The profession of architecture has become a commodity in the minds of many, weakening the profession as a whole. If architecture is to have a significant impact on society and the environment, the profession must be stronger. And the path to a strong profession runs through the business engine of individual practices. Unfortunately, the business engine of professional firms is widely misunderstood, and its misuse or neglect by practice leaders is a limiting factor in building stronger, more influential organizations. The current state of the economy may provide firms with a unique opportunity to optimize practice.
Profitability is a key driver of influence for the profession. It is not the only requirement but without profit, firms cannot be strong and influential on a sustainable basis. Profit = Net Fee -Expenses. That’s the business engine. Let’s take a hypothetical firm as shown in Figure 1 to explain the parts of the business engine in more detail.
Figure 1 shows the three-year average results of a firm of 12 personnel. Net fees are the starting point. The net fees exclude consultants and other direct expenses such as check-sets, plots, and other non-reimbursables. Net fees also exclude reimbursable expenses such as travel, printing, permits and other expenses paid on behalf of the client. Net fees are what the firm has to work with after all these flow-through expenses are taken into account. Net fee is your fuel gauge. Work in process and fee backlog define how much fuel you have in the tank. The quality of those fees is also critical. If fee quality is poor, the chances of arriving at your profit destination are severely compromised.
Direct labour is the first of two major expense categories. It is the raw cost of all the billable hours for you and your staff. It excludes personnel expenses such as dental, statutory holidays, CPP, EI, and other mandatory or customary benefits. Direct labour effectiveness is measured by the multiplier. The multiplier is like your speedometer. It is an indicator of how efficiently you are employing direct labour and it tells you how fast you are going. The multiplier is calculated simply as Net Fee Direct Labour.
Overhead is the second major expense category. It is the cost of all other aspects of running the practice. Overhead expenses include occupancy costs (rent, heat, power, etc.), benefit costs (statutory holidays, dental plans, etc.), consultants (legal, accounting, etc.), office equipment (hardware, software, copiers, plotters, etc.), promotional costs, taxes, and indirect labour. The overhead rate is used to measure how effectively all of your overhead resources are being deployed. The OH rate is simply Overhead Expenses Direct Labour.
The single largest component of overhead is indirect labour, which is the cost of paying you and your staff for all non-billable hours. Indirect labour can amount to approximately 40-50% of all overhead costs. Indirect labour typically includes hours spent by project personnel who are between tasks or between projects. It also represents the majority of hours logged by support personnel such as marketing, office administration, accounting, etc. Since indirect labour is the largest component of overhead, it is measured separately. This measurement is known as the utilization rate. This is an indicator of how much time your staff is being deployed on billable work. The utilization rate is akin to a tachometer in that it indicates how hot you are running. The utilization rate is Direct Labour Total Labour.
PSMJ Resources Inc. is one of several well-known A/E consulting firms that track key indicators in the industry. PSMJ’s survey provides benchmarks for key indicators. The median values taken from the 2007 survey were as follows:
• Net Fees per Full-Time Equivalent (FTE) $118,126
• Multiplier 3.09
• Overhead Rate 1.60
• Utilization Rate 60%
• Profitability 15% With an understanding of the business engine and the key metrics, you are able to make both strategic and day-to-day decisions about how to operate your practice more effectively. You only have three adjustments at your disposal–net fee, direct labour, and overhead. Each firm has unique goals reflected in its mission, vision and values. The net fee, direct labour and overhead targets you set for your practice must be aligned with your goals.
Let’s take another look at the hypothetical firm to explore optimization options. Let’s assume that this firm has decided to reposition itself as a leader in two specific building types within a four-hour driving radius of its current location. It recognizes that it will need to change aspects of all three areas to ensure its goals are met.
The best place to start is with a labour analysis of this firm as shown in Figure 2. The firm currently has 12 staff including two principals. Figure 2 shows that the utilization rate for the firm is currently 70%. This is significantly higher than a median firm in the PSMJ survey and likely means that the firm is running too hot. Running hot could mean investments in this firm’s future such as professional development and marketing are running behind, principals may be spending excessive time on non-strategic tasks, staff may be overworked which can lead to disgruntled clients, not to mention high staff turnover. Another aspect of this firm is that the average salary for principals and staff is quite low. In fact, the junior principal in this firm may be asking himself/herself if these new responsibilities are a reasonable risk/reward balance.
Referring back to Figure 1 reveals that in addition to low compensation and high utilization, there is very little profit for the principals to share. This also means very little in the way of staff bonuses, growth potential, rainy-day funds, and return on investment. With profitability of 3.8% this hypothetical firm is underperforming. Thin margins may also mean that cash flow is a problem. Our hypothetical firm is most likely a weak practice that has very little influence in its community.
Optimization is not a linear process. Net fees, direct labour and overhead must be optimized simultaneously, but the highest leverage place to start optimizing is by critically reviewing the quality of this firm’s net fees. Net-fee quality is more important than quantity. It does not make any sense to take on more fees and the risk associated with those fees unless it can be done more profitably. Although it may seem counterintuitive, the most effective way to optimize is to reduce fees in the short term by walking away from unprofitable clients. Our current economic situation may help to facilitate these decisions. Once the quality of net fees is stabilized, this firm can consider increasing the quantity of revenue by increasing its service offering, diversifying its areas of specialty, expanding geographically, or a myriad of other strategies. Figure 3 shows the impact of actually reducing net fees but increasing fee quality. Note the increase in multiplier as a result of focusing on higher-margin work.
After net fee, the next best place to optimize is direct labour as measured by the multiplier. Strategies include reducing staff count, outsourcing, changing the skills mix, introducing improved design, technical and project management methodologies, improving information technology infrastructure, and a myriad of other possible operational interventions. If direct labour is optimized it makes sense to also increase fee quantity as long as fee quality is not compromised.
The third and final place to optimize is overhead. Optimizing overhead is not just about reducing costs–in some cases increased costs may be warranted. Utilization is the first place to start. Again it may seem counterintuitive, but this firm should increase its non-billable hours so that more time can be invested in business development to generate higher-quality fees. In addition, training and professional development should receive investment funds so that projects can
be delivered more efficiently and with higher value to clients. Other expenses that warrant a review are variable and fixed costs such as benefits, rent, office equipment, IT, etc.
The end result is a firm that has increased its revenues in both quality and quantity, is more efficient, and has optimized its overhead. It is able to attract better staff and the principals are more adequately rewarded for their investment and risk. The revised new business engine shown in Figure 5 and the revised labour analysis shown in Figure 6 indicate a firm that is able to grow, be stronger and ultimately more influential.
The path to a stronger profession runs through individual firms. Ironically, the current economic downturn may afford practitioners the time to optimize their practices. If principals focus on optimizing net fee, direct labour and overhead in their individual firms, architects and the profession as a whole can be more influential. Greater influence in turn will increase the impact the profession has on society and the environment. CA
Rick Linley is a Past President of the Manitoba Association of Architects, a Fellow of the RAIC, and holds the designations of Project Management Professional and LEED AP. He is a Principal and Director of Operations of Smith Carter Architects and Engineers Inc. in Winnipeg and a Sessional Professor at the University of Manitoba Faculty of Architecture.