Making Money the "Chicago" Way – Early and Often
“The real fiscal nightmares came from the older projects that had been entered incorrectly on the old KPMG PEAT system and on the non-U.S. accounting software. “In the past, we had some folks that did some things that were not within the context of the processes or the design we had put in place for the system,” Tom Wilde explains. “We had some contracts and engagements that basically got started off on the wrong foot.”
For instance, consultancies use a variety of revenue recognition processes. If an employee in the past used a revenue recognition process that differed from that used by BearingPoint, the contract in question had to be redone, employing the BearingPoint approach. “These systems are so tightly wound around the project accounting side that it took a long time to get all that identified, reconciled and fixed,” Wilde says.”
I have a soft spot for BearingPoint Inc, formerly KPMG Consulting. I worked there for a while and had one of the best career opportunities, best bosses and the most rewarding experiences when I worked for them in Latin America. However, the issues they had with revenue recognition and other project accounting and reporting systems go back to their legacy as a part of KPMG and as a partnership. The leadership that took the company public were career auditors and protégés of the private partnership model.
One example of revenue recognition roulette that persists in many private partnerships is the fixed fee/hours contract, the most frequent way that internal audit outsourcing/co-sourcing engagements are proposed and billed by the Big 4. For example, the firm bids an internal audit and/or SOx engagement as a total of hours, estimated based on the audit plan or number of processes and locations that must be reviewed, for example. They use any indicators or information provided that helps estimate level of effort and staffing needed.
The firm looks at the type of staff needed to complete the work (usually disproportionately 2-5 year level staff) and the budget the client says they have for the engagement. After working the expected profit margin into the equation, it’s a simple mathematical exercise to calculate the total bid. That total is divided by the total hours that have been committed during a specific time period to come up with a “blended rate”. In other words, even though there may be a mix of Partner, Manager and Staff time, and even though we’re not talking about the staffing or temporary firms here, the clients often expect to see the average hourly rate based on the total cost divided by total hours committed.
Once those total hours are committed and a blended or overall average rate is also publicly committed to, the firm has the burden to meet that expectation by managing the client, managing the team’s performance and managing their staff mix. Partner and Senior Manager hours are sometimes “given away” in order to keep the blended rate down but, since they will be accounted for anyway via timesheets, the effect is to reduce the expected profit margin internally in order to “come up with the number”.
The work may be performed unevenly, that is, some months are more intense than others, work may be seasonal and extra hours may be expended in a lumpy way to meet deadlines. Billing is, however, often a monthly retainer, cash in advance and the same amount each month. The total contract is divided by twelve months or the life of the contract and billed evenly. Both sides usually like this. However, a financial and performance obligation now exists on both sides.
What happens when a client expects a particular number of locations and/or audits and the associated hours of work to be performed and the firm can not accomplish this due to resource constraints or poor management of the client? What happens if the firm reaches the end of the contract and has billed the full contract but not delivered all the hours they committed to?
In professional services speak, this is called, “negative unbilled.” Instead of the typical business issue of having work done and not billed or collected from the client, professional services firms, sometimes end up in a situation where they owe the clients work. They get away with this because their clients still trust them. But they have an obligation to their clients.
When a contract is multi-year, such as in a co-sourcing engagement or a multi-year audit contract, then the firm may not be pressured to “true-up” each year. Instead, they can roll the obligation over and theoretically deliver later. This is possible because they are not publicly owned firms using GAAP, but private partnerships, entities whose partners probably love getting cash faster than they earn it.
Whether they ever deliver the “negative unbilled” or have to make good on their contract depends heavily on whether or not their clients are keeping track of what they are supposed to get, what they got and comparing that to what they paid for. How many of these liabilities exist in the Big 4 due to the resource constraints that existed during the highest point of Sarbanes-Oxley demands? Are they “on the books” or informally tracked or blown off?
I found this chart in my vast repository of useless information – useless until I decided to write this blog and the book. If anyone has any additional points of agreement or disagreement, I’d love to hear.
Fixed Fee/Capped or Not to Exceed Contracts
Advantages to Client
• Limits budget exposure for long complex project
• Puts risk of performance on consultant
• Due to strict necessity for specified deliverables, milestones, timelines, and scope assumptions, delineation of vendor/client responsibilities are made clearer
• Billing may be smoothed out as a percentage of completion or monthly or deliverables basis to avoid spikes in fees due to higher resources during particular stages of engagement
Disadvantages to Client
• Limits flexibility to change scope without formal contract amendment
• Could be subject to cheaper, less experienced consultant resources to make budget and/or meet cap
• Recourse for serious non-performance is often only a lawsuit
• Project or task may not be completed adequately before cap is reached due to client error, delay, non-participation or other issues. Additional charges may result in higher overall costs.
• Consultant may bill up to cap or not-to-exceed amount regardless of true level of effort required
Advantages to Consultant
• Tight scoping, estimating and project management could result in financial upside
• Billing may be done on a monthly or deliverables basis with upfront retainer in order to minimize and perhaps get ahead of front-end investment
• Consultant manages staffing and resource assignment per project requirements, skills requirements and budget, not based on client sensitivity to individual rates
• Strict necessity for specified deliverables, milestones, timelines, and scope assumptions makes client expectations easier to manage
• Billing has simpler, less detailed presentation often with no individual staffing names and no need to show individual rates
• Can bill up to cap or not-to-exceed amount regardless of true level of effort required
• Can assign less expensive resources as appropriate to meet cap or not-to-exceed limits
Disadvantages to Consultant
• Risk of performance is on consultant. Client often does not provide significant resources or oversight
• When source of error or bad estimate is less than clear, client relationship concerns often require small to large giveaways
• Changes in scope and approach must be communicated and documented with client in order to receive any additional compensation and manage client expectations
• Inadequate or incorrect scoping, timeframes, budgeted hours, required skills, resource planning or travel planning could result in significant un-billable hours, un-billable expenses and financial downside as well as run-away project and client dissatisfaction resulting in legal action
• Obstacles to completion from client side (i.e. delays, lack of access to client personnel, incorrect or inadequate information) must be specifically documented and negotiated in order to exceed cap on charges
• Client has visibility to hourly rates and staffing assignments in detailed billing statements
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