Misconceptions About Utilization Rate for A/E Firms
May 13, 2020
Utilization rate is a term used to describe how much of a person’s or a business’s or a machine’s potential output is being used. In its simplest form, if a device has the capability to produce 10 units in a particular period and completes 8 of them, it has an 80% utilization rate.
As you can see, the math for deriving utilization rate is easy. However, the real-world application of this simple formula to people—in particular those who work for architecture and engineering (A/E) firms—and their productivity isn’t nearly so clear cut. Unfortunately, many A/E firms, and the software vendors and others that cater to them, try to stick to the simple math and ignore the human factor.
That’s understandable, as we’re talking about people who are very focused on clarity and precision in their work. But misconceptions about utilization rate can ultimately cause problems at a firm.
People Aren’t Machines
One of the most prevalent mistakes regarding utilization rate is to treat the productivity of a person exactly like the productivity of a machine. The problem is that while a machine can put out the same number of widgets for hours on end, A/E firm team members are not equally productive from one hour to the next.
Their energy level, the type of work they’re doing, the number of times they’re interrupted, and dozens of other factors influence how much they get done in any given hour. For example, when writing a report, a person might get one page done in the first hour and three in the next. So, there is a huge amount of variability in output, and that fact alone breaks the utilization rate formula. But it’s just one of the reasons that firms should be cautious about how they use the number in operational and financial forecasts.
In fact, it’s been proven repeatedly that there is a very low correlation (less than 10% according to some experts) between increased utilization and increased profitability. That said, it’s still important to track utilization rate. You just have to use that figure wisely and in conjunction with a number of other variables.
Utilization Is Not a Measure of Billing Efficiency
Utilization does not track directly with billing, but is instead related to charging time to projects. What a client is ultimately charged is hardly ever the same as the number of hours recorded for the job due to budget problems, mistakes, etc. In other words, many hours may be direct (i.e. specific to a job) but non-billable.
Each Hour Worked Is Not Equally Valuable to the Firm
Different team members are paid at different rates. Consequently, the value to the firm of one hour of Employee A’s work and one hour of Employee B’s work isn’t equal. And since a firm’s profit is the difference between an hour billed to the client and an hour paid to the employee who did the work, you run into problems when you use averages to compute a capacity utilization rate for the firm. Utilization rate must be calculated based on cost from the general ledger not hours from a timesheet.
One of the problems in an A/E firm is that the people who cost the most are typically the least billable. Owners and principals have to dedicate a great deal of their time to non-billable activities like business development, but they tend to pay themselves the most. So, utilization rate based on hours is generally much higher than utilization rate based on cost.
As a result of the discrepancies above, the flawed numbers that are then used to derive optimal billing rate and ideal utilization rate cause those figures to be even further from reality.
"The real-world application of this simple formula to people—in particular those who work for architecture and engineering (A/E) firms—and their productivity isn’t nearly so clear cut."
Overtime for Salaried Employees Is Problematic
Many A/E firm employees are salaried rather than hourly. How should the time tracking system adjust for uncompensated hours over 40? What if a person is exempt from overtime and they put in 45 billable hours? Now, their utilization rate based on hours is 112%, and the benefit to the firm is even greater than that because the compensation for the five surplus hours is zero. And if you calculate utilization based on hours, you miss that whole piece.
Similar problems arise for hourly employees who work overtime and get paid time-and-a-half. How does utilization rate based on hours capture premium time? The answer is it doesn’t. So, an hour over 40 that gets paid at time-and-a-half is much less valuable to the firm than the 39th hour.
Utilization Rate and Goals
We believe that every A/E firm should have an overall utilization rate goal. It may even make sense to set goals at the department/studio level. However, what you shouldn’t do—as it’s been shown to be destructive—is to set utilization rate goals for individual employees. This doesn’t work, in part, because employees aren’t in control of the amount of work they’re given in any week or month.
The approach also fails because employees who see their work queue approaching zero tend to stretch the remaining work. This increases their utilization rate but will drive the project over budget and produce no incremental profit for the firm.
The Move to Lump Sum Fee Contracts
Another issue affecting the use of utilization rate is the growing movement to lump sum fee contracts. For multiple years now, over 50% of A/E firms projects have used this fee structure, and in this scenario, lower utilization actually equals higher profit. Plus, clients are happier when projects are completed faster. Bottom line: Lump sum projects undercut the idea that when you bill more hours you make more money.
Utilization Rate and Firm-Wide Budgeting
The highest and best use of utilization rate is for budgeting purposes. It’s critical that you know your firm’s capacity to generate fees. Each person’s cost multiplied by a market-specific direct labor multiplier gives you your billing rate. That number multiplied by the number of available hours gives the firm’s possible revenue. And that number times your targeted utilization rate gives the actual revenue you can expect in a year.
The composite utilization rate across all staff members is an important metric, as it gives you an indication of whether you need to hire or how aggressive you need to be in looking for work to fill your pipeline. You make that determination by comparing the number to your annual backlog.
However, if you’re measuring utilization based on hours, you may fool yourself into thinking that your firm has more capacity than it actually does. This can cause you to overcommit yourself by a significant amount as opposed to if you’d used a utilization rate based on cost.
The Trouble With Timers
One tool promoted as a way to help track utilization is work timers that auto-populate timesheets. The problem is that the user simply starts and stops the timer as they begin and complete a work session, with no way for their judgement on their productivity level to be taken into account. Here again, this approach is based on the fallacy that all hours are equally productive.
Employees should know that their firm has utilization goals, and that their work is a piece of that goal. However, they have to keep the client’s interests in mind when determining what percentage of any given hour is truly billable.
Non-Billable Time Is Necessary
Finally, when considering utilization rate, what successful firms will tell you is that a certain amount of non-billable time is necessary for success. Not only is vacation and sick time critical for good physical and emotional health, there needs to be time built into every employee’s schedule for training so they can continue to improve their skills and advance their career. Withholding that time so that a person’s utilization rate is higher hurts both the employee and the firm in the long run.
Ideally, an employee’s “available time” should be the total work hours in a year (2,080) minus the sum of whatever leave they are allowed plus planned education hours.
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