April 11, 2017 20:30
I’ve been thinking a lot lately about how companies buy management consulting services. This has led me back to a slightly more fundamental question as to the economic incentives that underpin the decision to buy these services i.e. what is the economic rate of return that needs to be on offer to ‘induce’ a manager to engage consultants?
The economically rational manger will spend/invest in anticipation of an economic return that exceeds her ‘hurdle rate’. In considering whether to engage consultants she will need to form a point of view as to whether the expected benefits arising from the consulting engagement – e.g. better operating performance, a more effective organization, better understanding of an existing risk or a perceived opportunity – provide an adequate rate of return on the fees that she will need to pay the consultants for their work. (note: in considering this, she should only recognise the incremental value that the consultants will bring relative to the ‘no-consultants’ scenario; consultants are often engaged to support high value opportunities and commonly make claim to ‘delivering’ the full value of the situation. In fact, their value relates only to the acceleration and/or improved capture of the opportunity associated with their activities).
From my own observation, I have postulated a target project NPV of about $2.7 per dollar of consulting spend ( based on a simple model where each dollar spent on consultants today provides the company with a dollar benefit in each of the following five years).
This target is set in anticipation/recognition that some projects will fail to deliver the anticipated benefits and that the net return of the consulting project portfolio will be significantly lower than the project target. For example, if ten percent of projects fail to deliver their expected return, the portfolio return drops to about $2.3 per dollar of consulting spend.
Again, my observation would suggest that the he average 'success' of projects is only about 60% (a mix of failed projects and/or projects which only partly meet their objectives). This leads me to calculate an expected net return on the consulting project portfolio of around $1.2 (basically, double your money across the portfolio of projects) and an implied hurdle rate in the 50% range.
Any views on this out there? I know that most managers wouldn’t explicitly do these types of calculations as part of the decision to hire consultants, but do these numbers ‘feel’ right? What is the ‘risk free inducement rate’? What proportion of projects fail to deliver on their target? By what amount? What is the ‘net return on consulting’?
Originally published on December 12, 2016 in LinkedIn Pulse.