Warning! We’re learning how to get rich (slowly) here. If you’re not interested in learning how to make money as an architect, carry on with your daily grind. For the rest of you… pay attention. We’re going to get deep into the numbers now.
This is Part 2 of a 3 part guest post by Steven Burns, FAIA, the Director of Product Strategy and Innovations at BQE Software. Steve is the creator of ArchiOffice® the leading office, project management and time tracking software used in more than 1,000 small and mid-sized architectural firms. In the 14 years Steve managed Burns + Beyerl Architects, the firm he co-founded in 1993, the firm’s earnings grew at an average rate of 24% per year (wouldn’t that be nice?).
Please visit Steve at Linkedin and Twitter, or check out his Blog and thank him for sharing with us at Entrepreneur Architect. – Mark
(This post contains spreadsheets, which may not view properly on some devices. You may download a PDF version of this post here.)
Financial Management for the Small Architectural Firm: Terminology and Examples
In my previous article, I made the strong case as to why your small firm needs to think like a business and not just like an architect. Your financial health starts with creating an Operating Budget – also known as a Profit Plan. Why a profit plan? Because you’re in business to make money, that is profit. Remember; no profit equals no business.
I’m going to share with you how to develop the simplest, most bare-boned version of a Profit Plan that is helpful to any small or emerging firm. So grab a pencil, a piece of paper and a cup of coffee. Turn off your email and silence your phone. This is dry material for an architect but important information you need to know.
There are three steps you need to do when creating a profit plan:
Step 1: Estimate your expenses. Don’t include any of those that are reimbursed by your client (e.g., printing, travel, pass-through consultant fees, etc.).
Step 2: Set a Profit Goal. This is generally thought of as your return on investment (ROI). It’s a percentage of your total expenses. All the effort, and money, you put into the business should return you a profit. This is what you would expect if you invested the money in something else like stocks, bonds or real estate. What’s the return you want to see? I recommend 20%. Otherwise, take the money and invest it in the stock market. You’re also pouring your life into these projects so the return should be commensurate with the effort.
Step 3: Add your expenses with your Profit Goal to get the Net Revenue Goal. This is called Net because it doesn’t include those reimbursable expenses I mentioned earlier. Your Net Revenue Goal is what you plan to invoice your clients for your services. In the sample profit plan shown below, the Net Revenue Goal is $500,000.
(You may download a PDF version of this post here.)
SAMPLE PROFIT PLAN |
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|
|
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5 Person Firm |
|||||
SALARIES |
|||||
Principal |
(1 @ $100,000) |
$100,000 |
|||
Project Architect |
(1 @ $70,000) |
$75,000 |
|||
Intern Architect |
(2 @ 35,000) |
$70,000 |
|||
Office Administrator |
(1 @ 25,000) |
$25,000 |
|||
TOTAL SALARIES |
$270,000 |
||||
PAYROLL TAXES AND BENEFITS |
$30,000 |
||||
OFFICE EXPENSES |
|||||
Rent |
$50,000 |
||||
Utilities |
$5,000 |
||||
Telephone |
$2,000 |
||||
Equipment Purchase/Maintenance |
$12,500 |
||||
Postage/Shipping |
$1,000 |
||||
Publications |
$667 |
||||
Insurance (Auto, General Office, Liability) |
$12,500 |
||||
Office Supplies |
$5,000 |
||||
Travel |
$6,000 |
||||
Printing |
$7,000 |
||||
Marketing Tools |
$10,000 |
||||
Miscellaneous |
$5,000 |
||||
TOTAL OFFICE EXPENSES |
$116,667 |
||||
TOTAL EXPENSES |
$416,667 |
||||
PROFIT GOAL |
(20% x Total Expenses) |
$83,333 |
|||
NET REVENUE GOAL |
$500,000 |
||||
Reaching Your Profit Goals
Now that we have created our Net Revenue Goal of $500,000 we need to understand where this revenue is derived. Architects earn their revenue (and profit), by working on projects. So it should come as no surprise that the most common denominator for planning and measuring financial performance is the Direct Salary Expense (DSE). This is the salary cost of the hours charged to projects (your billable time).
We can actually use the sample profit plan to easily calculate our DSE multipliers. These are the numbers that will be used to determine the values such as the target break-even, profit and revenue amounts. But in order to do this we need to know our Efficiency Ratio.
Efficiency Ratio = Direct Salary Expense / Total Salary Expense
Or
Direct Salary Expense = Total Salary Expense x Efficiency Ratio
So how do we know the efficiency ratio for your firm? Well, I don’t. But there are statistical surveys which show that, on average, architectural firms achieve about 65%. This averages all employees (principals and all employees). While Principals may only be 50% efficient (spending 20 of their 40 hours/week billable on projects), Interns may be 95% efficient. Please, no comments about the 40 hours/week. I know, I know.
I use ArchiOffice to help manage project finances. Among other things, It’s able to monitor your staff’s efficiency daily, weekly and annually. You can set targets for them and know if the Efficiency Ratio you are using is realistic. Understand that low efficiency ratio equals low revenue potential and a high efficiency ratio equals high revenue potential.
So let’s modify the sample profit plan above by making adjustments to acknowledge our estimated efficiency ratio:
(You may download a PDF version of this post here.)
SAMPLE PROFIT PLAN |
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Using 65% Efficiency Ratio |
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DIRECT SALARIES |
($270,000 X 0.65) |
$175,500 |
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INDIRECT EXPENSES |
|||||
Indirect Salaries |
($270,000 x 0.35) |
$94,500 |
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Payroll Taxes and Benefits |
$30,000 |
||||
Office Expenses |
$116,667 |
||||
TOTAL INDIRECT EXPENSES |
$241,167 |
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TOTAL DIRECT SALARES + INDIRET EXPENSES |
$416,667 |
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PROFIT GOAL |
(25% x Total Expenses) |
$83,333 |
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NET REVENUE GOAL |
$500,000 |
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In the chart above we know that our Total Salary is $270,000. But since we have a 65% efficiency ratio – our Direct Salary Expense is $270,000 x 0.65 = $175,500.
To Pay for DSE: $175,500 / $175,500 = 1.00
To Pay for Indirect Expenses: $241,167 / $175,500 = 1.37
Combined, these give you the Break Even Multiplier of 2.37.
Now, you’ll want profit: $83,333 / $175,500 = 0.47
Therefore, your Planned Net Multiplier is 2.85. This is that magic number, specific to your firm.
Setting Ideal Billing Rates
The Planned Net Multiplier is an incredibly important number to help you determine what the minimum hourly billing rates should be for your staff. So let’s take a look at each staff member:
(You may download a PDF version of this post here.)
COST RATE AND IDEAL BILL RATE |
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Principal |
Project Architect |
Architect Intern |
|
Gross Annual Salary |
$100,000 |
$75,000 |
$35,000 |
Payroll Tax (15%) |
$15,000 |
$11,250 |
$5,250 |
Health Insurance |
$8,000 |
$4,000 |
$4,000 |
Retirement Plan |
$3,000 |
$2,250 |
$1,050 |
Net Cost/Year |
$126,000 |
$92,500 |
$45,300 |
Gross Hours/Year |
2,080 |
2,080 |
2,080 |
Vacation |
(120) |
(80) |
(80) |
Holiday/Personal Leave |
(80) |
(80) |
(80) |
Net Hours Worked/Year |
1,880 |
1,920 |
1,920 |
Net Cost Rate/Hour Worked |
$67 |
$48 |
$24 |
Planned Net Multiplier |
2.85 |
2.85 |
2.85 |
Ideal Billing Rate |
$191 |
$137 |
$67 |
As long as your office maintains the 65% efficiency rate you must bill your Principal at $191/hour, your Project Architect at $137/hour and your Architect Interns at $67/hour to obtain the desired profit.
Granted, some firms don’t like to look at the global efficiency rate, opting instead to evaluate the Ideal Bill Rate for each employee based on their true efficiency levels. But that’s a discussion that I don’t want to get us involved with at this time.
The final exercise we’ll do at this stage is to calculate the Projected Realizable Income from each of our employees.
(You may download a PDF version of this post here.)
Potential Realizable Income |
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Principal |
Project Arch. |
Intern 1 |
Intern 2 |
Total |
|
Net Hours Worked/Year |
1,880 |
1,920 |
1,920 |
1,920 |
|
Actual Efficiency Rate |
50% |
75% |
90% |
90% |
|
Billing Rate |
$200 |
$125 |
$75 |
$75 |
|
Realizable Income |
$188,000 |
$180,000 |
$129,600 |
$129,600 |
$627,200 |
As we can see, the Total Realizable Income of $627,200 is greater than the $500,000 we projected in our Profit Plan. In order to achieve the profit plan we only need to invoice 80% of our potential. This is a very common position for most firms. Obviously, we would like to bill the full potential and hopefully you will. Considering that the Principal will be spending half of his or her time working on non-billable things we would hope that these efforts are what will continue to bring new work into the firm.
Our next installment will be to discuss the practical applications of your office financial management.
Thank you for sharing this information. It similar to the information in the Architect’s Handbook of Professional Practice but the author explains the method very well. Have do questions. How do you apply this method if you are sole proprietorship and how do you determine Overate? I have seen other methods to determine billable rate use overhead rate.
Jerome,
The AIA’s Handbook of Professional Practice is a great resource that is often overlooked and in desperate need of updating. I’m currently working with the AIA Small Firm Roundtable on a project to create a Small Firm Toolkit which would be the go-to source for small and emerging firms. Not as overwhelming as the Handbook and also built for a new generation.
As to your question about overhead rate for a sole proprietorship. The basic concept isn’t any different than if you have 1, 3, 5 or 25 employees, so I would continue to do the spreadsheet but adapt it for just the one employee (you).
You are correct, there are various methods used for calculating an employees billing rate. I gave one good example. Many firms simply take the firms’ planned net multiplier (overhead rate) and multiply that by the employee salary rate. That may be fine in most situations but it could also depend on the realization (efficiency) of the employee. As a sole proprietor, you’ll probably see a very low efficiency rate. But there are other non-typical factors to a sole proprietor. Overhead costs tend to be very low. For example, there may not be any rent if you’re using your home as the office. And the hours you spend/week may be significantly different than if you had a partner or staff. You could spend more or less hours depending on your lifestyle choice.
Thanks for following up Steve. So much information here. Thanks again.
All these should be taught at 1st year of architecture school. Architects should also get involve in small construction or properties flipping projects as these will sharpen the real world business skill even faster. After doing a few, one might not even want to be an architect for hire anymore; instead you just want to do your own project as a builder.
Great beginnings, will look for the follow up at once.
Thank you
Question:
you mention ArchiOffice in your post. I use quickbooks and I am getting pretty good with it although improvements can be made (for me) with cashflow projection. Any comments?
Steve;
Again, thx for this info, really appreciate it.
I am going through the efficiency ratio but the profit goal jumped from 20 to 25%. is this correct and what would be the reason for the change?
Great article! The way you lay out cost, expense, and billing rates is so honest it is refreshing.
Steve, this is an excellent tutorial that every firm leader and project manager of every professional design firm should read, learn and master to enhance their firm’s profitability.
I would however, with all due respect, point out one serious flaw in the Sample Profit Plan for the calculation of the ‘Profit Goal’ to get to determine the ‘Net Revenue Goal’.
The above calculation is mistakenly based on the ‘mark-up’ method and doing it that way would cost a firm, for a 25% profit target, a large percentage of the potential ‘Profit Goal’, than if it were otherwise properly calculated.
Rerspectfully, I offer the following method as the proper calculation for the ‘Profit Goal’ and the ‘Net Revenue Goal’:
1. First determine the ‘Net Revenue Goal’ by dividing the ‘Total Expenses’ (Break-Even Cost) by the complement of the desired Profit Goal. For a 25% profit, the denominator would be 75%.
Example: Using the figures from the article; Total Expenses (Break-Even Cost) are $416,667, when divided by 75% the ‘Net Revenue Goal’ would be $555,556.
2. Next, check and verify by multiplying the ‘Net Revenue Goal’ ($555,556) by 25% and it provides a ‘Profit Goal’ of $138,889.
3. Then, compare the ‘Profit Goal’ in the article ($83,333) to this properly calculated ‘Profit Goal’ ($138,889) and the difference is $55,556, which is an amazing 67% more profit than the amount calculated when using the mark-up method.
There are many reasons why our professional colleagues are unable to create financial sustainability for their firms. This simple mistake in the calculation of the ‘Profit Goal’ will impact every project and rather than enhancing profitability, it will diminish the potential amount of profit.
In my experience over the last 45 years, this is but one of dozens of mistakes made every day because most professional design firm leaders and project managers, “don’t know what they don’t know. The knowing of which would alter their lives forever” (Werner Ehrhard).
I would be pleased to discuss this topic with you and any of the readers of this excellent article if you and/or anyone else might be interested in expanding the dialogue in the interest of ‘best practices’.
Respectfully,
J’ai une question:
Qu. Why would One hire an intern @ 75/hr and not a principal architect @125/hr , what defines the value that you need at any one time?