What is a Service Margin and How Can it Help My MSP?

Hear Rex Frank explain the 4 service margin levers in our Frankly MSP podcast interview.

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Savvy service executives know that what matters at the end of each month, quarter, and year is gross service margin. We measure margin in both gross margin dollars and gross margin percent.

Here’s how you calculate each figure:

Gross margin dollar = (all service revenue – (all service hard costs + all service labor))

Gross margin percent = (gross margin dollars / all service revenue) * 100

Let’s say our monthly service revenue is $110,000. Our hard costs for tools such as endpoint RMM, network RMM, antivirus, and so on are $10,000. And our cost to pay the engineers, dispatcher, and service executive is $33,000.

Here’s how that looks using the formulas:

Gross margin dollars: ($110,000 – (10,000+33,000)) = $67,000

Gross margin percent = ($67,000/110,000) * 100 = 61%

Most CFOs would agree that a service business consistently producing a 61% gross service margin consistently is doing pretty well.

The 4 levers within a service desk manager’s control

They are four elements—I call them levers—that a service desk manager can adjust to directly affect gross service margin.

Lever 1: Engineer pay rate
Lever 2: Billing rate
Lever 3: Utilization
Lever 4: Agreement efficiency ratio

Most of us are accustomed to working with the first three levers. For example:

• If you keep the engineer pay rate and billing rate in the same place, and move utilization up, the gross margin goes up.
• If you keep billing rate and utilization stationary, and move engineer pay up, the margin goes down.
• If you keep pay rate and utilization stationary, and increase your billing rate, the margin goes up.

Lever 1: Utilization

Here’s a table that shows typical non-working and non-billable hours per year.

Keep in mind that 76% is the yearly billable percentage. When you consider that vacation, sick days, holidays, and training are 0% billable, they actually have to be nearly 83% billable to average 76% at the end of the year.

Not accounting for 0% billable time is a common mistake we see. Service executives aim for 75% billable for the days their engineers are at work—and end up with yearly averages in the mid-60s.

Levers 2 & 3: Billing rate & engineer pay

Before we can cover billing rates and engineer pay, we need to discuss the term engineer billing multiple. And before we get to that, we should quickly review the three different kinds of service:

• Technical services: Ad hoc, non-contract, break/fix and staff augmentation
• Professional services: Scoped project work
• Managed services: SLA-based, all you can eat, recurring contract revenue

Technical services are typically the lowest margin service because they’re fraught with inefficiencies, like driving all over town and back again, constant non-billable travel to find parts, high-skill resources needed to deliver entry-level work, callbacks, disputed invoices, and on and on.

Professional service margins are better because work is scoped in advance, parts are ordered in advance, and engineers are typically scheduled in four to eight-hour chunks. This drives up utilization and is scheduled to match the skills required.

Managed services promise even better margins because most of the travel is cut out, and we leverage tools, technology, standard processes, and standardized equipment. In many ways, standardization allows lower-cost resources to deliver better services.

Calculating the engineer billing multiple

Here’s how you calculate your engineer billing multiple.

Engineer billing multiple = Total service billing / Engineer pay

For example, if an engineer bills $15,000 monthly and is paid $5,000 monthly, their multiple is 3.0. In the table below, you can see that technical service with a 50% labor cost amounts to a 2.0 engineer billing multiple. Another way of saying it is the engineer bills twice his cost. Professional service engineers should have about a 40% labor cost or a 2.5 engineer billing multiple. Managed services, if you’re really leveraging your tools and processes, promise a 25% labor cost, or a 4.0 engineer billing multiple.

Note that a typical IT solution provider is doing some mix of technical, professional, and managed services and that a 3.0 multiple is the goal for all these services combined.

The chart below illustrates the relationship between utilization, billing rate, and engineer pay.

Let’s assume a 3.0 multiple is our target, and we can expect an engineer to bill 76% of his time. We can see that an engineer earning $60,000 per year will need to bill $115/hour for 76% of his available time to achieve a 3.0 engineer billing multiple.

Many companies that we coach at Sea-Level discover they have a big problem with one of the first three levers simply by reviewing this chart.

Lever 4: Agreement efficiency ratio

Now, let’s talk about the elusive and misunderstood 4th lever of gross service margin: agreement efficiency ratio. At Sea-Level, we spend a lot of time coaching IT solution providers on how to understand, measure and use this lever.

Here’s how you calculate the agreement efficiency ratio:

Agreement efficiency ratio = Flat fee billing amount / shadow billable

Shadow billable is the amount you would have billed the client at your normal billing rates for time and materials work. For example, if your normal billing rate is $150/hour and you work for three hours, your shadow billable is $450.

A flat fee billing amount can be a ticket, project, or agreement. Let’s say you have a flat fee agreement with your client for $1,500/month and your normal billing rate is $150/hour.

In month 1, you do 5 hours of work (shadow billable) to earn the $1,500 flat fee. Your agreement efficiency ratio for this month is 2.0 — 1500/(150*5).

In month 2, you do 20 hours of work to earn the $1,500 flat fee. Your agreement efficiency ratio for this month is 0.5 — 1500/(150*20).

In month 1, you’re doing half the work you “should be” and in month 2, you’re doing twice the work you “should be” for the flat fee you’re paid. Another way of saying this is that in month 1 you’re working for twice your normal billing rate, but in month 2 you’re working for half your normal billing rate.

At Sea-Level, we consider 1.25 to be the optimum efficiency ratio. In other words, you ideally have $800 of shadow billable for every $1,000 earned in flat fees. This effectively creates a 25% “premium” for taking on the risk of the flat fee service.

Tying the 4 levers together

Let’s set some values for our levers to create an example.

Lever 1: Utilization | 76%
Lever 2: Billing rate | $150/hr
Lever 3: Engineer pay rate | $60,000/yr
Lever 4: Agreement efficiency ratio | 1.0

First, we’ll break down some of these numbers:

• An engineer earning $5,000/month with a target 3.0 billing multiple should be billing $15,000 per month (5,000*3).
• $15,000/month divided by $150/hour tells us we require 100 hours of billing per month.
• 40 hours/week times 52 weeks is 2,080 hours per year. 2,080 hours/year divided by 12 months is 173.33 hours/month.
• 173.33 hours/month divided by 100 billing hours means we need to be 58% billable to achieve our 3.0 billing multiple.
• 76% billable would mean the engineer should be billing 132 hours per month.

This all assumes a 1.0 efficiency ratio ($1000 flat fee / $1000 shadow billable).

The following chart shows what can happen as you manage and adjust your 4th lever: agreement efficiency ratio.

Look at line 28 where the efficiency ratio is 0.5. The effective billing rate is half your normal billing rate. Your engineer will need to be 115% billable—to bill for 200 hours out of the 173 available—to bill three times their pay. We can agree this is not reasonable. If the engineer is 76% billable (132 hours), his total billings will be $9,925 for the month.

Look at Line 38 where the efficiency ratio is 1.0. The effective billing rate is exactly your normal billing rate. Your engineer will need to be 58% billable—to bill for 100 hours out of the 173 available—to bill three times their pay. We can agree this is reasonable. If the engineer is 76% billable (132 hours), his total billings will be $19,850 for the month.

Now let’s look at the power of managing the 4th Lever on Line 43 where the efficiency ratio is 1.25. The effective billing rate is 1.25 times your normal billing rate. Your engineer will need to be 46% billable—to bill for 80 hours out of the 173 available—to bill three times their pay. We can agree this also is reasonable. If the engineer is 76% billable (132 hours), his total billings will be $24,812.50 for the month.

There’s a massive difference in gross service margin between $9,925 and $24,812.50 in billing. Three of the levers didn’t change, but by moving the 4th lever, you had a big impact on revenue without changing costs. In other words, you had a big impact on the margin.

Sea-Level has coached a couple of hundred companies in the last seven years. When we start, the average agreement efficiency ratio we find is around 0.7, meaning our clients are working for about 70% of their normal billing rates when servicing their flat fee agreements.

Spending management effort to control the 4th lever on flat fee tickets, projects, and agreements means you’ll spend fewer engineer hours to earn the flat fee. This frees up your engineer’s time to do more time and materials work, more projects, or to service more new agreement revenue with the same labor costs.

Now, imagine dumping that utilization-based engineer bonus plan you have (since it only promotes burying more time in flat fee agreements) with a plan aligned to the 4th lever, efficiency ratio. Imagine the places you’ll go!