Financial Management Terminology for Architects
For many design professionals the subject of Financial Management is complex and can become problematic if the terminology used in the discussion or writing of this subject are not precise.
For clarity, the term, Financial Management, refers to the accrual-basis accounting process of a professional design firm. Accrual-basis accounting is primarily used to determine true profitability and the metrics, or key financial performance indicators (KFPI’s) that can be calculated only in this form of accounting system.
Three Financial Basics Every Entrepreneur Architect MUST Understand
The following are three financial basics every architect my understand. Unfortunately, they may be some of the most problematic and misused terms used by architects when structuring their financial management systems.
Profit/Loss Statement vs. Income Statement
Each of these terms are uniquely tied to the respective accounting process they represent. The Profit/Loss Statement refers to the financial report for the accrual-basis accounting process. The Income Statement refers to the financial report for the cash-basis accounting process. Often, the term ‘profit/loss’, is referred to as ‘profit & loss’. While, not significant, it is nonetheless, another misnomer. Obviously, within the confines of any single financial document, having both profit and loss at the same time is not possible.
Revenue vs. Income
In the accrual-basis accounting method, the word ‘income’ in a misnomer. Accrual recognizes ‘revenue earned’, which is based on time spent on project activities. For the most part, with few exceptions, the design profession uses a ‘modified’ accrual-basis in its recognition of revenue earned. Modified in that revenue is based on only the dollar value of what has been invoiced, regardless of what has been collected or paid out. It is essentially a recognition of an ‘obligation to be paid, or ‘to pay’. The actual exchange of dollars is not considered. Hence, ‘income’ is reflected in the cash-basis accounting process.
Billable, Chargeable and Utilization
These are three different, yet interrelated terms, but are not necessarily interchangeable.
It is thought by many of my professional colleagues that any time spent, working on an active project, is billable. This is simply not the case. In fact, the only type of project that has billable hours are those with an hourly fee-basis. The other fee-basis type projects are invoiced on a percentage of work completed, or the dollar value of a contract amount.
Hours spent on an active project are always chargeable and might also be billable (hourly projects).
Utilization, is the ratio of chargeable hours to total hours spent, in any defined period of time. Utilization, expressed as a percentage, has two components: as a targeted goal for the percentage of project hours to be spent and once spent, as the actual utilization rate.
And 4 More Rules…
It is essential that all hours spent on an active project, regardless of being billed or not, need to be reflected as such on each respective project report, unless otherwise directed by the Project Principal and/or the Project Manager.
The following are a few random comments to keep in mind to help professional design firm principals attain their profitability goals.
- Given that all we as design professionals have to sell is our time, establishing a strict time-tracking policy will result in more productive metrics and an enhancement of the firm’s profitability.
- Every dollar spent on any expense (direct hours are also an expense) will result in a dollar less profit. It’s a one-to-one ratio.
- Develop a project fee budget for EVERY project BEFORE quoting a fee to a client.
- Never use the ‘mark-up’ method to add profit to the calculated break-even cost. Instead, divide the break-even cost by the complement of the targeted, desired net profit. (E.G.: for a 20% net profit, divide by .80). The result will be the total fee and if you multiply that fee by 20% and subtract it from the total fee, you will get the break-even cost you used.
Break-even cost = $300,000, target net profit = 20%.
$300,000/.80 = $375.000 (total project fee)
$375,000 x .20 = $75,000 (net profit)
If the mark-up method was used, the net profit would be $60,000, a loss of $15,000, or 20% of the 20% net profit calculated above.
To learn more about Financial Management for Architects, visit my prior post, A Financial Management System for Architects, right here at EntreArchitect.
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 (watch for an updated edition coming soon). 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.
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