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.
A Financial Management System for Architects & the ‘P2P Format’
The vital relationship between your firm’s financial performance and its ability to fulfill its mission and achieve its vision is made possible through an ‘internal’ accounting practice referred to as ‘Financial Management’. Once that connection is clear to you, both your skill and interest in financial management will grow and your firm’s operations will, if you follow all of the lessons you receive, be enhanced.
The P2P Format is a proprietary system created and developed by this author starting with its initial and original origins based on the seminal work of Robert F. Mattox, FAIA (retired). Mr. Mattox wrote two volumes for the AIA Press in 1978 and 1980. The first volume: Standardized Accounting for Architects (1978) and the second volume: Financial Management for Architects (1980) are out of print and copies may be available on Amazon.
From the second volume, I discovered a number of critically important distinctions that separates accounting for professional design firms (and likely other types of service industry firms) from the general business accounting for firms that sell a tangible product. For our industry there isn’t any product; all we sell is our time. And for that reason the lowly timesheet is actually the most critically important financial resource of every professional design firm.
You can only manage and improve what can be measured. A good financial management system enables you to measure the financial performance of your firm. With the insight that comes from understanding the key financial metrics, (which I explained in my Master Class Expert Training session inside EntreArchitect Academy on December 7th, 2016) you can go beyond measuring to optimize and enhance your firm’s financial performance.
Note: You may access the video recording of Steve’s Master Class (and more than 2 dozen other sessions) when you enroll as a Level 2 or Level 3 member at EntreArchitect Academy.
The goal of effective financial management is to be able to ‘read the numbers’ so that you can make sound business decisions and achieve your business goals, whether it is to increase firm profitability, grow the firm, expand into new markets, or all three and more. In order to generate reliable metrics, you first have to implement a system to compile reliable financial data in an organized and recognized way, and then implement a regular process to review, analyze, and act on that information. That system is the P2P Format.
Financial Management (FM) Concepts
The following is an overview of a ‘FM System’. It’s both a circular and linear process.
The goal of the FM System is the ability to read and comprehend the meaning and impact of the numbers on financial statements, to facilitate sound business decisions and achieve firm goals.
The five (5) primary components of a FM System for a professional design firm include:
- An appropriately organized Chart of Accounts
- A systematic, timely, accurate method for tracking of time
- A properly formatted Annual Budget and Profit Plan
- Properly formatted financial statements
- Eleven (11) key financial performance indicators (KPFI’s)
Note: Graphic representation of these Concepts are available to members at EntreArchitect Academy Level 2 and Level 3.
1. Chart of Accounts (CoA)
A list of all two-tier, numeric, data entry codes to facilitate the populating of the CoA for both the Profit/Loss Statement and the Balance Sheet. The two-tier numeric codes represent the major accounts (1100–9100) and each of their respective nine sub-accounts (1110-1190 to 9110-9190). If necessary, each of these respective sub-accounts (1110-9190) can each be further expanded up to nine sub-sub-account levels (1111-1119 to 9191-9199).
This report represents the central database for each of the financial reports.
2. Time Tracking
One of the critically important resources of a FM System is the capture of ‘time spent’ by every member of the firm. Without exception, time spent, especially project related hours, need to be captured on a timely, accurate, daily timesheet. These daily entries facilitate the accounting software in separating the time spent into two primary categories – Direct Labor (project) and Indirect Labor (non-project). The two categories consist of the following components:
- Direct Labor: Consists of two sub-components:
- Time spent on project activities that are chargeable to a project and billable to the client.
- Time spent on project activities that, while chargeable to a project, are not-billable to the clients. (Not all chargeable time is billable)
- Indirect Labor: Time spent on non-project activities, referred to as general and administrative labor, as an overhead cost.
Unless time spent has been divided into the two primary categories by the accounting software, the calculation and determination of a true* overhead rate and the true* Net Profit for a firm would be impossible.
3A. Annual Budget (AB)
Using the 4-digit numeric major account codes (1100-9100) and each of their respective sub-account and sub-sub account codes (as described above in item 1), a list of firm-appropriate line items descriptions can be developed for each major account and their respective sub-accounts. (e.g. On P/L: 4100: Net Operating Revenue and 4110; Total Fees Billed; 4111: Firm Fees Billed; 4112: Outside Consultant’s Fees Billed; 4113: Mark-up on Outside Consultant’s Fees Billed).
This spreadsheet is developed concurrently with and supports the development of the Annual Profit Plan for the coming year, during the last quarter of the current year.
3B. Profit Plan (PP)
Using the projected data ($ amounts) from the coming year’s AB and other data (current annual salaries, targeted utilization rates and overhead rates from the current year’s 3rd Quarter Accrual-basis Profit/Loss Statement, a PP spreadsheet can be developed that will calculate the projected annual billing, the estimated total break-even cost, and the projected Net Profit for the coming year.
4. Financial Statements
There are three types of financial statements that every accounting system should be able to develop for the firm principal(s) to review every month; they are:
- The Balance Sheet: This report indicates the current status, on a real-time basis, of a firm’s financial condition related to Assets, Liabilities and Equity.
- The Profit/Loss Statement (P/L): This is the accrual-basis report that is an ‘in-house only’ document that reports the Revenue earned, the Expenses incurred and the Net Profit. This report does not relate to any incoming or outgoing of dollars. The P/L defines seven (7) of the KFPI’s (see item 5. below).
- The Income Statement: Also a Profit/loss statement based on the cash-basis reporting of the firm’s income received and expenses paid every month. This report is almost always the source of a firm’s Cash-Flow Statement.
Note: FM reporting is only related to the accrual-basis accounting reports.
5. Eleven (11) Key Financial Performance Indicators (KFPI’s). Also called ‘Metrics’
These metrics are calculated using the data from the Profit/Loss Statement and the Balance Sheet.
- The P/L has seven (7) KFPI’s, including:
- Overhead rate
- Break-Even rate
- Utilization rate
- Net Multiplier
- Aged Accounts Receivable
- Profit-to-Earnings Ratio (P/E)
- Net Revenue per Employee
- The Balance Sheet has four (4) KFPI’s, including;
- Current Ratio (SOLVENCY)
- Quick Ratio (LIQUIDITY)
- Debt-to-Equity (LEVERAGE)
- Return on Equity (ROE)
Note: Other desired KFPI’s can also be calculated as necessary. (See Below.)
Recognizing the importance of these 11 KFPI’s is only the first half their impact on a firm’s financial status. The rest of their impact is being able to correctly calculate these metrics with the proper formulas. As numbered above, the following are the respective proper formulas for each KFPI:
For the P/L
- Overhead rate: Total Indirect Expenses/Total Direct Labor (TDL)
- Break-Even rate: Overhead Rate + 1.0 (Unit Cost for Salaries)
- Utilization rate: TDL/Total Labor
- Net Multiplier: Net Operating Revenue (NOR)/TDL)
- Aged Accounts Receivable (AR): Avg. Annual AR/NOR/ 365 (Days in Year)
- Profit-to-Earnings Ratio (P/E): Net Profit/NOR
- Net Revenue per Employee: NOR/Total No. of F-T Employees
For the Balance Sheet
- Current Ratio (SOLVENCY): Total Current Assets/Total Current Liabilities (Ability to pay current debt)
- Quick Ratio (LIQUIDITY): Cash+A/R’s+WIP/Total Current Liabilities (Ability to convert current assets to cash)
- Debt-to-Equity (LEVERAGE): Total Liabilities/Total Equity (Ability to manage debt effectively)
- Return on Equity (ROE): Net Profit/Total Equity (Total Cum. Net Profit (Retained) relative to the investment made)
When these formulas are properly applied, the accurate calculations provide access to these 11 critically important metrics.
In addition to these 11 KFPI’s there are additional metrics related to the P/L that could also be included in a firm’s calculations. Among these are:
- TDL to NOR: TDL/NOR. This metric will indicate the balance between revenue being earned and the number of FTE’s. The optimum ratio is: a range of 28%-32%.
- Outside Consultant’s (O-C) Fees Billed/Total Fees Billed: The optimum ratio for this metric is: a range of 25%-30%. Keep in mind that every dollar of revenue or expense paid out is a dollar less profit.
- Cash Flow: No Formula. Represents the available dollars for the firm to use to pay its salaries, taxes and all overhead expenses.
- Proposals Pending: No Formula. Represents those Proposals that have been sent and are still waiting for a decision to be made. Proposals Pending are comprised of two types of proposals:
- Prospects: Those proposals with a 50% or better chance of becoming a real project.
- Suspects: Those proposals with less than a 50% chance.
- Backlog Volume: Represents the unbilled portion of existing contracts.
Proposals Pending are a critical factor in helping to maintain the Backlog Volume, since each represents potential revenue. Similarly, these proposals also represent the firm’s best chance to attain the budgeted Net Operating Revenue.
A firm that produces monthly financial statements, as referred to above and calculates all of these metrics, ensures its opportunity to achieve its targeted NOR, Overhead and Break-Even Rates and a minimum of 20% Net Profit* (before distributions and Federal taxes).
These, in my opinion are the ‘Keys to the Kingdom’, for every professional design firm.
* The ability to calculate ‘true’ overhead, net profit and a minimum 20% net profit are possible through the adoption of the ‘P2P Format’, a copyrighted, proprietary methodology that can used by any professional design firm. For more information, please contact me directly by email.
Question: Have you developed a working Financial Management System for Architects at your firm?
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