Costs Are Credible

Capturing costs is challenging because the numbers must be reliable and realistic. Although most organizations develop costs with much more ease than the monetary value of the benefits, the true cost of consulting projects is often an elusive figure even in some of the easiest projects. While the direct charges are usually easily developed and are part of the problem, it is more difficult to determine the indirect costs of a project. While the major costs are known up front, the hidden costs to the organization that are linked to the project are not usually detailed. To develop a realistic ROI, costs must be complete and credible. Otherwise, the painstaking difficulty and attention to the monetary benefits will be wasted because of inadequate or inaccurate costs.

Fully Loaded

Today, there is more pressure than ever before to report all consulting costs, or what is referred to as fully loaded costs. This takes the cost profile beyond the direct cost of consulting fees and expenses and includes the time that others are involved in the project, including their benefits and other overhead. For years, management has realized that there are many indirect costs of consulting. Now they are asking for an accounting of these costs.

With this approach, all costs that can be identified and linked to a particular consulting assignment are included. The philosophy is simple: For the denominator of the ROI equation, when in doubt, include it (i.e., if it is questionable whether a cost be included, it is recommended that it be included, even if the cost guidelines for the organization do not require it). When an ROI is calculated and reported to target audiences, the process should withstand even the closest scrutiny in terms of its completeness and credibility. The only way to meet this test is to ensure that all costs are included. Of course, from a realistic viewpoint, if the finance department or executive client insists on not using certain costs, then it is best to leave them out.

The Danger of Reporting Costs without the Benefits

It is dangerous to communicate the fully loaded costs of a consulting project without presenting benefits. Unfortunately, many organizations have fallen into this trap for years. Because costs can easily be collected, they are presented to management in ingenious ways, such as cost of the project, cost per employee involved, and cost per unit of product or service. While these may be helpful for efficiency comparisons, it may be troublesome to present them without benefits. When most executives review consulting costs, a logical question comes to mind: What benefit was received from the project? This is a typical management reaction, particularly when costs are perceived to be high.

In one organization, all of the costs associated with a major transformation consulting project were tabulated and reported to the senior management team at their request. The total figure exceeded the perceived value of the project, and the executive group's immediate reaction was to request a summary of (monetary and nonmonetary) benefits derived from the complete transformation. The conclusion was that there were few, if any, economic benefits from the project. Consequently, future consulting projects were drastically reduced. While this may be an extreme example, it shows the danger of presenting only half of the equation. Because of this, some organizations have developed a policy of not communicating consulting cost data unless the benefits can be captured and presented along with the costs (or at least have a plan for it). Even if the benefits are subjective and intangible, they are included with the cost data. This helps to maintain a balance between the two issues.

Developing and Using Cost Guidelines

For some consulting groups, it may be helpful to detail the philosophy and policy on costs in guidelines for the consultants or others who monitor and report costs. Cost guidelines detail specifically which cost categories are included with consulting projects and how the data are captured, analyzed, and reported. Standards, unit cost guiding principles, and generally accepted values are included in the guidelines. Cost guidelines can range from a one-page brief to a hundred-page document in a large, complex organization. The simpler approach is better. When fully developed, cost guidelines should be reviewed and approved by the finance and accounting staff. The final document serves as the guiding force in collecting, monitoring, and reporting costs. When the ROI is calculated and reported, costs are included in a summary form or table, and the cost guidelines are referenced in a footnote or attached as an appendix.

Sources of Costs

It is sometimes helpful to first consider the sources of consulting cost. There are three major categories of sources as illustrated in Table 14.1. The charges and expenses from the external consulting team will usually represent the latest segment of costs and may be transferred directly to the client for payment. Internal consulting groups with charge-back arrangements would also transfer their expenses. These are often placed in categories under fees and expenses. The second major cost category is those related expenses absorbed by the client organization—both direct and indirect. In many consulting projects, these costs are not identified but nevertheless reflect the cost of the consulting project. The third cost is the cost of payments made to other organizations as a result of the consulting project. These include payments directly to suppliers for equipment and other services prescribed in the consulting project. The finance and accounting records should be able to track and reflect the costs from these three different sources, and the process presented in this chapter has the capability of tracking these costs as well.

Consulting Process Steps and Cost

Another way to consider consulting costs is in the characteristics of how the project unfolds. Figure 14.1 shows the specific functions of a complex consulting assignment, beginning with the initial analysis and assessment and migrating to the evaluation and the reporting of the results. These are the functional process steps that were outlined earlier in the book and later in this chapter. They represent the typical flow of work. As a problem is addressed, a solution is developed or acquired and implemented in the organization. There are maintenance and monitoring processes usually put in place that will result in ongoing costs. The entire process is routinely reported to the client and evaluation is undertaken to show the success of the project. There is also a group of costs that will support the process primarily from the client perspective, as these represent important administrative support and overhead costs. To be fair, the consulting project should be analyzed in these different categories, as will be described later in the chapter.

This may be a bit complex for some consulting processes, which are small in scope and involve only a few consultants—in some cases maybe only one consultant. In these situations a more simplistic approach is taken following a simplified process flow described in Figure 14.2, which represents the consulting process reflected in fees, the direct cost of the expenses, and the client cost. These occur as the consultant allocates time, generates costs, and the client has some recurring or ongoing costs in the project. The important point is to consider costs as they occur naturally and systematically in the consulting intervention.

Prorated versus Direct Costs

Usually all costs related to a consulting project are captured and allocated to that project. However, some costs are prorated over a longer period of time. Equipment purchases, software development and acquisition, and the construction of facilities are all significant costs with a useful life that may extend beyond a specific consulting project. Consequently, a portion of these costs should be prorated to the consulting project. Using a conservative approach, the expected life of the consulting project is fixed. Some organizations will consider one year of operation for a simple project. Others may consider three to seven years. If there is some question about the specific time period to be used in the proration formula, the finance and accounting staff should be consulted, or appropriate guidelines should be developed and followed.

Employee Benefits Factor

Employee time is valuable, and when time is required on a consulting project, the costs must be fully loaded, representing total compensation. This means that the employee benefits factor should be included. This number is usually well known in the organization and is used in other costing formulas. It represents the cost of all employee benefits expressed as a percentage of payroll. In some organizations this value is as high as 50–60 percent. In others, it may be as low as 25–30 percent. The average in the United States is about 38 percent.

Initial Analysis and Assessment

One of the most underestimated items is the cost of conducting the initial analysis and assessment. In a comprehensive project, this involves data collection, problem solving, assessment, and analysis. In some consulting projects, this cost is near zero because the project is launched without an appropriate assessment of need. However, as more consultants and clients place increased attention on needs assessment and analysis, this item will become a significant cost in the future. All costs associated with the analysis and assessment should be captured to the fullest extent possible. These costs include consulting time, direct expenses, and internal services and supplies used in the analysis.

Design and Development of the Project

One of the more significant items is the cost of designing and developing the solutions for a consulting project of the project itself. These costs include consulting time in both design and development and the purchase of supplies, technology, and other materials directly related to the project or solutions. As with needs assessment costs, design and development costs are usually fully charged to the project. However, in some situations, major expenditures may be prorated over several projects.

Acquisition Costs

In lieu of development costs, many organizations purchase hardware, software, equipment, or facility from other sources to use directly or in a modified format. The acquisition costs for these projects include the purchase price, support materials, and licensing agreements. Many consulting projects have both acquisition costs and design and development costs.

Capital Expenditures

For expenses that represent significant investments, such as in a major remodeling of facilities, the purchase of a building, and purchases of major equipment, the expenses should be recorded as capital expenditures and allocated over a period of time. If the equipment, building, or facility is used for other projects, then the costs should be allocated over the different projects and only a portion captured for a particular assignment.

Application and Implementation Costs

Usually the largest cost segment in a consulting project is associated with delivery and implementation. Six major categories are reviewed below:

1. Salaries and benefits for consulting time. This includes all of the charges for consultants assigned directly to the staff. This cost represents specific fees for the time they are involved in the project. These are direct charges only and are usually charges allocated directly from the consulting organization.
2. Salaries and benefits for coordinators and organizers. The salaries of those who implement the consulting project should be included. These are usually client staff members. If a coordinator is involved in more than one project, the time should be allocated to the specific project under review. If external facilitators are used, all expenses should be included in the project. The important issue is to capture all of the time of internal employees or external providers who work directly with the consulting project. The benefits factor should be included each time direct labor costs are involved. This factor is a widely accepted value, usually generated by the finance and accounting staff and in the 30–50% range.
3. Participants' salaries and benefits. The salaries plus employee benefits of consulting participants represent an expense that should be included. These client costs are significant and can be estimated using average or midpoint values for salaries in typical job classifications.
4. Consulting materials and supplies. Consulting materials and supplies, such as field journals, instructions, reference guides, case studies, job aids, and participant workbooks should be included in the delivery costs, along with license fees, user fees, and royalty payments. CD ROMs and supplies are also included in this category.
5. Travel, lodging, and meals. Direct travel and lodge costs for consultants, consulting participants, facilitators, coordinators, and managers are included. Entertainment and refreshments during the intervention are included as well.
6. Use of facilities. The direct cost for the use of facilities for the consulting project should be included. For external meetings, this is the direct charge from the conference center, hotel, or motel. If the meetings are conducted in-house, the conference room represents a cost for the organization, and the cost should be estimated and included—even if it is uncommon to include facilities costs in other reports. A common-sense approach should be taken with this issue. Charging excessively for space or charging for small intervals may be unreasonable, underscoring the need for formal guidelines.

Maintenance and Monitoring

Maintenance and monitoring involves routine expenses to maintain and operate a system process, procedure, or solution implemented as part of the consulting project. Although not always present, these represent ongoing expenses to make the new solution continue to work. These may involve staff members, additional expenses, and may be significant for some projects.

Administrative Support and Overhead

Another charge is the cost of support and overhead, the additional costs of consulting not directly related to a particular project. The overhead category represents any consulting cost not considered in the above calculations. Typical items include the cost of administrative support, telecommunication expenses, office expenses, salaries of client managers, and other fixed costs. A rough estimate will usually suffice.

Evaluation and Reporting

Usually the total evaluation cost is included in consulting costs to compute the fully loaded cost. This category includes the cost of developing the evaluation strategy, designing instruments, collecting data, data analysis, report preparation and distribution, and communication of results. Cost categories include time, materials, purchased instruments, or surveys.

Definitions

The term return on investment is occasionally misused, sometimes intentionally. In these situations, a very broad definition for ROI is offered to include any benefit from the consulting project. ROI is thus defined as a vague concept in which even subjective data linked to a project are included in the concept. In this book, the return on investment is more precise and is meant to represent an actual value by comparing consulting costs to monetary benefits. The two most common measures are the benefit/cost ratio and the ROI formula. Both are presented along with other approaches to calculate the return or payback.

For many years, consultants sought to calculate the actual return on investment for a consulting intervention. If the consulting intervention is considered an investment, not an expense, then it is appropriate to place consulting in the same funding process as other investments, such as the investment in equipment and facilities. Although the other investments are quite different, management often views them in the same way. Thus, it is critical to the success of the consulting intervention to develop specific values that reflect the return on the investment.

Annualized Values: A Fundamental Concept

All of the formulas presented in this chapter use annualized values so that the first-year impact of the consulting project investment can be calculated. Using annualized values is becoming a generally accepted practice for developing the ROI in many organizations' projects (guiding principle #9). This approach is a conservative way to develop the ROI, since many short-term consulting projects have added value in the second or third year. For long-term consulting projects, first-year values are inappropriate and longer time frames need to be used. For example, in an ROI analysis of a technology consulting project involving software implementation at a hospital, a three-year time frame was used. However, for most short-term consulting projects that last only a few weeks, first-year values are appropriate.

Benefits/Costs Ratio

One of the earliest methods for evaluating a consulting project is the benefits/cost ratio. This method compares the monetary benefits of consulting intervention to the costs, using a ratio. In formula form, the ratio is this:

In simple terms, the BCR compares the annual economic benefits of the consulting project to the cost of the consulting project. A BCR of 1 means that the benefits equal the costs. A BCR of 2, usually written as 2:1, indicates that for each dollar spent on consulting, two dollars are returned in benefits.

The following example will illustrate the use of the benefits/cost ratio. A consulting project designed to improve the efficiency of procurement was implemented at a nonprofit. In a follow-up evaluation, direct cost savings and time savings were captured. The first-year payoff for the project was $439,480. The total fully loaded implementation cost was $141,000. Thus, the ratio was:

For every dollar invested in consulting, 3.1 dollars in benefits were returned. There are no standards that constitute an acceptable benefits/cost ratio from the client perspective. A standard should be established within the organization, perhaps even for a specific type of consulting intervention. A 1:1 ratio (breakeven status) is unacceptable for many consulting projects. In others, a 1.25:1 ratio is required, where the benefits are 1.25 times the cost of the consulting.

ROI Formula

Perhaps the most appropriate formula for evaluating consulting investments is net project benefits divided by cost. The ratio is usually expressed as a percentage when the fractional values are multiplied by 100. In formula form, the ROI becomes this:

Net benefits are consulting benefits minus costs. The ROI value is related to the BCR by a factor of one. For example, a BCR of 2.45 is the same as an ROI value of 145 percent (1.45 × 100%). This formula is essentially the same as the ROI in other types of investments. When an organization builds a new plant, the ROI is developed by dividing annual earnings by the investment. The annual earnings are comparable to net benefits (annual benefits minus the cost). The investment is comparable to fully loaded consulting project intervention costs, which represent the investment in consulting.

An ROI on a consulting project of 50 percent means that the costs are recovered and an additional 50 percent of the costs are reported as “earnings.” A consulting ROI of 150 percent indicates that the costs have been recovered and an additional 1.5 times the costs is captured as “earnings.” An example illustrates the ROI calculation. A quality improvement–consulting project was implemented in a small manufacturing company in Italy. The results of the project were impressive. Quality improvements alone yielded an annual value of €243,340. The total fully loaded costs for the project were €79,400. Thus, the return on investment becomes this:

For each euro invested, this company received €2.06 in return after the costs of the consulting project had been recovered. Using the ROI formula essentially places consulting investments on a level playing field with other investments using the same formula and similar concepts. Key management and financial executives who regularly use ROI with other investments easily understand the ROI calculation.

While there are no generally accepted standards, some organizations establish a minimum requirement or objective for the ROI. This objective could be based on the accepted ROI for other investments, which is determined by the cost of capital and other factors. When there is low inflation in a country, this value may be in the range of 10–15 percent. An ROI objective of 25 percent is set by many organizations in North America, Western Europe, and the Asia Pacific regions. This target value is usually greater than the percentage required for other types of investments. The rationale? The ROI process for consulting is still relatively new and sometimes involves subjective input, including estimations. Because of that, a higher standard is required or suggested, with 25 percent being the desired figure for most organizations. Sometimes it is helpful to let the client set the ROI objective with the caution of keeping it reasonable.

Payback Period

The payback period is a common method for evaluating capital expenditures. With this approach, the annual cash proceeds (savings) produced by an investment are equated to the original cash outlay required by the investment to arrive at some multiple of cash proceeds equal to the original investment. Measurement is usually in terms of years and months. For example, if the cost savings generated from a consulting project are constant each year, the payback period is determined by dividing the total original cash investment (development costs, expenses, etc.) by the amount of the expected annual or actual savings. The savings represent the net savings after the project expenses are subtracted.

To illustrate this calculation, assume that an initial project cost is $100,000 with a three-year life. The annual net savings from the project is expected to be $40,000. Thus, the payback period becomes this:

The project will “pay back” the original investment in 2.5 years. The payback period is simple to use but has the limitation of ignoring the time value of money. It has not enjoyed widespread use in evaluating consulting investments.

Discounted Cash Flow

Discounted cash flow is a method of evaluating investment opportunities in which certain values are assigned to the timing of the proceeds from the investment. The assumption, based on interest rates, is that money earned today is more valuable than money earned a year from now.

There are several ways of using the discounted cash flow concept to evaluate the consulting investment. The most common approach is the net present value of an investment. This approach compares the savings, year by year, with the outflow of cash required by the investment. The expected savings received each year is discounted by selected interest rates. The outflow of cash is also discounted by the same interest rate. If the present value of the savings should exceed the present value of the outlays after discounting at a common interest rate, the investment is usually considered acceptable by management. The discounted cash flow method has the advantage of ranking investments, but it becomes difficult to calculate.

Internal Rate of Return

The internal rate of return (IRR) method determines the interest rate required to make the present value of the cash flow equal to zero. It represents the maximum rate of interest that could be paid if all project funds were borrowed and the organization had to break even on the projects. The IRR considers the time value of money and is unaffected by the scale of the project. It can be used to rank alternatives and can be used to accept/reject decisions when a minimum rate of return is specified. A major weakness of the IRR method is that it assumes all returns are reinvested at the same internal rate of return. This can make an investment alternative with a high rate of return look even better than it really is and a project with a low rate of return look even worse. In practice, the IRR is rarely used to evaluate consulting investments.

Measures the Contribution

With this, methodology consultants will know the contribution of a specific consulting project. The mystery of the success and contribution of consulting is removed. The ROI will show how the benefits, expressed in monetary values, compare to costs. It will determine if the project made a business contribution to the organization and if it was a good investment.

Develops Priorities for Consulting Projects

Sometimes there is a need to identify which projects are adding the most value. Calculating the ROI for different types of consulting projects will determine which projects contribute the most to the organization, allowing priorities to be established for high-impact projects.

Improves the Consulting Process

As with any evaluation system, an ROI study provides a variety of data to make adjustments and changes to the consulting process. Barriers and enablers to success are identified and used as a basis for changes and improvement. Because different data are collected at different levels, from different sources, the opportunity for improvement is significant. This allows for a complete analysis.

Focuses on Results

The ROI methodology is a results-based process that focuses on outcomes from all consulting projects, even for those not targeted for an ROI calculation. The process enhances business alignment in the beginning and requires consultants and support teams to concentrate on measurable objectives (i.e. what the consulting is designed to accomplish). In short, the use of ROI drives results. Expectations are created with stakeholders. Key managers, who make the project successful, are involved in the project.

Builds Management Support for the Consulting Process

The ROI methodology, when applied consistently and comprehensively, can convince the management group that consulting is an investment and not an expense. Managers will see consulting as making a viable contribution to their objectives, thus increasing the respect and support for the process. ROI use is an important step in building a partnership with senior management and increasing the commitment to consulting.

Alters Perceptions of Consulting

Routine ROI impact data, when communicated to a variety of target audiences, will alter perceptions of the value of consulting. Consulting participants, their leaders, and other client staff will view consulting as a legitimate function in the organization, adding value to work units, departments, and divisions. They will have a better understanding of the connection between consulting and results.

Simplifies a Complex Issue

As discussed in Chapter 6, developing the return on investment for consulting appears to be a complex issue. The approach presented in this book is to take a task that seems complex and simplify it by breaking it into small steps, so it is understandable and acceptable to a variety of audiences. When each step is taken separately and issues are addressed for a particular topic, the decisions are made incrementally all the way through the process. This helps reduce the process to a simplified and managable effort.