This is a guest post written by Steve L. Wintner, AIA, Emeritus, an architecture management consultant and co-author of the book, Financial Management for Design Professionals: The Path to Profitability. To learn more about Steve, his firm Management Consulting Services or to dive deeper into the subject that Steve is sharing with us here at EntreArchitect™, visit his website at ManagementConsultingServices.com.
I am often asked, “How might I make my small firm more financially successful?” Well, a great place to start is to track your progress and adjust as necessary. Steve shares seven key financial performance indicators that we should all be following.
Do you have questions? I’d love to know your thoughts. Share your comments following the post below and Steve will follow up with some answers.
The material for preparing an annual budget, an annual profit plan, developing project fee budgets, and calculating billing rates—is the stuff of financial planning. Each is a type of forecast that serves as a benchmark for financial management. Annual profit plans and annual budgets are your firm’s financial goals expressed in dollars—your vision of what you hope your firm will achieve in the coming year. Accurate project fee budgets and profitable billing rates are your tools for achieving those goals.
With an annual budget and profit plan in place, and with good accounting and financial management practices (time and expense reporting; accurate project fee budgeting) throughout the firm, managing your firm’s finances is a relatively simple process consisting of three tasks:
- Measuring the variances between your year-to-date actual financial activity and your year-to-date budget
- Understanding why these variances have occurred
- Taking prompt, corrective action, as necessary
You can complete the first two tasks—measuring variances and understanding why they have occurred—by regularly tracking the seven key financial performance indicators related to the accrual-based Profit/Loss Statement. These seven indicators provide a snapshot of your firm’s financial performance at a given point in time. Their greatest value, though, is in showing trends as they develop over time. As the indicators go up or down, they signal underlying changes in the firm’s financial performance. All indicators will vary with normal business cycles—which you will come to recognize—but a consistently downward or upward trend over several reporting periods without a clear reason for such a trend could be an early warning sign of an erosion of your financial plan for the year. Firm principals who are good financial managers monitor such trends, determine why they are occurring, and respond to them before they develop into a serious problem.
The Seven Key Financial Performance Indicators (KFPI’s)
The seven key indicators, in no particular order, are:
- Utilization rate
- Overhead rate
- Break-even rate
- Net multiplier
- Aged accounts receivable
- Profit to earnings ratio
- Net revenue per employee
1. Utilization Rate
Formula: (total direct labor / total labor) × 100
(Note: the utilization rate is usually measured in hours and expressed as a percentage.)
Your firm’s utilization rate is the ratio of the time worked on projects (direct labor) to total hours worked (total labor), expressed as a percentage of total hours worked. It is not a measure of billable time versus nonbillable time because not all time charged to projects is billable. Nor is it a measure of productivity, which is notoriously difficult to measure in professional service industries, including professional design firms. Finally, it is not, by itself, a measure of profitability, though maintaining a utilization rate in an optimal range can enhance your firm’s profitability potential.
The utilization rate is a measure of your firm’s overall efficiency and effectiveness. If the rate is within a reasonable range, it’s a good indicator that you are using your firm’s primary resource (labor) effectively.
2. Overhead Rate
Formula: (total indirect expenses / total direct labor)
(To express as a percentage of direct labor, multiply result by 100.)
Your overhead rate is simply the ratio of your total indirect expenses to your total direct labor cost. It’s the most important of the seven P/L key indicators. You need to know your overhead rate in order to establish appropriate, profitable billing rates and fees for your services. If it is not known, or is incorrectly calculated, there is simply no reliable way to determine the firm’s profitability.
3. Break-Even Rate
Formula: (overhead rate + 1.0; which represents the unit cost of salaries)
(If expressed as a percentage of total direct labor, multiply result by 100.)
Your break-even rate is your overhead rate plus the unit cost for an hour’s salary (1.0). If you have an overhead rate of 1.5 (150 percent of total direct labor), $1.50 is being spent on indirect expenses for every $1.00 spent on salaries. Therefore, in order to break even, you must earn $2.50 for every dollar you spend on salaries. Simply stated, the break-even rate is your cost of doing business for every dollar of salary you pay your employees. For example: a project manager earning an annual salary of $75,000 has an hourly labor rate of $36.06 ($75,000 ÷ 2,080 hours). If your overhead rate is 1.5, the hourly break-even cost for that project manager would be $90.15 ($36.06 × 1.5 + $36.06).
4. Net Multiplier
Formula: (net operating revenue / total direct labor)
The net multiplier is the ratio of net operating revenue (NOR) to total direct labor. If you think of direct labor as an investment, the net multiplier is a measure of your return on that investment. It tells you how many dollars of revenue you are generating for every dollar you spend on direct labor. You can compare the net multiplier to your break-even rate to determine if you are generating a profit. If the net multiplier is less than the break-even rate, you are operating at a loss; if it’s greater than the break-even rate, you are earning a profit. The figures for both net operating revenue and direct labor can be found on your accrual-basis P&L statement.
Though the net multiplier is of the same order of magnitude as your break-even rate, it should not be used for setting billing rates. Your overhead rate, break-even rate, and billing rates are all determined from what you know about the actual cost of doing business and what you need to earn in revenue to generate a profit.
The net multiplier measures actual performance: how much money you are actually earning for every dollar you spend on direct labor. It measures results, not costs. It’s a gauge of the firm’s financial well being.
If your overhead rate and target profit margin are within typical industry ranges, and your staff is effective and efficient, your direct labor will be about one-third of NOR, and the net multiplier will be in the 2.75 to 3.25 range.
5. Aged Accounts Receivable
Formula: (annual average accounts receivable / (net operating revenue / 365 days)
You determine your “annual average accounts receivable” by adding up the dollar value of your accounts receivable at the end of each of the past 12 months and dividing by 12. Using the formula above, you then calculate your aged accounts receivable, which is the average number of days that it takes for you to receive payment from the invoice date. For example, if you have an annual average accounts receivable of $125,000 per month and annual net operating revenue of $1,000,000, then your aged accounts receivable is 125,000 ÷ (1,000,000 ÷ 365), which is equal to 45.6 days.
6. Profit to Earnings (P/E) Ratio
Formula: (profit before distributions and taxes / net operating revenue)
Profit is what remains after all expenses, including salaries, have been accounted for, and before nonsalary distributions are made to shareholders and employees and income taxes for the firm are paid. The P/E ratio indicates the firm’s effectiveness in completing projects profitably. The higher the number, the more profitable the firm is.
7. Net Revenue Per Employee
Formula: (annual net operating revenue / number of employees)
Like the P/E ratio, net revenue per employee is not a leading indicator, but a measure of past, or actual, performance. It’s a useful gauge, however, that you can use to check whether the net operating revenue you are projecting for the coming year is realistic.
There is no target range for this indicator; the higher the number, the better. Checking it semiannually is usually sufficient. You’ll know long before looking at this number if you are having trouble. However, with each monthly P/L statement, it’s possible to do a very quick calculation of this indicator, which, again, will help you maintain a realistic idea of what your goals should be when you prepare your profit plan for the coming year.
The Seven Key Indicators for the Accrual P/L Statement
1. Utilization Rate
Formula: Direct labor (project-related hours) / Total hours worked × 100
Targets: All staff: 60 to 65 percent; professional/technical staff (incl. principals): 75 to 85 percent
Measures: Overall efficiency and effective use of labor; not a measure of productivity.
2. Overhead Rate
Formula: Total indirect expenses / Direct labor
Target: 1.5 to 1.75 (or 150 to 175 percent) of direct labor
Measures: The cost of operating your business that cannot be attributed directly to projects. This is the most critical indicator; if unknown or calculated incorrectly, profitability cannot be measured.
3. Break-Even Rate
Formula: Overhead rate + 1.0
Target: 2.5 to 2.75 (or 250 to 275 percent) of direct labor
Measures: Your total cost of doing business for every dollar spent on direct labor. When developing project fee budgets, calculate this indicator for every team member. Add desired profit to determine billing rates.
4. Net Multiplier
Formula: Net operating revenue / Direct labor
Target: 2.75 to 3.25 or better
Measures: The revenue generated for every dollar spent on direct labor. Compare with the break-even rate to determine if profit is being generated.
5. Aged Accounts Receivable
Formula: Annual average accounts receivable / (net operating revenue / 365 days)
Target: 45 to 60 days or less
Measures: Average time interval between invoice date and date payment is received.
6. Profit to Earnings Ratio
Formula: Profit before distributions and taxes / net operating revenue
Target: Equal to or greater than the anticipated profit in the annual profit plan
Measures: The firm’s effectiveness in completing projects profitably.
7. Net Revenue per Employee
Formula: Annual net operating revenue / the number of employees
Target: As high as possible.
Measures: Revenue earnings per employee. Helps establish a realistic target for the net operating revenue in the budget for the coming year.
Question: Are you using Key Financial Performance Indicators at your firm? Share your thoughts in the comments below.
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