Friday, October 19, 2007

Are you creating value?

This is one of those bullshit questions from the corporate world that makes it sound so much more elegant, intellectual, yet virtuous than the actual thing. In consulting, your essential job is to add value to the client, or in even more simpler terms, increase the net worth of the client. To understand how you "add value" as a consulting, you have to look at what how strategy consultants get charged out to clients.

An entry-level post-MBA consultant (the title varies, but let’s go with Associate) makes between $110k-$140k base salary. This is then leveraged up by a multiple, varying between 4 and 7 (depending upon region, market, how shit-hot your team is). This multiple makes sure that when you’re being billed out that you cover all the firm’s costs of you (401k, health care, offices) while making loads of cash for your partner when you do your job. 100% utilization is impossible, and in most cases not desirable by the firm, as they want you to charge hours to recruiting, thought leadership work, vacation, and the inevitable beach time. An 80% utilization is a reasonable benchmark.

When you do the math you see that an average Associate charges out around $500,000 a year to the client (roughly $45,000 per month).

So, when you arrive at a consulting firm post-MBA, your job is to, as a bare minimum, find at least $500,000 in incremental EBIT during that year during your engagements. If you don't, you've actually lost your client money. That would be called "not adding value."

And that’s just the start. Did you forget about ROI?

Why should a company hire you for a year, spending $500K, to generate $510K of extra EBIT that they wouldn’t have had before? That’s a 2% ROI. Why would a company pay so much for such a low return?

Therefore, the real goal is to deliver a multiple of your charge rate (NPV’ed back, or within a certain payback period). Some examples that I’ve seen are:

  • Payback within 3 years
  • EBIT improvement of 7.5x charges
  • NPV 10-to-1 return on the consulting bills
Some recommendations will achieve incremental EBIT well into the future, but you have to apply a discount rate to NPV those profits back to the current date. Consulting engagements deal with highly complex, ambiguous, dynamic environments. In other words, it is a highly risky project, so you should apply a suitably high discount rate, like 20%.

So, to summarize:

Your job as an Associate at a top strategy firm is to find $5 million in incremental EBIT per year during your client engagements. If you don’t, you will be fired.

Isn’t that a lot better than “Are you creating value?”

Calculation Summary
$120K / year (base salary)
5 (leverage)
80% (utilization)
$500K The Amount you're charged out at
10 (client's ROI expectations)
$5M Incremental EBIT you're expected to find

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Friday, October 19, 2007