On profitability and the qualification of prospects

After having dealt with so many software projects over the years, I have came somewhat to the conclusion that not every deal is made the same. Some deals are more profitable than others, some deals need to be avoided altogether.

While the idea of expanding my business operation is a good one, I concluded it was even more important that I be able to expand this operation of mine while maintaining the same level of profitability, the same quality in terms of work and my good reputation (aka a technological version of the McDonald’s business model). This further lead me to ponder upon the feasibility of what I am trying to achieve. I have been deliberating over this notion in one form or another with my dad, my mum, Jim, Peter and Steven during the course of the past two months.

My recent intensive dwelling into Warren Buffett’s 800+ paged biography as well as the 600+ paged literature by his mentor Benjamin Graham titled “Security Analysis” did provide very important insights as to why banks and insurance companies of strong reputation collapsed during each and every bust period after a boom. Peter and the CMO of huelabs had in fact enlightened me on the same lesson last year. One will not die immediately from starvation but one will definitely die immediately from indigestion.

During the boom period in any economy; demand will be strong; competitors will all be seeking expansion; shareholders will be expecting increasing rates of returns on capital. Businesses overcame by optimism focus on maximizing the upside potential while neglecting to curtail the downside risk of their business operations – a human behaviour pattern Johnson commonly term as “greed”. Validating of job that passes through their system become laxed, while abnormal profit level is reported in the short run, the business sustains losses in the long run.

Keeping all these in mind, I now surmised my contemplations in the following points with regards to IT industry. These points need to be taken into consideration when judging the profitability of any deal:

Face value of the deal

In layman terms, it means how much is the total likely amount of money that will change hand via the delivery of the project from customer to vendor. It is wrong to assume that the larger the face value of a project, the more lucrative it is.

The profit margin

In layman terms, it is the difference between the face value of a contract and the cost of delivery expressed as a percentage of the contract’s face value.

Payment terms

A dollar today is worth more than a dollar tomorrow. How is the payment term crafted in the contract? It is 50% up front, 50% upon delivery or is the face value amount split into intermediate portions for released during the life span of a project.

Customer credibility

A dollar today is worth more than a dollar tomorrow. How prompt is the payment by the customer.

Customer liquidity strength

What is the cash level the customer has in his coffers? What is the monthly net cash flow into the customer’s coffers? A customer who has no established infrastructure that brings him a positive cash flow on a monthly basis that is attempting to commission a concept that is somewhat close to rocket science and might potentially cost multiple times his monthly cash inflow amount, should raise some alarm in your customer qualification meter.

Grounded-ness  of underlying business concept

Each project is backed by a certain business concept. A concept that deviates significantly from the usual day to day business operations of an established business might expose a vendor to a higher level of risk as compared to one that is a obvious next step in the advancement of that business.

In the event whereby no established business backs the idea, both the amount of available funding and the deviation of proposed concept from the market norm are to be considered as coefficient in the vendor risk level assessment. Lower levels of available funding and higher levels of deviation from market norm adds to the risk of the vendor in terms of default for the former and long turn around time for the latter.

Ambiguity of concept

The further away from the market norm is a concept, the higher level of ambiguity is it. The higher the level of ambiguity, the higher the level of potential  risk for the vendor. The longer the potential turn around time for a project.

Technological maturity of client

The higher the level of technological maturity in a client, the less the after sales technical support is required, the more profitable the project is in terms of effort saved versus effort spent. Such negated calculation is often overlooked by vendors when evaluating potential clients.

The worst case scenario is a client with technological maturity at an infantile stage. More than average effort will be required to support client not only on system delivered by vendor, but on other technical questions that are totally out of scope of this project.

A vendor cannot hope to avoid ill feelings by client if vendor attempts to excuse himself from answering technical questions out of the project scope he delivered.

Brain pattern of client

A client with a convergent brain pattern is more profitable than a client with a divergent brain pattern. A client with a convergent brain pattern will eventually converge towards very specific tasks he would like accomplished. A client with a divergent brain pattern will inevitably expand his list indefinitely. Vendor serving this latter group of client will face potentially face issues of scope creeping and subsequent conflict.

Relationship level with client

While level of relationship between client  and vendor affects the chances of sales turnover rate of a project proportionately, situation gets potentially sticky when a vendor attempts to extradite his service from a project that might potentially be costly for his operation.

Level of bureaucracy within the client organization

A client organization with a higher level of bureaucracy puts in place more red tapes that a vendor will have to maneuverer through as well as imposes more downward pressure on the profit margin of the vendor. The level of bureaucracy in a client organization has a positive relationship to the face value of a project and a negative relationship to the profit margin.

Successful handling of bureaucracy in client organization results in the retaining of profit margin while unsuccessful handling of bureaucracy in client organization results in net losses in the course of project delivery.

Throughput rate

Each project has a deadline, the definiteness of the deadline determines the throughput rate required. A more definite and tighter deadline will likely demand for a higher throughput rate. A vendor faced with a higher required throughput rate will have to expand his operations capacity and thus overhead cost. Increase in overhead cost might in the long run wipe out whatever margin, if any, he managed to gain from this project in a break even scenario. In the worst case scenario, the vendor has too much capacity that could be absorbed by the market, thus faces net losses.

Area of expertise

This factor takes into account the core capabilities of the vendor. A vendor incurs more resources per output when attempting to function outside his area of core capabilities then he would if he attempts to generate output within his area of core capabilities.

A vendor that is constantly subjected to work outside his area of expertise will thus experience a lower profit margin as compared to one that is tightly working within his area of expertise.

Underwriting Arrangements

In the event whereby the vendor is not the main party delivering the scope of work, the reliability of the supplier the vendor is underwriting on behalf of, the level of control a vendor has over the supplier as well as the margin the vendor can retain in the event of contingency are all coefficients for considerations. A supplier with a well established reputation will lower the risk faced by the vendor. A high margin level retained by the vendor will lower the potential of making losses in the event a supplier defaults.

A vendor who is able to manipulate himself out of the position of being the underwriter and exchanges instead a commission for his service thus limits his risk.

Conclusion

Applying this matrix towards the qualification of clients, a vendor should thus be able to filter off projects that are potentially loss making and instead focus his effort on projects that have a high level of profitability.

Leading back to the original question I have in mind. Can the market provide such levels of qualified customers on a consistent basis as would justify the operating capacity I have in mind?

Whilst sales leads volume has been extremely high lately, already based on the above matrix quite a few have already fallen into the risky non-lucrative category. Instead of thinking how to close the deals, I am now considering ways and means of extraditing myself from these risk. Only three of the remaining sales leads qualify as ones with high profit margin and a fast turn around time. These are the ones, I should instead focus my effort on closing.

In hindsight, I did sustain losses engaging in two projects of similar nature to the former group in 2010.

First of which had to do with a hardware procurement deal, factors contributed to the losses are as listed below:

  • high level of bureaucracy within the client organization

The factors that contributed to losses in the second dealing as a sub-contractor are as listed below:

  • payment terms
  • customer credibility
  • area of expertise

In year 2009, I sustained major losses engaging as a sub contractor in one project. The magnitude of the losses was nearly of sufficient magnitude to threaten the continued existence of my enterprise. Factors that contributed to my losses:

  • customer credibility
  • customer liquidity strenght
  • grounded-ness of underlying business concept
  • throughput rate

    As of now, I am engaged in the midst of another project that belongs to this risky group too. Underwriting agreement, ambiguity of concept are two factors that contributed to these losses.

    Aside from the percieving from an enterprise point of view, I learned another lesson the hard way. Business must never get mixed up with friendship. What Satheesh said is correct. As a matter of policy henceforth, “nothing personal, just business”

    From a personal point of view, I conclude that while it is a nice to have, it will not be possible for me to maintain my continued good reputation in the industry if I leave my outstanding clients in the lurch while flying over to Russia to attend my Pasha’s wedding. In my opinion, I believe as a friend he understand my decision.

    Looking forward

    As I have discussed with my Dad over lunch a few days ago, there is a bubble forming in the IT industry at the moment that might be somewhat similar to the 2000 Dot.com bubble. Rental prices of commercial property in Singapore is rising, more and more companies have been set up in the country to cater for customer demands for mobile applications. Valuation of Dot.com companies in the Silicon valley has of late achieved significantly high levels without generating a corresponding level of profits. Venture capitalist are chasing after these “highly valued” Dot.coms with their investors’ money.

    Taking this trend for granted what I will need to do, over the course of the next few months, ponder upon the effects of the forthcoming Dot.com bust. Thereafter, I will need to position myself properly in the most lucrative position possible when that happens.

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