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If you run a small design firm or other project-based business, it’s important to consider a profitability analysis before undertaking a new project. When determining project profitability, you’ll need to weigh factors including projected costs, expenses, and income. We’ll cover how to calculate profitability in this guide so that you can make more informed project management decisions.
What is project profitability?
The term project profitability describes the degree of profit that a project is projected to earn. A project with tight profit margins might make sense for a start-up that needs to grow, but it’s also important to consider your cash flow and employee demands. Additional factors that can impact project profitability (or lack thereof) include scope creep and degree of risk.
Accounting software often includes a “project profitability” category that can be used to track the performance of projects over time. This reporting tool tracks and manages time, expenses, and costs, with team members able to record progress along the way.
Understanding profit margins
When learning how to project profitability, one of the first orders of business is understanding profit margins and how they work. Revenue alone doesn’t paint the full picture of profitability, which also takes factors like overhead costs and growth into account. By calculating profit margins of a new project, business managers can rank their projects to determine which ones will lead to more success. There are two types of profit margin calculations to be aware of.
Gross profit margin deducts expenses from project revenue, without taking added costs like taxes and interest into account.
Net profit margin is more complicated, factoring in revenue as well as operating and overhead costs.
Generally, professional service providers aim to have operating profit margins between 25 and 40%. That means that for every dollar earned, between 25 and 40 cents can be recorded as profit. This is one important measure of project profitability.
How to calculate profitability using the profitability index
A second way to calculate profitability is by using the project profitability index, also known as the cost-benefit ratio. This calculation determines whether expected project revenue will be higher than the initial investment. To calculate profitability index, you can use the following formula:
Profitability Index = Present Value of Future Cash Flows / Initial Investment
This shows you how much money you can expect to earn in relation to each dollar you’ve invested. Ideally, the index will be higher than 1 for the project to be profitable. If the index is under 1, this means the project will not be financially viable.
How to project profitability with time tracking
What about the use of project profitability in accounting software? When it comes to tracking profit throughout the duration of a project, time tracking is one of the most important tools. It’s also important if your business charges clients by the hour for its services. This measures how much time is spent on a particular task or aspect of the project. Logging the time spent on each task helps you measure billable hours for accurate invoicing and payment. This increases profit, ensuring all hours are accounted for without any wasted effort.
Employee utilization rate is another calculation that relates to time tracking and profitability. This rate measures the degree that an employee’s efforts drive project revenue. If the utilization rate is 100%, this means that the employee has spent all their time on billable client work. However, this isn’t always ideal because that leaves zero time for admin, team-building activities, or other aspects of working life. To calculate utilization rate, use the following formula:
Employee Utilization = Billable Hours / Total Hours in Work Period x 100
Most accounting software will automatically calculate this profitability metric for you.
The bottom line
Tracking project profitability involves several different formulas, including the profit margin, employee utilization rate, and profitability index. It’s easy to get set up with automated tracking of these key metrics by using accounting software. You’ll be able to set up separate workspaces for each project with all clients, tasks, and employees listed. Track time with billable hours included to generate invoices and receive payment.
GoCardless integrates easily with top accounting software like Xero, making it easy to connect the payment and accounting sides of your project management. This cuts down on payment delays to improve cash flow, which is particularly important for any project with tight profit margins.
We can help
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