Strategy, Legal & Operations
How the professional services sector can walk the tightrope of recession as other markets fall
With inflation persistently high for more than a year now, the Federal Reserve (or Fed) keeps raising interest rates at a stunning rate. Depending on who you ask, we are about to be or are already in a recession. Yet, more than half of global CEOs expect growth to pick back up by the year's end.
With inflation persistently high for more than a year now, the Federal Reserve (or Fed) keeps raising interest rates at a stunning rate. Depending on who you ask, we are about to be or are already in a recession. Yet, more than half of global CEOs expect growth to pick back up by the year’s end.
So, is the correction over? It’s hard to predict what happens next. Only weeks ago, investors were hopeful that rate cuts will come by the summer of 2023. But after a recent job report put unemployment at its lowest level in 53 years, they worried that a too-hot economy will set the Fed on a more aggressive path to future rate increases. Then SVB collapsed, and Credit Suisse sold to UBS. Now unions are protesting for slower rate increases.
There is ample evidence that inflation is firming up and becoming more persistent. Interest rates have never in history been so low for so long. The central bank simply must keep raising interest rates further, and more importantly, keep them higher for longer, in hopes of finally cooling the economy. Especially since Fed policy seems to have had little impact on inflation so far.
Macroeconomic decisions indeed take a while to permeate through the value chain.
However, the big conundrum is that our historical data doesn’t seem to line up. For example, the S&P500 has declined a median of 24% in recessions since 1946. Yet, at the time of publishing, it’s up over 7% for the year.
So, if we are in a recession, why isn’t it showing up in the data? And why does the economy seem so reluctant to be led by the Fed rate increases?
Historical comparatives don’t account for the fact that the services sector now makes up almost 80% of the US GDP.
And that’s important because a services economy is significantly less reliant on major inflation drivers than the manufacturing sector is.
The costs of running a manufacturing business
In the context of inflation, manufacturing businesses are much more susceptible to global market forces. Manufacturing companies have material costs, real-estate costs for manufacturing and warehousing operations, as well as energy and labor costs. They also often need to buy and maintain expensive machinery that relies on price-volatile raw materials and a global supply chain to source.
Then, there is competition with international markets for cheaper labor and raw materials, which are beyond the control of the manufacturing business.
Many of the costs of a manufacturing business are trailing, as they may buy raw materials or energy in large quantities at a fixed price. Once they run out, they can face sudden and steep price increases, which they then pass on to consumers. All that takes time and consumer prices are usually 6-8 months behind production prices.
Of course, that’s also true today. Production Prices started to increase significantly in April/May of 2021, finishing the same year at 7% on average, while the CPI didn’t peak until a year later. In 2022, the PPI averaged 9.6%, while the CPI averaged around 8%.
It’s fair to assume that a few more percentage points of consumer price inflation are left in the value chain.
And that hits manufacturing businesses harder because they will deal with higher upfront costs while not immediately being able to pass them on to consumers. In other words, manufacturers act as an inflation buffer.
But manufacturing only accounts for about 16% of the GDP.
Service companies are different
You are not tied to most of these factors in a services business. You don’t have to keep the same level of inventories and have little to no upfront costs. You also recoup your cash a lot faster than most manufacturers. As a result, you have a much lower need to borrow money. This is a key factor in why Fed interest-rate decisions affect services business less than manufacturing.
In the world of professional services, this is even more visible. The work-from-home economy during Covid-19 only accelerated the trend of remote work. In a post-Covid world, professional services workers can do most of their work at home or a client site. This trend has been evident for some time as cities transform empty office spaces into residential units.
The most significant difference compared to the manufacturing sector is labor costs, which tend to be much higher for multiple reasons. In a services business, your workforce is your capital and IP. But employee pay alone is not an inflation driver.
The competitive landscape is also different. Most services are provided locally or at least domestically. Apart from commoditized services, service providers don’t have to fear the competition of low-cost offshore labor.
On the other end of the value chain, there is no need to warehouse goods, and different billing models can speed up cash collection, even on longer-term projects. Once your service is delivered, you bill your customer.
Vendor relationships are also more direct, transparent, and less susceptible to global markets. As a result, your operational costs are generally not as closely tied to market swings.
If a software subscription becomes too pricey at the end of its term, you can shop around for a different vendor and often negotiate discounts. You are unlikely to have that same flexibility when purchasing raw materials tied to volatile market pricing.
Of course, that’s not to say interest rates won’t eventually catch up with services companies. It will be less direct and take longer.
Preparing for what’s ahead in 2023
So, what does all this mean if you are running a services business? In short: more uncertainty, for longer. 2023 will not be the year that things calm down.
On the one hand, the impact of Fed decisions is more indirect than overall market expectations suggest. As the collapse of SVB has shown, what will put your business under pressure may not be high borrowing costs, but your bank going out of business. And even if your business is not directly affected by a bank collapse, one of your critical vendors might be.
On the other hand, markets overall have proven to be poor predictors of what’s to come because market expectations are based on historical data, which fails to properly account for the service shift in the country’s economic fabric.
If we go with the current expectation of easing interest rates in the summer, consumers and businesses alike are tempted to delay big purchases while they can. They simply hope to get a better price later in the year, or finance at a better cost.
“Wait and see” may not seem like a bad strategy now, but it has broader economic implications. If everyone follows this path, a real recession can become a self-fulfilling prophecy. We are starting to see hints of it at car dealerships and in real estate.
Responding to uncertainty
So how will your business model respond to market pressures? And how can you ensure that your firm is resilient enough through more volatile economic times?
The answer is simple: focus on the things you can control. SPI Research released its 16th annual Professional Services Maturity benchmark report in early February. The report looks at various types of service organizations and common business drivers. With hundreds of participating organizations globally, it provides a reliable basis for determining what makes service businesses successful. SPI’s data goes back to the 2008 financial crisis and, more recently, Covid-19.
What the data shows is that services companies which fared well through difficult economic times are the ones that understand their financial and operational data.
For example, do you understand how your costs have changed from 2019 through today? How much does your company spend on labor, suppliers, and customer acquisition? Can you break this data out by location, client, and type of service provided?
Truly understanding your data might yield surprising results. For example, Halloran Consulting Group, a life science regulatory, quality, and clinical consulting firm based in Boston, Mass., found that changing its billing model could increase profit by $4 million. In addition, by requiring daily timesheets, the firm was able to speed up its billing cycle, which opened up another $1 million in new monthly cash flow.
Tania Zieja, Halloran’s President and former CFO, says, ”[W]e couldn’t drive real-time data-driven decisions with week-old data. We were, unfortunately, driving decisions reactively, and that’s not best practice when running a consulting firm. Daily timesheet submission was an adjustment, but the integrity of the data made it worthwhile, and now it is simply part of everyone’s daily routine.”
What are things you can take advantage of? Perhaps daily time sheets won’t fly at your company. But maybe your data will tell you that you should shift your focus to a different service or type of client. Can you specialize in something more profitable?
The economic environment will remain volatile for the foreseeable future. Understanding the micro trends in your business is the best way to combat the uncertainty caused by the macro trends.
Certainty in your numbers and understanding where you stand will give you the intelligence and confidence to make the right decisions, no matter what the markets do. SPI’s data shows that this has been true all along.
What top-performing services firms do better
Financial and operational data is vital to running a successful services organization. Top performers understand this data inside and out. By running their business in real-time, they can quote jobs more accurately, execute projects more effectively, and leave a happy customer with a bill in hand faster.
They know their spending; they have a tight handle on their pricing models and know which customers are most profitable. Moreover, they know how to collect cash quickly.
The market keeps changing, and you must stay abreast of changes in it. The only way to do that is to use data to predict changes and adjust faster and better than the competition.
How to stay ahead of your data
Actively managing the business requires access to accurate real-time analytics, and forecasting tools that can provide actionable insights. After all, if you don’t have detailed data and the right tools, scenario modeling could be nearly impossible—and you will continue to view your business in the rear-view mirror.
Bill Fuesz, Principal Marketing Manager for Sage Intacct, recently outlined why entry-level accounting tools like QuickBooks hold businesses back. Transitioning to a modern accounting system can provide services firms with the data and insights they need to get ahead of their competition and be more resilient in uncertain economic times.
Take a look at what Sage Intacct can do for Professional Services firms. As the number 1 project-based ERP software, you could see a return on investment within your first year, helping your professional services business to be more recession-proof.
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