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Beyond Intuition: Financial Management for Small Firms

By Rena M. Klein, FAIA

As a financial management tool, intuition has its limitations. While most small firm owners have a good sense of what’s happening at their firms, operational indicators such as cash flow shortages or mounting receivables don’t tell the whole story. Strategic decisions including hiring and moving to a larger office require understanding of financial trends on both a macro and micro level.

Financial management involves tracking financial indicators pertinent to firm financial health and using the information to project future performance. This work does not need to be done by firm owners themselves, but it is essential to overall firm development. Without some reasonable expectations of future revenue, expenses and profitability, it is difficult to plan and make basic business decisions. Understanding financial trends helps firm owners to see what is currently occurring and what might realistically be expected in the future. Financial management, along with clarity of purpose and a sound marketing plan, is critical to a creating a successful practice.

This article is based on a 2007 AIA National Convention workshop, WE07, Financial Management for Small Firms: Beyond Intuition.

Unpredictability

All architectural firms operate in an environment of unpredictability. The work is unrelenting, demanding and unpredictable. Anything can happen at any time, and in small firms, there is often little cushion to fall back on. The day-to-day demands make it hard to take time to plan for the future and even when planning is done, there are no guarantees.

According to Chaos Theory, you can’t tell where a system is heading until you’ve observed it over time. Over time there is an inexplicable tendency towards order and repetition; patterns emerge, even from the most chaotic circumstances. In architectural firms, noticing trends over time gives an improved sense of what is currently occurring and what to do about it. This is always preferable to reacting to a single circumstance, no matter how significant it may seem. For instance, looking at your firm’s income statements over time to understand financial trends will be much more meaningful than planning based on one good, or bad, year.

Figure 1: Year-to-Year Income Statement Chart

Figure 1 is a simplified graphic of a small firm’s income statement, illustrating operating revenue (revenue after direct expenses, such as consultants, are deducted - called gross income in chart), overhead expenses, and net income over time. It is a simple and extremely useful tool for understanding the financial trends. The expense bar (red) can be further broken down to show salary expense or other components of overhead to reveal additional valuable information. For firms in business under two years, creating a month-to-month income statement chart would be an appropriate application of this tool.

In this chart, notice the years between 1989 and 1995. In these years, net income decreased while revenues increased relative to the previous year. This is an unsustainable trend. Small firm owners in this situation may find that they are paying their employees more than they take home themselves. After 1996, the trends at this firm are markedly improved and appear to be holding steady by 2003.

Macroeconomics

Part of the improvement illustrated in this chart reflects the macroeconomic situation in the late 1990s. The dot-com boom years, coupled with low interest rates, created an expansive and prosperous time for many in the design and building trades. Economic indicators, such as the gross domestic product (GDP), prime rate, and consumer confidence can be predictive of overall activity in the construction industry, and the likelihood of activity in individual firms. Since architectural work occurs early in the building development process, numerous inquiries, or lack of them, are an early indicator of shifts in the business cycle. Other firm-based indicators include size of potential projects, aging of receivables, and ability to increase fees. Twenty-first Century globalization and the movement towards sustainable economics complicate and expand potential macroeconomic effects.

Figure 2: Year-to-Year Income Statement Chart

Influences on Profitability

Even in boom times, when there are plenty of projects and overall revenues increase, profitability may still be difficult to achieve. Figure 2 illustrates this situation, not uncommon in small firms. Here we see that operating revenue going up and expenses increasing at a nearly equal rate, resulting in little or no net income year after year. In a situation like this, no matter how much work is done or how big fees are satisfactory profit margins will never be achieved. A chart like this is a clear indicator of poor productivity.

Productivity in economics is defined as the rate at which a company produces goods or services, in relation to the amount of materials and employee time needed. In architectural firms, productivity is tracked as a relationship between billable hours (direct labor) and total hours worked by both partners and staff. The cost of non-billable hours (indirect labor), whether they are spent working on a project or on firm development, is a component of overhead. Therefore, when productivity is low, overhead increases along with increased revenue. If this goes on year after year, the inevitably result is illustrated in Figure 2.

Client Expectations

One way to improve this situation is to insure that fee agreements are carefully structured to provide adequate revenue for the work that needs to be completed. Profitability is influenced by client expectations as much as by staff productivity. These expectations are conditioned by written agreements and verbal assurances. The fee agreement will determine the amount that can be charged, no matter how many hours it takes to complete, unless a project is charged by the hour. Even with hourly contracts, it is not unusual for firms discount the number of hours actually worked.

The importance of client expectations in creating profitability can not be understated. Proposals and contracts need to be based on accurate historical data from similar projects, and on an understanding of the market value of the services offered. When appropriate, clients can be charged for additional services, but only if included services are well articulated and the need for additional services communicated effectively and permission is granted. Many small firms have a tendency to undercharge, to lack clearly articulated agreements, and to not carefully consider whether a potential project is likely to be profitable.

Figure 3 illustrates the influences on profitability.

Figure 3: Influences on Profitability

Strategic Indicators

These financial indicators of firm health are important to track and are useful in projecting probable future performance.

    Chargeable ratio: direct labor divided by total labor, expressed as a percentage. This is usually calculated using data from time sheets records of staff hours and how they were spent. The result may need to be adjusted to reflect that all direct hours are not actually billable. Industry benchmark is around 60 percent.

    Multiplier achieved: operating revenue divided by direct labor equals the earnings achieved for each dollar of direct labor. If the multiplier achieved equals 2.45, than the firm earned $2.45 for every $1.00 it spent on direct labor.

    Overhead rate: overhead (general overhead + payroll burden + indirect labor) divided by direct labor. Industry average is 1.5, but it can vary wildly by region and circumstance. For instance, sole proprietors who work out of their home will probably have lower overhead rates.

    Break-even multiplier: overhead divided by direct labor + 1 (direct labor divided by direct labor). If the break-even multiplier is less than the multiplier achieved, the firm is being profitable; if the break-even multiplier is greater than the multiplier achieved, the firm is not operating profitably.

    Billing Multiplier: includes profit goal beyond break-even, First determine profit goal and then divide break-even multiplier by the compliment of that goal. For example, to obtain the billing multiplier needed for a 15 percent profit goal, divide the break even multiplier by .85. Periodically, it is advisable to check the billing multiples being charged to clients to see if they are in line with profit goals.

    Profitability: net income (before taxes and distribution) divided by operating revenue expressed as a percentage. A net income of $40,000 from operating revenues of $400,000 equals a profitability of 10 percent. Industry benchmark for small firms is around 15 percent.

    Operating revenue per staff: operating revenue divided by the number of staff members at the firm. It is useful for comparison to industry benchmark of $100,000 - $120,000 and as a predictor of realistic future performance.

Strategies for Increasing Profitability

By understanding and using these strategic indicators, a number of common management decisions become easier. If profitability is too low and the break-even multiplier too high, there are steps that can be taken for improvement.

If chargeable ratio is below industry benchmark, analysis of work processes to identify bottlenecks and wasted efforts can yield good results. This can be especially effective if the professional and administrative staff is involved. A process improvement effort is an excellent opportunity to empower and engage the staff while taking advantage of their intelligence and know-how. In slow times, process improvement is value added activity.

Improving chargeable ratio may also involve actions to assure that most direct hours are billable. These may include reviewing the entire proposal process; making sure that fees are adequate to allow for excellent job performance; establishing clear and frequent communication with clients; and instituting a go/no go process for deciding which projects to pursue based at least in part on whether the project is likely to be profitable. If it is not, there needs to be another very compelling reason to take it on.

If chargeable ratios are adequate, then it is essential to engage in profit planning and use financial ratios to understand how to meet profit goals. Start by determining probable direct labor for the next 12 months. This is done by listing all staff members, their utilization rate, and their salary, as shown for a fictitious firm in Figure 4.

Figure 4: Determining Direct Labor

Utilization rates will be different for different staff roles and can be determined from time sheets or even by a thoughtful estimate. Since all firm expenses must be paid by selling direct labor, determining a billing multiplier that will yield the desired profitability is the next step. To do that the break-even multiplier and the billing multiplier must be determined. This billing multiplier times direct labor will yield the operating revenue needed to reach the desired profit goal.

Example based on Figure 4:

    Assume 2.5 break-even multiplier and an18 percent profit goal

    2.5 (break-even multiplier) /.82 (compliment of 18%) = 3.049 (billing multiplier)

    3.049 (billing multiplier) x $257,000 (direct labor) = $ 783,593 (operating revenue needed)

A quick check on these results can be had by dividing the operating revenue by the number of staff members. This will indicate operating revenue per staff member. Industry benchmark is between $100,000 and $120,000, depending on many external and internal factors. In this case, the operating revenue per employee to achieve an 18 percent profit margin is $130,598. The question to consider at this point is whether this goal is realistic.

If this firm can demand high fees because of the expertise of the staff or the market it operates within, $130,000 per staff member may not be unrealistic. Revenue projections to validate this may be developed based on historic data, financial trends, and amount of backlog (projects contracted but not yet completed).

Profit planning typically begins with projected revenue and an overhead expense budget. The financial ratios can then be used to develop staffing scenarios as needed to accomplish the work.

Chargeable Ratio: 257,000 / 475,000 = 54%

Figure 5: Scenario Planning

Based on Figure 5:

2006 Multiplier achieved: 776,000 / 257,000 = 3.02

Overhead rate: 400,000 / 257,000 = 1.55

Break even multiplier: 1.55 + 1 = 2.55

2006 profitability: 776,000 – (400,000 + 257,000) = 15.3 percent

Case Study

Considering the projected revenue for 2007, could the firm noted in Figure 5 afford to hire two more project architects in order to complete the upcoming work?

The answer and a brief analysis will be found at the end of this article.

Firm Business Model

Ability to be profitable depends to a great extent on matching the operations, staffing, and project types to the business model that a firm follows. If a firm is not being profitable, it may be that its staffing is not a good fit to the types of projects the firm undertakes. A common typology, based on the work of David Maister [Managing the Professional Service Firm, Simon & Shuster, New York, NY, 1993] places professional service firms into one of three models – efficiency, experienced, or expertise.

    Efficiency based firms make their profit by doing mostly routine projects and selling their services as quicker and cheaper than their competitors. This type of firm has a bottom heavy staffing triangle, employing many junior staff to perform the routine work load. Many firms are very successful using this model and in doing so, also provide training to many young design professionals. Project types can range from speculative housing to tilt-up concrete warehouses and retail malls.

    Experience-based firms. Most firm owners, when asked, will describe their firms as experience based. These firms do more complex project types and sell their services based on their experience in doing them. These firms say to prospective clients “we’ve done it before and we can do it for you.” Staffing in these firms needs to be balanced between senior, middle, and junior people. The key to profitability here is careful staff management that includes delegation, ensuring that tasks are performed by the person who possesses the correct skill and salary level.

    Expertise firms tend to be firms that specialize and hold cutting-edge knowledge about a narrow aspect of the field. In architectural practice, expertise type also includes firms headed by “star” designers who have a unique talent or style. These firms make profit through the ability to charge high fees and usually require a highly experienced staff.

Importance of Financial Management

In small firms, management processes can be very personalized. Like designing a custom home, small firms present the opportunity to create an organization that truly reflects the tendencies and proclivities of the principal and the staff that he or she has gathered. It doesn’t have to be conventional or rigid, but it could be if that was the nature of its leadership. Big firms are like big buildings – most of the time they need to be more formal and have well defined structures to make them stand up. There’s less opportunity for personal choice and often, for personal expression. Small firms can maximize flexibility and creativity as long as they don’t get bogged down in a chaotic atmosphere, lacking organizational structures that foster effectiveness.

With clear vision of firm purpose and business model comes explicit guidance for making management decisions. Financial management then can provide a way to track and predict whether intentions are becoming manifest, including goals involving profitability and satisfactory compensation for both owners and staff. While profit is not the only “bottom line” that architects consider meaningful, it adds to the sense of satisfaction and success for most. Regardless of the goal, financial management is essential to meet all the bottom lines.

Case Study Answer:

2 new Project Architects (PAs) increase DL to $359,000

New overhead = 1.55 x $359,000 = $556,450

Projected profitability = 950,000 – (556,450 + 359,000) = $34,550 = 3.64 percent

Another way: Billing multiplier achieved with two new PAs = 950,000 / 359,000 = 2.64

Break even multiplier with two new PAs = (556,450 / 359,000) + 1 = 2.55

Profit margin = .09 (of direct labor = amount in dollars)

Answer is yes, but at risk of not being profitable in 2007, may be best to hire only one new PA and plan the work schedule for staffing at this level; if hiring two PAs is unavoidable due the project schedule, work on process improvement to improve chargeable ratio.

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Rena M. Klein FAIA is principal of RM Klein Consulting, a Seattle-based management consulting firm providing assessment, strategy and management coaching to design firms in the Pacific Northwest and nationwide.

Keywords: Practice, Small firms, Financial management, Financial planning, Practice tools and systems, Overhead expense budgets, Revenue projections, Workload forecasts, Macroeconomics, Profitability, Billing multipliers, Utilization rate, Direct labor, Overhead costs, Firm business models, Private practice firms, Article

 

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