The Margin Mirage: Why Improving Metrics Might Signal Trouble Ahead

While practice leaders celebrate AI efficiency gains, these improvements are quietly eroding firm-wide profitability through hidden cost migrations. What if your improving metrics are actually leading you toward crisis?

This blog is the third in a series of five discussing the challenge for professional services pricing when disrupted by AI technologies.

Sarah Roberts (not her real name) was finally seeing glimmers of hope. After a brutal year where even the perennial rainmakers weren't hitting plan, indicators were pointing in the right direction. M&A deal flow was picking up, IT spending forecasts were strengthening, and certain pockets of her mid-sized consulting firm were showing surprising strength. The AI adoption metrics from her CIO's dashboard were trending up, with some practice areas reporting significant efficiency gains. A few innovative service leaders had dramatically reduced their delivery hours while maintaining or even improving their engagement margins.

But as CFO of a firm with hundreds of entrepreneur-minded VPs, Sarah knew that promising pilots don't always translate to enterprise-wide results. BCG calls this the 'jagged frontier' of AI adoption - improvements coming in unpredictable spurts across different practices and service lines. Still, the early signs were encouraging. Engagement margin percentages in the early-adopting practices were strong, and other service line leaders were starting to catch on.

That's when she noticed something in the enterprise financials that made her question whether these improvements were actually making things worse.

In our previous explorations of artificial intelligence's impact on professional services, we examined how AI is forcing a fundamental reinvention of the business model and why traditional approaches to client investments are becoming increasingly dangerous. But there's an even more immediate challenge lurking in professional services firms' financial statements - one that threatens to turn apparent success into real crisis.

The Engagement Margin Paradox

Consider the standard measure of success in professional services: engagement margin. For decades, this above-the-line metric has been the industry's north star - much like batting average once dominated baseball. Just as baseball teams historically paid premium salaries for high-average hitters, professional services firms have built entire systems around engagement margin percentages.

But baseball experienced a revolution when Billy Beane and the Oakland A's discovered that traditional metrics like batting average were poor predictors of what actually mattered - winning games. They found that different metrics, like on-base percentage and slugging percentage, better predicted success. More importantly, they recognized that the game itself was changing, requiring a fundamental rethinking of how value was created and measured.

Professional services faces a similar moment. The engagement margin formula was simple: calculate resource costs, add the desired margin percentage, and there's your price. In an industry blessed with steady demand and reliable growth, this cost-plus approach became the unquestioned standard. But just as baseball's traditional metrics failed to capture true value creation, engagement margin is becoming an increasingly unreliable indicator of firm success.

The Tech Company Mirage

"We need to become more like a technology company."

This rallying cry echoes through professional services boardrooms as firms grapple with AI's impact, but what does it truly entail? It's a seductive vision - higher margins, scalable solutions, better multiples. With this kind of opportunity, it's no wonder that several PE firms are currently rolling up professional services firms. The challenge, however, will be transforming them into exit-worthy entities.

Don't be fooled by "improving" engagement margings. The costs aren't going away. They're shifting.

This comparison reveals more than just different business models - it shows where AI's impact will hit hardest. As artificial intelligence reduces direct labor costs above the line, improving engagement margins, it simultaneously increases technology costs below the line through enterprise-wide subscriptions and infrastructure. Professional services firms, historically focused on above-the-line metrics, often miss this critical cost migration.

The Hidden Drain

The true impact of AI adoption reveals itself in shifting cost structures. Consider Microsoft's Co-Pilot: While it reduces billable hours on engagements - improving engagement margins - it introduces new enterprise-wide subscription costs based on total user count. These costs silently migrate from above-the-line delivery metrics to below-the-line IT expenses.

The result? A growing disconnect between practice-level success and enterprise economics. While service leaders celebrate improved engagement margins, the firm's overall cost structure steadily rises. The very metric designed to measure success now masks a fundamental transformation in how value is created and costs are incurred.

The Innovation Trap

Many firms counter concerns about falling delivery hours with promises of AI-enabled innovation - new products and services that will replace lost revenue. But this optimism reveals a crucial misunderstanding of what it takes to develop and maintain technology products.

The math is sobering. Resource-based calculations still drive pricing for a significant amount of solutions and offerings across the industry. When a professional services firm develops a new AI solution, they typically price it based on the resource costs invested in development - the same cost-plus thinking that governs their traditional services. But this approach ignores ongoing maintenance costs, upgrade requirements, and the fundamental differences in how technology products need to be sold and supported.

The Measurement Divide

The transformation from a professional services model to a technology company demands fundamentally different ways of measuring success. While traditional firms obsess over utilization rates and billable hours that drive Engagement Margin, technology companies focus on metrics that are tied to the economics of customer value: customer lifetime value (CLV) and customer acquisition costs (CAC), and Annual Recurring Revenue (ARR). These metrics aren't just different numbers on a dashboard; they represent an entirely new way of thinking about business performance. This shift in measurement philosophy exposes the central challenge facing professional services firms today.

The Cobbler's Children

The irony is rich: Professional services firms that advise clients on digital transformation often struggle most with their own technology investments.

"We're the cobbler's children," one managing director told me, referencing the old tale of the shoeless children of shoe makers.

As we explored in our previous article about the investment fallacy, most professional services firms lack basic capabilities for tracking investment returns or sales costs - a gap that becomes increasingly critical as AI transforms the economics of service delivery. The same firms that meticulously track billable hours often have no systematic way to measure the return on their technology investments or understand their true cost of sales.

The Warning Signs

How can financial leaders identify if their firm is caught in this success trap? Look for these indicators:

1.     Improving engagement margin percentages alongside flat or declining enterprise profitability

2.     Rising enterprise technology costs as a percentage of revenue

3.     Missing or inadequate investment tracking capabilities

4.     Resource-based calculations (effort/hours) driving pricing for a significant amount of solutions and offerings

The Recovery Challenge

Professional services firms aren't blind to these challenges. They recognize their limitations in adequately valuing, measuring, and allocating technology impacts. In response, many have attempted to bridge the gap with technology fees - additional charges added to client invoices as a percentage of total fees. But these efforts often meet resistance for a simple reason: clients struggle to see the value proposition.

"We tried implementing a tech fee," one national sales leader told me. "But our account leaders couldn't explain why clients should pay extra for something that should be built into our rates. When clients asked how this fee translated to better service or results, we didn't have good answers."

This reaction reveals something crucial about the industry's transition: The mindset of both firms and clients needs to change. But traditional metrics and capabilities are actually impeding this necessary evolution.

The Path Forward

Sarah Roberts's recognition of the problem catalyzed a fundamental transformation in how her firm measured and managed success. Beyond new financial reporting aligning practice-level metrics with enterprise economics, she introduced technology cost allocation models to proxy engagement impact. Her team developed capabilities to separate true innovation investments from routine technology costs.

Most challenging was the human side of change. She reconfigured leadership performance management systems and updated compensation models to reflect total economic contribution. New pricing models emerged to reflect the changing market - along with the "air cover" necessary to provide forgiveness as the organization learned them.

"We had to fundamentally rethink how we measured success," she told me. "Engagement margin was still important, but it couldn't be the only metric that mattered. Our field people were hesitant to try the new approaches. The change process, still ongoing, is a deal-by-deal support effort. It's tough."

The Stakes

For professional services CFOs and PE investors, the implications are significant. Traditional valuation models based on engagement margins may miss fundamental changes in enterprise economics. Due diligence must evolve to consider the full impact of technology costs and their allocation. Roll-up strategies need to account for hidden transformation challenges.

The firms that will thrive in this transition are those that recognize the limitations of traditional metrics and develop new capabilities accordingly. This might mean reimagining the construct of engagement margins to better incorporate enterprise economics. It might require new pricing models that better reflect the reality of AI-enabled service delivery. It will certainly demand new ways of measuring and communicating value.

As we'll explore in our upcoming examination of decoupling price from cost, the path forward requires more than just new metrics - it demands a fundamental rethinking of how professional services firms create and capture value.

The Call to Action

The margin mirage in professional services isn't just a reporting problem - it's an existential challenge to how firms measure and create value. The math is simple but often hidden:

Calculate your improving engagement margins against your rising enterprise technology costs. Now project that trend forward as AI adoption accelerates across practices. How long before apparent success becomes real crisis?

The window for adapting financial metrics and management approaches remains open. But for those who continue to rely solely on traditional measures of success, that window is closing fast.

Don't let improving metrics mask a deteriorating foundation. The time to act is now, before the margin mirage becomes a profit plunge. Re-evaluate your metrics. Rethink your value. Reshape your future.

Disclaimer: The stories and insights shared in this blog are based on my personal experiences and conversations throughout my career. While some content reflects recent events, they are drawn from a broad range of interactions with professionals across professional services, including friends and colleagues from various organizations, and do not specifically refer to or represent any single employer, past or present. Identities have been anonymized, and quotes may be paraphrased or combined for clarity and storytelling purposes. This blog is a personal endeavor and does not reflect the views or proprietary information of any employer.