Business Metrics

Learning Series

April 10 2016 // 11:07 PM

Overhead, Profit, and Everything In Between: Part 1

Written by Aaron Mitchell | @PAEVENaaron

Overhead, Profit, and Everything In Between is the beginning of our Business Metrics series. Business Metrics is an ongoing series of articles covering various facets of business tailored specifically to the needs of the Architecture and Engineering world.  My name is Aaron Mitchell, PE, SE.  As you can likely tell from the self-impressed and overly advertised abbreviations that follow my name, I am a registered professional and structural engineer by trade.  The company I work for is an AE firm that implements  open book business practices.  That’s correct, open book.  What that means is ALL financial information is available to all employees, including how much co-workers are paid, how much principles are paid, amount of expenses the company incurs, which projects are profitable, which are not, how profitable the company is, and so on.  Every piece of financial information can be accessed by any employee.  This open book methodology is what initially piqued my interest and prompted my creation of the following series.

Business Metrics is a resource for anyone interested in the understanding and successful execution of financial calculations for AE consulting firms.  My goal is to take what can be overcomplicated and uninspired topics, and present them in clear, simple, and entertaining ways.

I have traveled, and am traveling, the same business finance learning path that you, my readers, are in the process of traveling. Whether you’re a current small AE business owner, aspiring business owner, or someone who works in the field of architecture and engineering wanting to have an understanding of what exactly is going on behind the scenes, Business Metrics has something for you.  Leveraging the knowledge you gain here will help you run your company more efficiently, allow you to start your own business with confidence, and help you cut through the financial mumbo jumbo your managers may be telling you.  If you have questions or comments about any of the topics discussed in this or future articles, or would like to suggest topics for future articles, feel free to contact me at amitchell@paeven.com.

Part 1: Clearing the Overhead Expense Fog

Imagine being the captain of a ship traveling in heavy fog.  You and your crew set sail with a plan to reach a desired destination by the end of the year.  Your crew is good.  The crew members know their daily tasks and do their jobs effectively.  As expected, the boat moves forward as intended every single day.  As you and your crew travel forward, there’s a change in the air.  What was once clear begins to become hazy.  Haziness turns to cloudiness and then cloudiness turns to what is now an impenetrable fog.  You have a total loss of orientation.  You can’t see around you, but you swear you’re still headed in the right direction, towards the destination you set out for.  The boat keeps moving forward.  Nothing has changed, but without the clarity to see where you are and what lies ahead, you can’t be certain of anything.

Being in charge of your company’s financial well-being can be a lot like navigating this same ship if you don’t have the proper ‘business metrics’ in place.  Many AE firms go through the same daily grind week after week.  The firm is busy, everyone is doing their part and getting work out the door, but how do we know if the firm is successful? And if so, how successful?  The real question you want to know is, are we profitable and, if so, why? The only way to know whether you’re successful is to have an accurate means of determining and tracking your company’s profit and expenses on both a short and long term basis.  Expense and profit tracking help you clear the financial fog and gets your company’s ship to where you intended it to go.

The first step is to figure out how to determine your expenses as they relate to time spent.  In order to do that, we must first learn about and build on of the following topics:
 

  • What is an Overhead Multiplier?

  • Types of expenses

  • Utilization Ratio

  • Determining an Overhead Multiplier

  • How to leverage your Overhead Multiplier


To kick off this series, I’m going to cover the first two topics outlined above.  I’ll cover the remaining topics in upcoming articles.
 
Determining you overhead multiplier

One question that all businesses ask themselves is, how much money did we make? It seems like a simple question.  You would think you could just count up the cash after each business transaction and have your answer, but in the AE world it’s not quite that clear. AE firms, in general, do not have goods to be sold or inventory to account for.  AE firms are service providers and their main expense is time.  So how do you accurately and efficiently account for your time spent on specific services you provide?  How do you know if your ongoing and indirect expenses are crushing you before your accountant tells you at the end of the financial year?

The most common way to do this is to calculate an overhead multiplier (OM).  As you will see, once established, an OM can be a strong tool to tell you what to charge on a certain project based on your anticipated time to complete. OM can be defined by the following simplified equation:

Capture.PNG


Sounds easy, well, the difficulty is in calculation of total expenses and what your direct labor costs are.  Total Expenses can be broken out into three types of expenses:
 

  •  Payroll Burden

  •  Operating Expenses

  •  Indirect Labor


A “Payroll Burden” is an expense incurred because you have to pay your employees and yourself. These expenses are paid by the company on behalf of the employee.  These expenses include payroll taxes, payroll expenses, health insurance, vacation time, retirement account administrator fees, and other expenses taken on due to the employment of staff or contractors.  These expenses are for both indirect and direct labor.

Operating Expenses are exactly what they sound like.  These are the expenses incurred in order to operate your business.  Or as that old boss of yours likes to say, “Keep the lights on.”  These expenses include property rent, utilities, computers, software, office supplies, license fees, continuing education costs, consultants (accountants, human resource, corporate event planner, etc.), and the list goes on.  Each company’s list can look quite different, but overall operating expenses incorporate the same varied expenses as every other business.

Indirect Labor is the expense resulting from time spent on non-billable tasks.  Some employee types, such as administrative assistants, human resources, marketing directors, party planners, and other indirect labor type positions typically found in large firms, are considered indirect labor 100% of the time because of the nature of their positions.  But what about non-billable time spent by employees who are generally billable?  Yes, that time is accounted for here.

Total expenses can be summarized in the following equation:

Capture2.PNG

Direct Labor, also known as billable labor, is the cost of labor spent on billable tasks.  That is the portion of salary or compensation you pay your billable employees, which is spent on projects your company is getting paid for.  It takes people to do the work, and those people have to spend time in order to complete that work.  That is why the OM is directly used in relation to direct labor.

What confounds many in the small business and AE industry is the differentiation between indirect and direct labor. As a small business owner you probably wear many hats.  Architect/engineer, designer, and drafter one day, marketing and business development another day, administrative duties of running a business all the time.  How is the distinction made?

The answer to that question comes in part 2 of this series, where I’ll explain the concept of utilization ratios.

Some of the fog clouding your business has been cleared, but your path moving forward is still not under your full control.  If you’re anything like me, then you’re feeling a bit of anxiety towards not knowing how to establish your company’s overhead multiplier and safely guide that ship forward. Rest assured that in due time these issues will become clear.  In the meantime, I leave you with the following cliché, “You must first set a solid foundation to build upon in order to create a stable structure.”

Aaron Mitchell, PE, SE
amitchell@paeven.com

 

Comments | 2
    Comments
  • Aaron Mitchell, PE, SE | 4/25/2016 6:47:34 PM Charles, glad to hear your looking forward to the future articles. The business metrics articles will be published bi-weekly. Feel free to subscribe to this article series at the bottom of this webpage and you won't miss when the articles are released.
  • charles k. daniels | 4/22/2016 10:48:47 PM Looking forward to your info sharing / discussions
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