In general, a capital budget for a given year covers that fiscal year only. For most firms, there is no automatic carryover of unused budget appropriations. If a project runs into a new fiscal year, the remaining spending requirement should be separately approved as part of the new fiscal years budget.

When developing the capital budget, the same principles discussed earlier for long-range planning and annual budgeting apply, that is, set macrolevel targets within the context of the long-range plan and then have line managers develop the detailed plan within those parameters from the bottom up. In determining the actual level of capital spending for each department, the following metrics may be helpful in rationing scarce capital resources:

Capital spending as a percent of projected revenue

Capital spending per projected headcount

Approval of capital project requests should be based on an analysis of the projects economic rate of return as measured by an assessment of its net present value (NPV), internal rate of return (IRR), return on investment (ROI), and payback period. Since most capital expenditures in a professional services firm are related to information technology, many justifications for replacement of basic personal computing equipment will not yield a meaningful rate of return analysis. However, larger system development projects should be scrutinized carefully to understand fully not only the initial capital costs involved in developing the system, but also the ongoing operating and maintenance costs related thereto (i.e., the total cost of ownership).

Once a capital project is completed, a postanalysis should be prepared on all material projects to ensure assumptions that supported the original approval of the project in fact yielded benefits set forth in its economic justification analysis. In practice, completion of this important analysis often falls to the bottom of the priority list in favor of more urgent operational matters. By not insisting on an accounting for each significant projects actual returns, management bypasses an excellent opportunity to learn from actual experience that may be applied productively to future capital request analyses.

Cost Estimates: Prebilling Authorizations to Spend Your Clients Money

Prebilling your clients based on an estimate of future expenses can dramatically improve the firms cash flows. Doing so for profit on the interest earned during the float period is not advised because it may significantly impair the relationship with your client. Rather, such billing arrangements should be utilized when the firm is asked to undertake projects for which significant out-of-pocket expenses are required on the clients behalf. In many cases, the firm may need to move quickly on behalf of the client, often before the client can physically forward the funds needed to cover the expenses. In

these cases, the firm should establish and enforce a policy that requires written authorization from the client that a certain dollar level of funding has been approved for a specific purpose and that the client will pay that amount before any commitments are made on the clients behalf. If the firm fails to secure that written approval from the client and the client subsequently changes its mind about the project, the firm may be liable for all such expenses. Thus, it is critical that these authorizations, also referred to as estimates, be signed before making any commitments. Finally, the firm should ensure that its written agreement with its client include clear language as to what types of expenses will be reimbursed to minimize any ambiguity that may occur as the assignment unfolds.

Project Cost Accounting

One of the most important factors executive management can monitor and control is the marginal cost of servicing its clients. The value of staff time is the most critical variable factor in determining the total cost of a project and thus must be rationed in accordance with expected revenues. In its simplest form, cost accounting in a professional services environment compares revenue from a client or project against the cost of providing labor, overhead, and nonreimbursed out-of-pocket expenses to the client. Each of those components is allocated as follows:

Revenue: Revenues specifically related to the client and/or project are separately identified in the accounting system.

Direct labor: In general, direct labor costs reflect the value of time spent on the client or project. Direct labor costs are computed by taking the number of hours recorded on each persons timesheet for each client and multiplying it by his or her per hour salary cost. In some cases, the salary cost may include a factor to cover related benefit costs as well. Further, some firms choose to use a standard hour factor other than 2,080 (52 weeks x 40 hours per week) as the denominator for the total number of hours in a year because not all of those hours will be chargeable due to vacations, sick time, and administrative time. The actual denominator used is subject to management discretion based on actual experience and may fall as low as 1,500.

Direct expenses: Direct expenses include all out-of-pocket expenses incurred by the firm in conjunction with the clients assignment that are not reimbursable by the client.

Indirect labor overhead: Rarely is every hour of every employee in a firm chargeable to clients. The value of the time not charged out to clients is normally assigned to an indirect labor overhead account. In simple form, it represents the salary cost of staff time spent on

administrative functions, including vacations and sick time. The total cost to the firm may be allocated among all of the firms clients for cost accounting purposes in a number of different ways, the most popular of which is as a percentage of total direct labor or revenue. Overhead: All other costs not listed in the preceding category are grouped into an overhead category and are allocated among all the firms clients in a manner similar to that described for indirect labor. Costs in this category include rent, taxes, insurance, office supplies, administrative travel and entertainment costs, utilities, IT expenses, and depreciation and amortization.

Once all costs have been allocated among the firms clients and their respective projects, management can then evaluate historical performance in terms of each projects relative profitability. Doing so for the past is helpful, but using that information to evaluate and price future projects properly is vital to the firms long-term existence. When evaluating the results of a cost accounting analysis, management must be conscious of the difference between marginal and fully loaded costs when determining if a project was good for, or well managed by, the firm.

Projects that show a loss on a fully loaded basis (i.e., with all labor, direct, and overhead costs included) may contribute positively to the firms profit if revenue exceeded the marginal costs of performing the work. In the long run, a firm cannot remain profitable if all its projects are priced to cover only its variable or marginal costs, but in the short term, squeezing in a project that covers only its marginal labor and direct out-of-pocket costs may help increase the firms overall profitability. In the very short term, even projects that do not cover their direct labor costs may still be profitable for the firm if it could not have avoided those labor costs otherwise because the staff that worked on the project was able to squeeze it into their normal schedule.

Client Compensation Contract Negotiations

Compensation contract negotiations with the firms clients are one of the most critical factors in determining the firms profitability. At the outset of a relationship, these negotiations form the foundation from which the firm will live, possibly for many years to come. Because of the long-term precedent-setting nature of these discussions, it is important that the firm negotiate the best terms possible. Often this may mean taking several months to negotiate in the case of a long-term relationship, but that upfront investment of time will, if done well, pay dividends for many years to come.

Most contracts include two main types of issues: financial and nonfinan-cial terms and conditions, including the scope of work. Getting the most favorable financial terms may not be best for the firm if it does not negotiate reasonable nonfinancial terms and conditions as well.