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.
Planning for Profitability
Please keep in mind that this is not a comprehensive FM process, it is merely an easy approach to gaining a better understanding of how to initially plan for profitability. Other articles I have written deal with the effective and simplest methods for developing the firm’s Chart of Accounts to enable the accurate calculation of the eleven (11) key financial performance indicators; the most effective method of formatting the firm’s accrual-basis financial statements; developing the firm’s Annual Budget and a simple methodology for developing any size Project Fee Budget (PFB); establishing a win-win negotiation process using the PFB to ensure never being in a position to have to accept a project fee that would start off at break-even (0%), or worse, a loss.
The best tool for planning a firm’s potential profitability is to first establish its ‘true cost’ of an hour of chargeable labor, which is also referred to as the ‘Break-Even Rate’ (B-E). Please note my use of the term ‘chargeable’ labor, as opposed to ‘billable’ labor. Unless a project awarded to the firm is billed on an hourly basis (either open-ended, or with a max.), all other project hours will not be ‘billable’, they are only ‘chargeable’. For these other project hours, the firm’s billings are usually based on a percent complete of the total (fixed or lump-sum) fee, or as a percentage of the cost of construction. Hourly fee project hours are both chargeable and billable, up to a maximum if one is stipulated.
Six (6) Steps for Developing the Annual Profit Plan
The Annual Profit Plan directly supports the firm’s Annual (Operating) Budget for the current calendar year.
Calculate the anticipated Total Direct Labor (Salary) Expense for the coming year. This total figure should be based on only the total 2080 hours of available time each year (40 hours x 52 weeks) and should not include any allowance for overtime. The total available hours are used for Direct Labor (project hours) and Indirect Labor (non-project or overhead hours).
Define the Utilization Rate (UR) for each staff member, including all principals.
This calculation can be done in one of two ways:
a.) Based on last year’s recorded hours, estimate the number of direct project labor hours to be spent for the new calendar year and divide them by the total labor hours (e.g.; 1664/2080 = 80%) or,
b.) If the data for the previous year’s hours spent is unreliable or unavailable, forecast a realistic, average Utilization Rate (UR) for each project/office job function category (e.g.: 60-65% for principals, 70-80% for professional/technical staff, and 15-25% for administrative staff).
Then, multiply the UR by 2080 hours to arrive at the total direct project labor hours and its complement for the total indirect hours. (Respectively, 60% x 2080 = 1,248 hrs., 70% x 2080 = 1,456. hrs., and 15% x 2080 = 312 hrs.)
Sample Annual Profit Plan – Utilization Rate Development
[table id=1 /]
Developing the Overhead & Break-Even Rates.
At this point, having a prepared, detailed Annual Budget for the firm would be very helpful and create a more meaningful set of indicators.
To determine the above two (2) indicators will require the defining the entire firm’s Indirect Expenses (General Administrative & Overhead), including Indirect Labor.
Assumed Totals for:
Indirect Labor: $330,500
Payroll Taxes & Benefits: $227,500 (est.@ 25% x Total Labor)
Office Expenses: $273,000 (est.@ 31.6% x Total Labor)
[table id=2 /]
Overhead Rate: Total Indirect Expenses/Total Direct Labor Expense ($831,000/$579,500=144%)
Break-Even Rate: Overhead rate + 1.00 for salaries = 144% +1.00 = 244%
Targets for these metrics are: Overhead Rate: 130 to 150% & Break-Even Rate: 230-250%
Calculate the Break-Even (B-E) Rate and Hourly Billing Rate for all firm members.
Using the firm’s B-E Rate (244%), multiply each firm member’s hourly salary (see Sample Profit Plan above) to define their respective B-E cost for every hour of Direct Labor (e.g.:$33.65/hr. x 244% = $82.10). After calculating a 20% profit ($82.10/.80-$82.10=$20.52) and adding it to the B-E cost ($82.10+$20.52) this firm member’s Hourly Billing Rate would be $102.62. This could then be rounded-up to $105.00/hr. for a higher (20%+) profit margin.
Calculating the Net Multiplier and the TDL/NOR Ratios.
This calculation requires a defined Total Direct Labor (TDL) and Net Operating Revenue (NOR), as determined in the above Sample Annual Profit Plan. The ratios between these two figures are two of the most critical of the key financial per performance indicators.
For the above example: NOR divided by TDL (1,762,500/$579,500) is 3.04.
This means that: $3.04 in NOR is being generated for every $1.00 of TDL spent. Target range for Net Multiplier is 3.25 or better. (See Caveat on P.4 below)
Care needs to be given to also keep the reverse ratio within its target range to ensure the targeted profit percentage for all project fees is maintained and the balance between the number of staff and the project workload remains balanced.
For the above example: TDL divided by NOR ($579,500/$1,762,500) is 32.88%.
Target range for this metric is 28 to 32%. If the result was out of range (in this example it’s slightly above the range) it might indicate the TDL would need to be decreased, or the NOR increased, accordingly. Either one of these two changes would increase the Net Multiplier and decrease the TDL/NOR ratio. However, being out of range almost always is an indication that the TDL is too high (overspent fees compared to project fee budget).
Consider the following:
The optimum relationship between the three components that comprise the NOR, would be as follows:
Direct Labor: 30% (as a percentage of NOR)
A more realistic industry-wide ratio is closer to:
Direct Labor: 30% (as a percentage of NOR)
In comparing the optimum ratios with the realistic ratios, two facts become obvious.
- Total Direct Labor is a constant (between 28 and 32%), which is important.
- When Overhead is reduced, Profit increases, on a dollar-for-dollar basis.
Therefore, for every dollar saved in overhead expense, is a dollar of profit is gained.
Caveat: A primary focus for any professional design firm would be to achieve a Net Profit of not less than 20%. As long as the NOR is greater than the Total Expenses incurred, there will be a profit. Also, the Net Multiplier (NM) can be compared to the Break-Even Rate (B-E) and if it less than the B-E, the firm would be operating at a loss.
Keep in mind, Total Direct Labor (TDL) is also an overhead expense item and is not a part of Net Operating Revenue (NOR), which is why maintaining the target ratios for NOR to TDL and TDL to NOR are so critical.
Calculating Net Profit (before Distributions and Federal Income Taxes are deducted).
The goal of every professional design firm should be to earn a minimum 20% profit on every project, by the time it has been closed-out. While that may not seem to be realistic, it is possible, especially if you are disciplined enough to accurately manage your time and develop a Project Fee Budget (PFB) for every project, as an important and integral part of the work to be done in preparing a response to a Request for Proposal (RFP). In any case, a project’s actual profitability is likely to be closer to the budgeted percentage at close-out if the Project Fee Budget includes at least a 20% profit margin at the outset and the PFB is used as the Project Work Plan.
* = The following steps and examples will provide the method for determining the Net Profit for each of these three different models: an NOR, an Hourly Billing Rate, or a Total Project Fee.
Step 1: Determine the Net Profit for the NOR, based on any Break-Even Cost.
Divide the Break-Even Cost by the complement of the desired profit percentage, which will provide the NOR amount. For a 20% Net Profit, the complement would be 80%.
Step 2: Subtract the Break-Even Cost from the NOR, which will provide the Net Profit amount.
Calculating the Net Profit for the NOR, using the figures in the Sample Annual Profit Plan above;
Per Step 1: B-E Cost/.80 = NOR
$1,410,000/.80 = $1,722,500.
Per Step 2: NOR – B-E Cost = Net Profit
$1,762,500 – $1,410, 000 = $352,500.
To check, $1,762,500 x 20% = $352,500.
Calculating the Net Profit for an Hourly Billing Rate, using the figures in the Sample Annual Profit Plan above;
Per Step 1: Hourly Salary x B-E Rate = B-E Cost/.80 = Hourly Billing Rate
$72.12/hr. x 244% = $175.96 (B-E Cost)/.80 = $219.96
Per Step 2: Hourly Billing Rate – B-E Cost = Net Profit
$219.96 – $175.96 = $44.00.
To check, $219.96 x 20% = $44.00.
Calculating the Net Profit for a Total Project Fee, and assuming a Break-Even Cost for the project of $750,000 and a target of 20% Net Profit;
Step 1: Break-Even Cost/.80 = Total Project Fee
($750,000/.80 = $937,500)
Step 2: Total Project Fee – Break-Even Cost = Net Profit
($937,500- $750,000./.80 = $187,500)
To check, $937,500 x 20% = $187,500.
In conclusion, it is important to recognize that too often the Profit included in a fee, even if the Break-Even Cost is established accurately, could be as much as 20% less if the calculation is incorrectly treated as a ‘Mark-up’. That will happen if the B-E Cost is multiplied by the actual desired percentage of Net Profit. To demonstrate the differences between these two methods:
- Mark-Up: B-E Cost ($750,000. x 20% = Profit: $150,000 = Total Fee: $900,000
- Net Profit: B-E Cost($750,000)/.80 = Total Fee: $937,500 x 20% = Profit: $187,500
$150,000 = 16.67% actual profit on $900,000
$187,500 = 20% actual profit on $937,500, and,
20% – 16.67% = 3.33%, divided by 16.67% = 20% less $ profit.
These are your dollars and this difference in calculating the Net Profit would create a ‘loss’ of profit, which could be significantly more than the example loss and a serious detriment to the firm.
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. – Mark
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