Architecture firms design buildings in exchange for compensation. With the exception of pro bono work, that’s the premise everyone agrees to when they sign a contract. And we measure the success of that exchange in lots of ways…and use lots of terms to describe those measurements. It may be Project Management 101, but here are six of those key terms, and why they matter.
Net Profit: Everyone wants a profit. And everyone knows what it means, right? It’s the leftovers after you subtract what you gain from what you lose—revenues minus expenses. But the simple concept actually encompasses a lot. A client may pay $100 to cover design and consultants (direct costs). If your labor costs are $75, you have a $25 profit right? But what about the cost of gas to take trips to the site? What about the paper used to print out the contract? What about the rent on the building where you worked? (These are indirect costs.) Just because what you were paid is more than what you spent to pay your employees doesn’t mean you made a profit.
Utilization Ratio: Since profit is a little more complicated, that’s where Utilization Ratio comes in. It’s a way of tracking beyond simple, direct expenses. Mathematically, it’s the ratio of hours reported directly to a project over the total hours reported by an employee. For example, if an employee has a utilization ratio of .8, they are billing 8 hours to a project for every 10 hours they put on their timecard. The remaining two hours account for things like general office tasks, vacation, etc.
Overhead Rate: The big brother to Utilization Ratio is Overhead Rate. Its official definition is “the ratio of total indirect expenses to total direct labor”. Its function is to not just acknowledge, but actually account for all the parts of work that aren’t directly billable to a project. It works by taking an employee’s hourly bill rate, and adding on a percentage to cover things like administrative personnel, building maintenance, and other costs necessary to run a business, but not directly associated with any specific project. Using an Overhead Rate helps companies propose more accurate fees, as well as better assess the profitability of a project. It can also be an indicator of how lean a business is running (how few extraneous costs it incurs to keep up with day-to-day operations).
Net Multiplier: Net Multiplier combines overhead rate and direct labor, and compares it to net operating revenue. Essentially it’s a way to measure the amount of revenue generated for each dollar spent on directly on a project. It’s a productivity measure that can be used to determine if billable employees are producing enough income to cover the full cost of operating the company.
ROI: Another way to track profit is from an investment standpoint. If a firm spends money on a proposal, but they win the project, it was a worthwhile investment, right? Well, what if they spent $100 on a proposal to win a $75 job? ROI, Return on Investment, puts numbers on the initial investment before comparing it to the actual return. It shows that ‘worthwhile’ may not always be the case. A firm can have a 100% success rate on proposals, but if they are investing more than their return, they will never profit.
Working Capital: Architecture functions more like buying a house than buying a shirt. Payment for work is most often received over time, not all at once. Why is this important? Assume a firm requires $5,000/month to stay operational, but they win a project with a $1,000,000 fee. They are more than set for a whole year right? Well, no, unless they get a piece of that $1,000,000 fee upfront. If not, they will be out of business after a month, no matter how big the fee. Working Capital measures a firm’s liquid assets (like cash), against a firm’s liabilities (like building costs and salaries). It’s important because it lets a firm know if they have enough money coming in at present—not sometime in the future—to maintain operations. It’s a particularly useful number to have when starting a new project and determining the terms by which you will need to bill your client.
Finances and the terms used to describe them span from simplistic to complex, but their importance never changes. Want to know more? Check out the AIA Handbook’s section on Financial Management: http://www.aia.org/aiaucmp/groups/ek_public/documents/pdf/aiab028666.pdf