‘margin’ and ‘increasing margin for a given period’ have been used to further the greed of investors in a capitalistic economy. I might write about it at some other time. Overall it can be detrimental to the economy and capitalism itself. It can also indicate a transformational phase of the environment from capitalism to service mindset. I see the rising of ‘start-up’ culture, ‘servant leadership’ and other concepts proposed by management gurus in alignment with this thinking.
Getting back to our financial concepts, if we consider a single project, and the related costs and revenue, then we will get the Project Gross Margin. At an organizational or business level, the same is referred to as Organization Gross Margin (Operating Margin). There could be other costs/revenue in executing a project and running an organization. If these are taken into consideration, we can say we get the Net Margin. I am trying to take my readers slowly into the terms and concepts. (especially PMs who haven’t had much training and put on the job). Financial gurus might have other opinions, different terminologies to add to this. I would welcome such comments for me to further improve this blog in later versions.
Let us now look at what constitutes the cost component and what can be considered revenue. Costs involved in executing a project can comprise of direct costs and indirect costs. For instance, direct costs include the cost of human resources deployed, cost of any hardware or software specifically procured for the project, etc. Indirect costs include cost incurred for training of human resources, standard administration and infrastructure cost, other overheads that are shared across projects. If the project is executed as part of a specific department or unit, there could be additional costs at the unit level and hence the margin at unit level will be slightly lower than the margin at the project level. Similarly, the revenue can also have multiple components, based on the pricing model. At organization level, other overheads including management costs, marketing and sales expenses, pre-sales activity can bring in their cost components and impact the gross margin.
Hence the Profit & Loss (P&L) statement will include multiple lines that detail out the various costs and revenue and companies adhere to various accounting standard when publishing their P&L statements. The tax that organization has to pay, currency fluctuations, will also be considered to arrive at profit before and profit after tax. Another term often used, but not considered part of most accounting standards is EBITDA (pronounced ebitda) — Earnings Before Interest, Taxes, Depreciation and Amortization. Operating income or earnings before interest and taxes (EBIT) is all the income minus all operating costs, overhead, such as selling costs, administration expenses and cost of goods(or services)
EBIT = Gross Income — (Operating Expenses + Depreciation & Amortization)
For comparison among companies, the depreciation and amortization amounts are added back to give EBITDA
EBITDA = Profit + Depreciation Expense + Amortization Expense
Understanding of these terms coupled with knowledge of your organization financial model will help in arriving at different targets for margins, and strategies to be followed in achieving the same. At a project level, understanding gross margin target, project costs and revenue, and what contributes to them, are the key controlling elements will help play with the factors within a project and balance with other non-financial targets and success factors.
I have given few references, some of them that I used and can help take the dive into the financial management further.
References:
https://www.investopedia.com/terms/g/grossmargin.asp
https://www.investopedia.com/terms/d/directcost.asp
https://www.investopedia.com/terms/o/operatingmargin.asp
https://www.investopedia.com/terms/m/margin.asp
https://cleartax.in/s/accounting-standards
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