Project Profitability Analysis: The Ultimate Guide to Metrics, Formulas, and Management

What projects should you accept and which ones can you decline? Many companies take every project that comes their way, and that might be a good solution in some situations. But at some point, you’ll have to make difficult choices as your company resources are limited. One way of making that choice is analyzing project profitability.

Project profitability analysis allows C-level executives to form an understanding of how much cash flow can be expected in the future and what margin rate each project has. In this article, we’ll explore what project profitability analysis is, what metrics you can use, how to calculate profitability, and what best practices you need to follow to analyze profitability.

Key takeaways:

• Project profitability analysis measures how profitable a new project can be or a past project was.
• It’s important for financial forecasting and project prioritization.
• To do it effectively, project managers need to accurately predict project costs, calculate project revenue, and use the profitability metrics to compare similar projects.

What is Project Profitability Analysis?

Project profitability analysis is the process of measuring how profitable a new project can be through examining multiple financial metrics. The metrics used for this analysis can include:

• Project profitability index formula.
• Return on investment.
• Utilization rate.
• Rate of realization.

Why is project profitability analysis important?

Analyzing project profitability is important for making strategic decisions because it allows project managers to:

• Understand which projects bring in more net profit.
• Create a data-backed pricing strategy.
• Prioritize projects based on profitability.
• Plan financials more accurately.
• Increase financial health of the organization.
• Keep predictable margins.

Where is project profitability analysis relevant?

Analyzing project profitability is relevant for all types of commercial projects. R&D projects don’t require profitability analysis as any profitability calculations will be far removed in the future and not very accurate.

Client-oriented projects where the revenue comes from a client commission as opposed to market sales are best suited for profitability analysis because the revenue is straightforward.

How to measure and determine profitability metrics

How to measure profitability? There are multiple metrics you can use. Here’s an overview of the most common and most effective ones.

Understanding the profitability formula for project success

The most basic project profitability formula is this:

But calculating true profitability is not as straightforward as this simple formula. You need to learn the following terms to understand the profitability formula.

• Direct costs. Costs of material and personnel directly involved in executing the project.
• Overhead. Also referred to as operational costs, additional costs associated with running the company, e.g. office space rent, admin staff payroll, insurance, etc.
• Gross profit. Profit made on the project after accounting for direct costs.
• Net profit. Profit made on the project after accounting for operating expenses.
• Profit margin. Representation of profit as a percentage of revenue.
• ROI. Return on investment, a comparison between net profit and project cost.

Now, let’s take a closer look at essential profitability equations for financial tracking

Gross profit

Gross profit is a metric that looks at profitability only taking into account the costs directly associated with creating a good or a service. The formula for determining profitability with gross profit is pretty simple:

Gross profit = Revenue – Direct costs.

The direct cots typically include billable hours and materials. For example if the project pays $10,000 and requires $2,000 in materials, and $3,200 in employee compensation, the gross profit calculation would look like this:

$10,000 – $2,000 – $3,200 = $4.800

Net profit

Net profit is a more accurate profit projection that takes into account the overhead costs like:

• Admin staff payroll.
• Marketing expenses.
• Facility costs.
• Depreciation.
• Amortization.
• Loan payments.

The formula for calculating profitability with net profit is:

Net profit = Gross profit – Overhead expenses.

The most important thing in calculating net profit is understanding your company’s overhead expenses and distributing them between the projects. The unit of distributing the overhead across projects is called allocation base.

The easiest way to define it is to base your calculations on the total number of hours available. You can also make total revenue or total budget spent on your allocation base. Allocation base helps you distribute the overhead between projects based on what share of company resources a project takes. The formula for calculating overhead distribution is as follows:

Overhead = (Project allocation base/Total allocation base) * Total overhead

In the example above, let’s say the company’s total monthly overhead that includes rent, utilities, and admin payroll comes to $25,000 and the resource capacity is at 700 work hours per month. The project in question takes 100 hours to complete. In this case, the calculation of overhead would look like this:

(100/700) * $25,000 = $3,571

The net profit calculation would look like this:

$4.800 – $3,571 = $1,229

Test different approaches to calculating the allocation base as they often lead to slightly different results. For instance, using the total number of work hours available at a company might produce a skewed picture in cases where the company doesn’t work at full capacity.

Profit margin

Profit margin is one of the most telling metrics in profitability analysis as it represents profit as a percentage of the revenue. The formulas for it are:

Gross profit margin = gross profit/revenue * 100

Net profit margin = net profit/revenue * 100

For the example we’ve been using, the numbers would be

$4,800/$10,000 * 100 = 48%

$1,229/$10,000 * 100 = 12%

This metrics helps you benchmark the profitability of a project against your average performance and goals to understand whether you should start or discard it. Renegotiating the payment is also one of the options if you see that the profit margin is not in line with your expectations.

Return on investment

ROI is one of the most widely used business metrics and is applicable to multiple areas of business, from R&D to marketing investments. In project management, it can show how much money you can expect to get back from every dollar spent. The ROI formula for project profitability goes like this:

ROI = net profit/total costs * 100

For the example we’ve used, the ROI would be:

$1,229/($5.200 + $3,571) * 100 = 14%

There are multiple ways to approach the ROI formula, though. In this example, we’ve added overhead, but you might omit in some cases:

• A project manager that doesn’t have control over overhead.
• Only project-level ROI is relevant.
• Other projects’ ROIs are calculated for direct cost and including overhead will prevent fair comparison.

For some projects, you might need to calculate other similar metrics.

• Payback period. Calculates how many years it would take for cost savings to break even with investments. Useful for internal R&D projects.
• Cost-benefit ratio. Calculates ROI of projected benefits of a project, not always represented as direct payment. Useful for R&D projects, but relies on accuracy of benefit evaluation.

Read more: How to Calculate ROI for a Project: Formula, Examples & Expert Tips

Rate of realization

If your company invoices the client by the hour instead of charging a fixed fee, rate of realization is a good metric to use. It finds the ratio of hours worked to hours billed to your client. The formula is:

Rate of realization = hours billed/hours tracked * 100

If this metric is lower than 90% this indicates that employee time that your company pays for is written off too often and not charged to the client. This shows either a billing or performance issues.

Calculating Profitability for Data-driven Reporting

Let’s look at a step-by-step process you can use to calculate project profitability. You can omit or add steps to fit your internal workflows and governance structures.

Create revenue projections

For projects with a fixed fee, this step is not necessary. With those, revenue is the sum a client agrees to pay before the project starts. For projects that rely on hourly billing or another type of payment, you may have to calculate the revenue.

Assess direct costs

A crucial step in profitability analysis is assessing the costs that go into the project. For many industries, human resources will be the main source of expenses for a project.

To assess how many hours a project will take, you need to meet with the team who is going to be doing the project and discuss how much time it could take. Compare it to historical data on projects with similar scopes, and consider adding a 15-25% buffer for resource requirements.

Assess overhead costs

The two data points above provide enough information to calculate gross profit and gross profit margin. To calculate the net profit margin, you’ll need to assess overhead costs. If you already know the monthly overhead and overhead allocation base in your organization, use them for calculations.

If not, start with calculating overhead costs. They include nonnegotiable expenses like administrative team payroll, office or facility expenses, and loan payments. In some cases, marketing spending is also included in overhead calculations.

Then, determine your approach to the allocation base. You can use:

• Share of total available non-admin hours.
• Share of total expected revenue.
• Share of total direct costs.

The idea behind the allocation base is to divide overhead expenses equally across a uniform unit. When total available hours serve as the allocation base, one hour of work incurs and therefore must cover an equitable share of overhead.

Determine metrics and KPIs

Once you have all the input data, decide which metrics you’re going to use and what results you intend to see. It’s important to use metrics and metric calculation methods consistently across all projects. Make sure KPIs are reasonable. For instance, if historically you were looking at 15% gross profit margin, setting a KPI to 50% would probably only lead to disappointment.

At the very least, you need to calculate gross profit and gross profit margin. Use other metrics if it makes sense in your project. Keep in mind that comparing projects based on different metrics may be impractical, and using the same metrics for vastly different types of projects may provide a skewed vision of their importance.

Read more: 10 PMO KPIs: Essential Metrics to Drive Project Portfolio Performance

Apply metrics

Use the input data to calculate the metrics you’ve chosen. Benchmark the results against the KPIs, historical performance, and compare them across the range of projects you’re choosing from.

Make decisions

Once you have an understanding of project profitability, you have several options:

• Initiate the project if it meets your profitability criteria.
• Renegotiate the price if the profit margin is slightly below the desired number.
• Postpone a project if you’re choosing among multiple and prioritizing ones with higher margins.
• Discard the project if the metrics are not right.

In many cases, project managers only create a project profitability report, and decisions are taken on a higher level.

Read more: How to Make Project Decisions Faster with Epicflow

Analyze performance after delivery

Project profitability analysis runs on estimations. If you don’t assess the amount of hours it takes to deliver the project, the whole profit magic calculation is off. If a project takes significantly longer to complete, you might even come to a point where you lose money on it.

To understand whether your estimates were correct, do another assessment after the project is complete.

It’s best to use project management tools that can track project progress and notify you when the budget is in danger so you can take preventive steps.

Make changes in your approach

If after the final analysis you find that some project assessments were incorrect, you’ll need to make changes to your processes. You can either change the project estimation process to be more accurate and raise the price to match the desired level or find ways to improve resource productivity.

Best Practices for Project Profitability Management

Here are a few best practices that can help you improve project profitability.

Accurate project assessment

To create an accurate projection of project profitability, project managers need to project resource requirements for projects accurately. If human resources are your most prominent expenditures in project costs, making a mistake might mean the difference between making a profit and breaking even.

To make accurate predictions about the amount of resources it would take to finish a project successfully:

• Consult the people who execute the project.
• Analyze historical performance data.
• Consider project novelty as an important factor.
• Add time and capacity buffers to project estimates.

Project scope management

An accurately assessed project can still fail to deliver a desired profit margin if its scope increases. Whether it’s due to internal pressure or due to the client changing their preferences, scope creep means increasing the amount of hours a project takes to complete.

In cases where the project is billed hourly to the client, it’s not a big deal. For projects with a fixed fee, you’ll need to find a way to manage the scope. Typically, you’d either renegotiate the fee upon project reassessment, or agree to add new features as another project once this one is finished.

If you find that you have to deal with scope changes often, it’s best to create a change management framework to standardize the approach towards expanding project goals.

Risk management

Managing project risks ensures your team stays on budget and delivers the project with the expected margin. It’s a complex process that goes beyond profitability assessment, sometimes involving a separate branch of project management. In short, your team needs to:

• Identify potential risks.
• Calculate their probability and impact.
• Create contingency plans for each scenario.

Here are a few examples of contingency plans:

• Subcontractor cannot deliver on their part of the deal: have substitute subcontractors on call.
• Price of supplies increases: procure supplies beforehand.
• Resource requirements assessment is wrong: add a buffer to the estimates.

You might also take overall portfolio risks into account, this will provide more clarity on whether you can accept projects with higher risk at the moment.

Resource optimization

Managing operational risks is one of the major parts of project portfolio management. They occur when projects conflict with one another and lead to resource overload. In this case, a company’s resources have more workload than they can manage, and projects take more time to complete.

This happens quite often, especially in rapidly growing companies. To solve this problem, you’ll need a mix of performance tracking, workload management, and project prioritization.

• Use PMO software to view your portfolio timeline.
• Find instances where projects overlap and lead to resource overload.
• Decide which of the overlapping projects has more priority.
• Shift the timelines to avoid overload.

Performance analysis

Analyzing how well your resources perform and tracking how many hours were spent on the project helps you understand the real costs that went into it. It also allows for more accurate project assessment in the future. If you constantly see that projects take more time than expected, you need to change your approach towards project assessment.

Reviewing workflows

It’s impossible to create a perfectly functioning system on the first try. Even with a calculated and data-backed approach, it will typically take some time to fine-tune a project profitability analysis system you’ve made.

Analyzing the accuracy of your estimates and the relevance of the metrics you use for project profitability analysis is part of the process. Do it regularly and change your processes if needed.

Strategic balancing

The ideal approach to profitability analysis in project management is, as with many other parts of a modern enterprise, a holistic one. You can’t view it as a process separate from the rest of the company.

Here in particular, treating the process as separate can mean chasing margins without understanding the whole picture of the company. If, for instance, net profit margins seem consistently low, this might mean that your organization needs to reduce overhead instead of trying to fit an unrealistic KPI.

Increase Margins Using Project Profitability Software

Let’s take a look at how using a project portfolio management tool, Epicflow, can help your organization achieve better margins.

Resource performance tracking

The first part of the process is tracking resource utilization and performance.

• View your portfolio as a Gantt chart to see which projects depend on each other and intersect in time.
• View it as a Bubble graph dashboard to see which projects are at risk of being over the budget.
• Analyze resource performance with capacity planning software to find resource overload.

Resource performance analytics

Analyzing how your resources perform now and how they might perform in the future lets you plan projects better and avoid bottlenecks. It also informs your future project assessments which improves the quality of the analysis.

Epicflow lets you do that with two primary analytical solutions:

• Historical load graph shows current performance and highlights existing bottlenecks in the portfolio.
• Future load graph shows predicted load based on scheduled projects and lets resolve potential future bottlenecks.

You can also access statistics like budget variance and schedule variance to understand where your planning has gone differently than expected.

Proactive operational risk management

The second is fixing planning errors that can lead to resource underperformance.

• Use scenario planning software to simulate scenarios with different project timelines to see which one performs best.
• Use Epicflow Portfolio Optimizer to automatically sort your portfolio based on resource availability and project priority.

Final thoughts

Project profitability analysis is an important part of financial planning and project prioritization. Use it to compare projects correctly, as only revenue-driven projects can be accurately compared with profitability metrics. Analyze and improve accuracy of calculating project costs and timeline to improve predictions on future cash flows.