Architecture Notes

Design publications and schools rarely mention financial management, but in the extraordinary business climate we have experienced, it certainly seems critical.  In an attempt to gain perspective on this important aspect of the profession, I recently read Financial Management for Design Professionals: The Path to Profitability by Steve Winter and Michael Tardiff.  The book  begins from square one; providing key information for architects who have little financial management experience.  This book provides a clear explanation of business challenges unique to design professions.  Here are some key points I took away from the read.

Dispel the myths

• Do not boast “ignorance of financial matters as though it were a badge of honor.” This belief that finance should take a secondary role to one’s design principles “relegates legions of design professionals to a marginal professional status …; diminishes their social status and influence in comparison to peers in other professions; and condemns them to difficult, unsatisfying careers and a financially insecure retirement.” I think the key point here is that beyond personal achievement, a collectively increased financial literacy might also benefit the profession as a whole.
• Financial information does not have to be confidential.  The authors explain the many benefits of creating a sense of ownership in a firm by sharing financial data with employees.

Essential Financial Concepts

• Timekeeping. The authors explain why proper timekeeping is so critical.  Without proper timekeeping by every member of the firm, you cannot properly manage finances.
• Financial Reports. These two key reports are critical in understanding the components of profitability.  The authors recommend reviewing these monthly.
  • Profit and Loss (P&L) Statement (or income statement)
  • Balance Sheet
• Profitability. The relationship between three elements (revenue, expenses, and profit) is represented in the net operating revenue (NOR).  The following numbers are evaluated as percentages of the NOR: direct labor, indirect labor and profit.

Terminology

Here are just of few of the terms reviewed:

• Accrual basis accounting. method of accounting in which revenue is recognized in the period in which work is performed. Expenses are recognized in the period in which they occur.  Used for profit and loss statement.  True profitability can only be measured on accrual basis.
• Cash basis accounting. method of accounting in which income is recognized when payment is received and expenses when they are paid.  Income taxes are paid on cash basis.
• Balance sheet. summarizes assets, liabilities and equities.
• Direct expense. nonreimbursable expense that can be attributed to a project. Many firms to do not track these as accurately as they do reimbursable expenses.
• Indirect expense. cannot be attributed or charged to a project.
• Direct Labor. Labor that can be charged to a project.
• Indrect Labor. Labor that cannot be charged to a project.
• Overhead rate. ratio of total indirect expenses to total direct labor.  Needed to establish break-even and billing rates.

The Annual Budget

The annual budget is the benchmark against which you measure the firm’s financial performance.   It is the basis for the key planning tool- the P&L statement. They discuss the importance of past financial data in forecasting future budgets.  Plans for new firms,with limited past financial data are also discussed.  The annual budget consists of: revenue, labor costs, fixed expenses and variable expenses.

Profit Plan

The profit plan is a forecast for expected revenue.  The firm’s backlog of work and its past financial data will be critical in developing the profit plan.  The authors describe how to prepare the plan as well as how to assess the ability of the marketing plan to support it.

2 key factors in forecasting anticipated billings:

• Utilization rate of employees
• Billing rate of employees

Profit or loss:

• (NOR) + (Other Income) – (Total Expenses) = Profit or Loss
• (Profit or Loss) ÷ (NOR) = Anticipated Profit Margin (%)

The profit plan and annual budget are ways to express financial goals.  Accurate project fee budgets and profitable billing are the tools for achieving these goals.

7 key indicators

• Utilization rate: total direct labor ÷ total labor = %
• Overhead rate: total indirect expenses ÷ total direct labor = %
• Break-even rate: overhead rate +1.0 = unit cost of salaries
• Net multiplier: NOR ÷ total direct labor
• Aged accounts receivable: (annual average accounts receivable ÷ (net operating revenue ÷ 365)
• Profit to earnings ratio: profit before distributions and taxes ÷ NOR
• Net revenue per employee: annual NOR ÷ number of employee

Billing Rates

• In order to calculate true profit margin, it must be calculated as a percentage of NOR.  This is explained in detail.
• Total break-even cost = (break-even rate for all project team members × anticipated hours) + outside consultant fees + project related expenses.

Fee budgets

• Top-down method:  the fee may be fixed.  If not sufficient, the scope of services may be negotiable.
• Bottom-up method:  Intended for private sector projects.  Usually begin with request for proposal (RFP).  Negotiations focus on project fee.