CRO Utilization Part #1
I have finally gotten around to writing an article about CRO utilization - which I believe to be one of the most important and at times least understood of CRO operating metrics. Since there is so much ground to cover I decided to split the article into 2 parts. I recently read "Irresistible: The Rise of Addictive Technology & The Business of Keeping Us Hooked" and it has a section explaining that cliffhangers keep people wanting more. I'll put that theory to the test - knowing a blog on utilization isn't Indiana Jones but I'll try. By the way "Irresistible" is a great book for parents who want to get a better understanding of how mobile devices can impact children (I've added a link for those who are interested).
I would define utilization as a calculation showing how effective an organization utilizes its billable workforce. Greater utilization should result in greater revenue and profit. However, there is a sweet spot since we are talking about human labor utilization (and not machine labor). Utilization that is too high could result in employee burnout, poor quality, employee turnover or all of the above. Many CROs have differing utilization calculations, but in my experience a utilization rate in the 75%-85% range seems to be the target norm. In theory a utilization rate of 100% for a full time employee with benefits (vacation, holidays, etc..) should be impossible as long as employees take vacation, etc...
Ultimately, we want to calculate a realistic number of billable hours to develop our Target Utilization Rate. The calculation below makes the following key assumptions:
Total Hours Paid or Total Potential Billable Hours in a work year equals 2,080 - basically 40 hours per week times 52 weeks in a year. Total Potential Billable Hours can vary by country or company. The following items are deducted from Total Potential Billable Hours to calculate Total Realistic Hours Available to Bill:
Vacation - the calculation assumes an employee would utilize three weeks vacation per year (obviously this amount can vary by company or person depending on tenure).
Time off from holidays - I assumed 8 days a year in my example.
Administrative/training time - Purely an estimate of 125 hours
After vacation, holiday and training/admin time is deducted from Total Hours Paid, 1,771 Realistic Hours Available to Bill are remaining. Our target utilization is calculated by dividing Target Realistic Hours Available to Bill / Total Hours Paid - which in this example is 85%. Actual Utilization would be Actual Hours Billed / Total Hours Paid.
Keep in mind the above is meant to be a demonstration - utilization rate calculations can vary by company philosophy.
The chart below demonstrates how the number of hours billed impacts the utilization calculation. Notice how total hours paid does not change - a full time employee would still be paid a fixed amount no matter how many hours he/she bills.
How Utilization Impacts Profitability
CROs may bill customers on units completed or time and materials - ultimately, CRO revenue is driven by hours billed. Utilization has a huge impact on overall CRO revenue and profitability. I am going to walk through numerous calculations to build up a profitability analysis with utilization as a key driver. First let's introduce a few financial terms:
Revenue - Total hours billed * a billable rate (I'll be using $135.52 in my example - I'll explain why I used $135.52 in a bit)
Variable Cost - Total annual compensation cost (including benefits, taxes, etc..) for a billable employee
Direct Overhead Costs - Direct overhead costs are included in the cost of service delivery - examples would be management, non-billable travel, etc... A good example would be the VP, Clinical Monitoring - that person would likely not be billable his/her costs would need to be considered.
Direct Costs - Variable Costs + Direct Overhead Costs or total cost of service delivery
Gross Margin - Revenue less total Direct Costs or profit after direct costs but before accounting for SG&A Overhead Costs.
SG&A Overhead Costs - Selling, General & Administrative costs associated with running a CRO. My role as CEO of Clinipace, finance systems, marketing costs are all good examples.
EBITDA - Gross Margin - SG&A Overhead Costs or a common profitability metric used in the CRO industry. EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortization.
Raw Employee Hourly Costs
Understanding the economics around becoming profitable are essential to running a business. Successful CROs typically have a good handle on their service delivery costs. Our first set of calculations will show total hourly cost per employee before taking utilization into consideration.
The items below not highlighted in yellow are primarily the items referenced above (Variable Cost, Direct Cost Overheads, etc...). The takeaway from the schedule below is the conversion of all those costs to what I call a Raw hourly Rate. The Raw Variable Cost or the Billable Employee Cost is converted to an hourly rate of $57.69. It's a simple calculation - Total Variable Cost (or compensation) of $120,000 / 2,080 Total Hours Paid (or potential billable hours). We know that if our employee worked a full year, he or she would be paid $120,000. The other cost elements are converted in a similar fashion (I used estimates for the other items to work through the example).
We all need vacation/holiday time so assuming an employee would bill a full 2,080 hours isn't realistic. Achieving our Raw Total Cost Per Employee (which would be 100% utilization and efficient) isn't practical.
Realistic Employee Hourly Costs
Below is the same calculation but using an 85% utilization rate (from our previous utilization calculation) which results in a more realistic 1,771 hours billed. You can see that our Total Employee Costs are still $192,000, however our Hourly Employee Cost has increased to $108.41 because we are spreading our total costs over less billable hours (1,771 vs. 2080). Our hourly service delivery cost at 85% utilization increased by over 17%.
The schedule below show how hourly service delivery cost changes with utilization - cost goes up as utilization goes down.
The schedule below shows the potential profitability impact of using our Realistic Hourly Rate versus our Raw Hourly Rate. Many CROs (and service providers) use a cost markup percentage to determine their hourly bill rates. In our scenario, using a 20% markup rate, had we marked up our Raw Hourly Rate of $92.31 but billed our Realistic Hours (1,771), we would have left $34,000 of EBITDA on the table. A good example as to why its important to know your true delivery costs.
The schedule below (last one - I promise), shows the profitability sensitivity at differing utilization levels. Our total costs stay the same at $192,000, however our revenue decreases in tandem with utilization. In our scenario, you can see the overall EBITDA turns to a loss at roughly 70% utilization (yellow shaded cells) and gross margin turns negative somewhere between 50-55% utilization.
Hopefully, I was able to demonstrate how utilization can impact a CRO's financial performance. Keep in mind there are numerous other factors that drive profitability, just to name a few:
Larger CROs typically gain operating leverage by spreading their SG&A costs over a larger pol of billable hours
Some CROs can charge higher prices due to being a premium service provider (thus generating a higher gross margin %)
Some CROs may have a strategy to price at the low end, thus dereasing their gross margin % but increasing their dollar EBITDA
Quality - poor quality can result in rework that can't be billed
However, in all those scenarios (and many more), understanding your internal costs, target and actual utilization is key to selecting and implementing the right strategy. My next blog will touch on how utilization is just one component when assessing profitability.
Jason Monteleone is CEO of Clinipace & President at Pivotal Financial Consulting, LLC. Clinipace is a global mid-size CRO with operations in the Americas, Europe and Asia-Pac serving small and mid-size pharma and biotech sponsors. Pivotal provides Divestiture Assistance, Acquisition Advisory Services and Strategic Planning to the Pharmaceutical Outsourcing Industry. Jason can be reached at email@example.com, firstname.lastname@example.org. Follow me on Twitter @JMPivotal. Sign up for Jason's latest blogs and updates at my www.pivotalfinancialconsulting.com.