Profitability is one of the most pressing concerns our profession faces today. Part one of this article (see CA May 2003) encouraged firms to distinguish themselves by creating a unique position in the marketplace. Part two takes a closer look at a financial model that can help to leverage your position for greater profitability.
“No other professional bills as low a multiplier as A/E firms,” says David Burstein of PSMJ in the March 2003 issue of the Principal’s Report. Burstein pointed to other professionals, including accountants, management consultants, ad agencies and attorneys, where a multiplier of 5.0 is the norm (more on multipliers later).
As one of my partners says, “this stuff can be tracked with a 10 cent scribbler.” Without being flippant, it really is quite simple. Profit is what you keep after expenses are deducted from revenue. In architectural practice, revenue and expenses are classified according to a financial model advocated by leading consultants, financial analysts and practitioners in North America:
Profit = Net Revenue – Direct Expenses
Profit = – Direct Labour – Overhead.
Let’s take a closer look at each of the elements of this financial model.
Net revenue is what you keep after reimbursible expenses have been deducted and sub-consultants have been paid. According to Deltek Systems Inc., a leading provider of financial management software to the A/E industry, the median design practice last year generated approximately $86,000 in net revenue per employee based on the total staff complement.
Direct expenses are incurred as a direct result of undertaking a project. These typically include items that are not recoverable from the client such as mileage, parking, parking tickets (if you reimburse your staff for these), photography, printing for internal check sets, plotting, incidental photocopies, and so on. If you are a skilful negotiator you may be able to include some of these as reimbursables in the Client/Architect agreement. A reasonable benchmark for direct expenses is between 1% and 3% of your net revenue.
Direct labour is all money spent to pay base salaries for people in your firm who work directly on a project. This includes all labour incurred by staff and partners/principals working on projects. Direct labour is your raw labour cost and does not include the value of benefits or bonuses. The median firm in surveys over the past several years indicates that firms spend approximately 35% of net fee on direct labour. Direct labour is commonly measured by the “multiplier,” which is discussed in more detail below.
Overhead includes all the other expenses involved in running a practice. The list is long and seems to get longer every year. Indirect labour tops the list. In fact, indirect labour–labour not billable to projects–will likely account for approximately 40% to 50% of your overhead costs. Indirect labour includes time spent by staff and principals for marketing, general promotion, down time between projects, administration time, and so on. Personnel expenses are a big item as well; payroll taxes, statutory holiday pay, sick time, vacation time, dental plans and other benefits. Premises costs are a big deal: mortgage payments, rent, maintenance and utilities. Other overhead costs include non-labour marketing costs, professional development costs, legal and auditing costs, hardware and software costs, professional liability insurance and the list goes on. Most practices will find that for every dollar they spend on direct labour, they will spend an additional $1.30 to $1.50 on overhead. This is referred to as the overhead rate and is expressed as a ratio, for example 1.3 to 1.5.
Profit is what you get to keep after your costs are paid. Commonly referred to as operating profit, it is calculated before taxes and bonuses. Profit is something you should plan for on each project and for your firm as a whole. It’s not supposed to just be what’s left over. Surveys by Deltek and PSMJ shows that median practices generate approximately 7% to 9% profits.
The multiplier is one of the best ways to measure your productivity and to compare your operation to other firms and industry standards, and can be expressed as:
Multiplier = Net Fee * Direct Labour
The multiplier for the median firm in Deltek and PSMJ surveys over the past several years has generally been 2.7 to 2.9.
Assuming a firm is satisfied being “median” or middle of the road, it might set a multiplier target of 2.7, resulting in project financials looking something like this:
Net Revenue$100,000.00
Direct Expenses@ 1.5% of Net Fee$1,500.00
(100,000 x 1.5%)
Direct Labour@ 2.7 multiplier$37,037.00
(100,000 2.7)
Overhead@ 1.45 overhead factor$53,704.00
(37,037 x 1.45)
Profit$7,759.00
(7.76% of Net Fee)
Not a very impressive profit margin when you think about it. You could have taken all the money you used to create the infrastructure of the practice and invested it in a mutual fund for at least a 10% return with far less risk.
Remember what Burstein said, “No other professional bills as low a multiplier as A/E firms.”
This financial model can help guide decisions that need to be made in achieving profitability, but your choices are quite limited. Your highest leverage is to increase net revenue, reduce direct labour or reduce overhead, in that order. How to increase fees, reduce direct labour and reduce overhead is, of course, the $64,000 question.
Profitability is inextricably linked to positioning your practice. If you have distinguished your firm so that you are providing unique and valuable services, your chances of increasing fees and multipliers is greatly increased. This simple model can help you determine the types and quantities of projects you need to pursue, the number and types of people you need, how to structure your compensation system, how many hours to budget for project tasks and a host of other key decisions made hour by hour every day.
Positioning is your best chance to distinguish yourself and generate the level of profit necessary to sustain your practice. Those firms that succeed will be able to do the work they want, keep the people they need and reward them appropriately. Firms not well positioned may find themselves working on undesirable projects, with low or no profits. Ultimately the profession’s ability to make lasting contributions to the built environment will be eroded if this situation is widespread.
Position your firm for profit and the whole profession will benefit.
Rick Linley, FRAIC, PMP is Vice President-Professional Services at Smith Carter Architects and Engineers Incorporated based in Winnipeg, and is an adjunct professor at the University of Manitoba.