The Importance of Leverage

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During consultancy interviews, after the inevitable grilling, you will often be asked if you have any questions. One question which will display your understanding of the industry is ‘what is the leverage ratio in your company?’. In fact, asking such a question is crucial, not solely for budding applicants but also for anyone running their own consulting business and reflecting upon their strategy.

So what is leverage and why is it so important?

Leverage is the figure you get if you divide the number of fee-earning consultants by the number of partners. It is crucial, not simply because it is one of the three factors that make up Profit Per Partner, but because the leverage ratio of the firm will determine its entire strategy, from recruitment and training to knowledge management, business development and the type of work it undertakes.

Let’s take two examples.

AAA has a high leverage ratio (around 30) because it generally performs fairly standardised IT and Outsourcing work. It has long manuals and procedures to guide consultants what to do and when. The great thing about standardised work is that you do not need to pay Harvard MBA rates to get it done: recruits tend to be mid-range graduates on mid-range pay and clients expect to pay mid-range fees. Standardised work also means that consultants do not need high levels of supervision, thus for every partner, it is okay to have a high number of consultants. Unfortunately for the graduate (but fortunately for the firm) this means they do not need to promote many consultants, that their average wage isn’t particularly high and that opportunities for training are very limited.

BBB on the other hand is a high-end strategy consultancy with a low leverage ratio. The reason it can charge high prices for its work is because it recruits the best people: problem-solving, creative types with great CVs – but it needs to pay them good salaries to keep them. Strategy work is rarely highly commodified – the tools and methods might be similar, but CXO level clients want a personalised and very high quality service. As a result, the Partner must be heavily involved in the work that consultants perform and also in their development and mentoring. As a result, leverage ratios can be as low as 7.

Note that the leverage ratio must fit with the strategy of the firm, their approach to talent management, the work that is performed, the way knowledge is managed internally, the promotion and training opportunities, and the pay of consultants. Yet both models are equally valid and can both generate great PPP.

A consequence of this is that firms change their leverage ratio at their peril. Increasing the leverage ratio of, say, McKinsey, may, in the short term increase profits (if there is work available) but, in the longer term, staff will leave because there will be fewer promotion opportunities and less challenge. Moreover, the reputation of the firm will eventually suffer because there is less mentoring and supervision, less staff development and consequently, poorer quality work.

A second issue to note is that in a well-run firm, the consultant does the work perfectly suited to their grade. If you have high-level consultants doing low level, commodified, work, your profit margins will be lower and you will have bored consultants. If you have low-level consultants doing high-level work, the project, and eventually your reputation will suffer.

Leverage is THE central metric in consulting firms around which the firm’s strategy must rotate.

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One Response to “The Importance of Leverage”

  1. Consulting Ideas » Blog Archive » Part Two: What the War for Talent means for Consultancies Says:

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