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AE Firm Performance in 5 Simple Metrics
October 8, 2019
This is one of the reasons that A/E firms rank near the lowest in profitability among all professional services providers. It’s not that they aren’t good at their craft, they just don’t excel in financial management. And it doesn’t help that the standard tools for project management, resource scheduling, time tracking, etc. aren’t designed to help firm owners and leaders assess and improve profitability.
Laying the Foundation for Better Financial Performance
Some A/E firms try to improve financial performance through painful “trial and error”. They quickly learn that that approach isn’t particularly effective. A better approach? Learn from the miscues of others. What we’ve found in trying to improve our firm’s profitability, and what we share with our customers, is that the best approach is a metrics-driven strategy. But not just any metrics.
Again, A/E firm owners and managers are very skilled in their specific discipline, but generally aren’t financial experts. Throw too many metrics at them and you’re likely to see “paralysis by analysis.” Instead of those numbers being useful, they can easily lead to confusion and poor decisions. So, presenting management with the right metrics is key. But even before that, A/E firms need to have their accounting systems set up to:
● Separate direct labor (activity that generates income) and indirect labor (activity associated with running the office) costs. If you aren’t able to draw a distinction between the two, you won’t be able to use the five metrics below to boost profitability.
● Identify “clean” labor dollars that don’t include overhead — things like benefits, payroll taxes, etc.
● Provide accurate numbers for gross revenue and net revenue. Gross revenue includes reimbursable costs like printing and travel, sub-consultant fees, etc. In some firms, the difference between gross and net revenue can be as much as 30-40 percent.
When you’re positioned to get this data (and many accounting packages can’t provide it), you’re ready to start focusing on five key profitability metrics.
"Having gone through plenty of “trial and error,” we now understand that the key to increasing your profitability is knowing which “levers” to pull and how to pull them."
Profit by the Numbers: The Metrics A/E Firms Need to Succeed
Having gone through plenty of “trial and error,” we now understand that the key to increasing your profitability is knowing which “levers” to pull and how to pull them. Through years of “in the trenches” experience, we’ve zeroed in on five key metrics that when manipulated properly have helped us achieve sustainable, long-term success:
- Utilization rate. This number is a percentage of the total labor cost that went to projects as opposed to costs that go to non-billable activities. Calculated as the cost of all labor applied to projects divided by total payroll cost, it’s typically expressed somewhere between 50 and 70 percent. You’re probably familiar with this figure, as it’s widely used by A/E firms. There was a time when utilization had a close relationship to profitability. With work no longer being billed strictly hourly, that relationship has changed and is more challenging to understand without the right tool.
- Net fee multiplier. This is the amount of net revenue divided by the cost of direct labor. It’s expressed in a whole number like 2.5 or 3.8. Essentially, it represents the number of times that your labor is marked up to get to the fee you charge the client on an hour-by-hour basis. For example, if you pay someone in your firm $25/hour and charge the client $75/hour, that’s a net fee multiplier of 3. As you would imagine, when projects are staying under budget and tracking as expected, net fee multiplier and utilization rate will be higher. But, if a project is over budget, you may have a high utilization rate but a low multiplier. So, the two metrics tend to counterbalance each other. We keep both in mind when managing our labor costs and project budgets.
- Revenue factor. Now we’re talking about probably the most important financial performance metric. Revenue factor is utilization rate times your net fee multiplier. It’s expressed in whole numbers like 1.6 or 2.2. This figure has a high degree of alignment with profitability. We’ve found that if you have a revenue factor of around 2.0, you’re generally close to 20 percent profit for your firm, and that’s double what firms typically make! Many experts consider a 2.0 revenue factor to be the dividing line between firms that are thriving and firms that are simply surviving.
- Overhead rate. Expressed as a percentage, overhead rate is the total amount of overhead costs divided by direct labor. It’s important to note that this is different than almost every other industry, where overhead costs are divided by revenue. Being able to separate direct and indirect labor is crucial to getting an accurate overhead rate, since indirect labor is one of its biggest components. In our experience, a typical overhead rate is 150-200 percent of direct labor.
- Net fees per employee. This productivity measure answers the question, “Are you utilizing your people for their highest and best use?” This is gauged based on full-time equivalents (FTEs) rather than truly “per employee.” From our discussions with architects and engineers today, we’ve learned that they are putting in a significant amount of overtime, which means FTE may be higher than actual headcount. This number is typically $150,000-200,000 per person.
Of course, there are many other metrics you should be aware of. But, if you’re effectively measuring and managing the numbers above, your firm will be performing well from a financial perspective. Just as importantly, your staff will be enjoying the financial benefits of their hard work!
The Middle Way to Better Business Results
It seems that most A/E firms are at one end of the information spectrum or the other. Either they aren’t measuring any metrics or they’re attempting to measure too many. Either way, the result is the same: they fail to meet their profitability objectives. Or worse, they stop focusing on profitability all together and just keep cranking out work and paying the bills, leaving a significant amount of profit on the table.
Factor A/E gives you the functionality you need to manage your firm but from a unique metrics-first perspective. Plus, it’s updated annually with industry standards for key metrics so you know what’s achievable. Is it time for your firm to get dialed in on financial performance?
Get on the Path to Higher Profitability
The first step in streamlining your operations and achieving your business goals is learning to look at profitability differently. Get started today!