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Part 5: Incorporating Profit into Your Overhead Multiplier
Overhead, Profit, and Everything In Between is a multipart mini-series aimed at providing guidance to understanding, quantifying, and anticipating your AE firm’s overhead and profit in order to clear the financial fog impairing your firm’s vision and better steer your company’s ship in the right direction. In Part 1: Clearing the Overhead Expense Fog we took a look at the different types of expenses AE business need to be aware of and understand in order to begin to clearly quantify overhead. In Part 2: Utilization Ratio we determined how to quantify and anticipate direct and indirect labor for business planning purposes. In Part 3: Overhead Multiplier we finally brought it all together, fully lifted away the fog clouding your understanding, and outlined how to establish your company’s overhead multiplier and breakeven number, and how to leverage those metrics. In Part 4: Overhead Multiplier Alternates & Benchmarks we discussed alternate ways to calculate an overhead multiplier and also reviewed industry standard overhead multipliers so you can compare your own company’s multiplier to your peers.
Part 5 is the final installment of Overhead, Profit, and Everything in Between. In part 5 we are going to discuss Profit. Profit is the main driver of business. It is the main reason why businesses exist. Businesses create and share wealth. It’s clear that profit is of great importance and we need to track it. In Parts 1 through 4 of this miniseries we have been working towards establishing your own overhead multiplier. Now let’s take advantage of that overhead multiplier we established and incorporate our business’s best friend, Profit!
When we incorporate a target profit into our overhead multiplier, we effectively establish a billing rate for our hourly direct labor which includes operating expenses and profit. We will ensure our operating costs are covered and if the job is done as estimated, a profit will also be realized. This is a much better plan than just using the overhead multiplier to break even.
Before we establish our multiplier to include profit we first must decide how to quantify profit. For AE consulting, as with most businesses, the best way to do this is with a Pretax Profit Margin, also known simply as Pretax Margin or PTM. PTM is the measure of a company’s earnings (or profit) before tax as a percentage of total revenue. In equation form PTM can be defined as follows:
Both of the equations above are exactly the same. The second equation simplifies the first by utilizing the fact that Total Earnings equals Total Revenue minus Total Expenses. To put those equations to use, here’s an example: if company ABC brought in a total revenue of $1.3 million dollars in the fiscal year and had $1.1 million dollars in annual expenses, we would calculate that company’s PTM as follows:
Note that the total annual earnings in the example above for company ABC would be $200,000. We would get the same result if we divided $200,000 by $1.3 million. The PTM calculated above can also be expressed as a percentage and in this example would be 15%. When considering the typical return on an investment in the stock market is somewhere around 5% to 7%, a 15% PTM is quite a good return on company ABC’s investment in itself.
Now that we have reviewed what a Pretax Profit Margin (PTM) is, how do we incorporate that into our overhead multiplier that we have established? Intuitively you may think one of the two following equations are the correct way to do so:
OM in the equations above stands for Overhead Multiplier, as established in previous parts of this miniseries. To better visualize these equations let’s use actual numbers. Let’s take another look at company ABC. Company ABC has an average hourly rate of $34/hour, an Overhead Multiplier (OM) of 2.30, and wants to establish a target PTM of 15%. Using both of the equations above we would calculate a Billing Rate with Profit as follows:
As we can see above both equations obviously give us different answers. Which one is correct? Are either of them correct? The answer is in fact that neither of the above equations are correct. As it turns out we cannot simply add PTM to our Overhead Multiplier and we also cannot simply multiply our breakeven rate by a PTM percentage increase. Not convinced? Let’s go back to the original PTM equation we introduced, but let’s look at it on an hourly basis, rather than annual total revenue and expenses.
In order to change the PTM equation shown above into an hourly basis we need to establish hourly terms that match the ones used in the equation above. Total Revenue in our case would be an hourly rate that includes profit and also covers operating costs. That by definition is the very thing we are trying to determine: Billing Rate with Profit. Let’s abbreviate that as BRwP. Total expenses would be our breakeven rate, which can also be expressed as our hourly rate (HR) multipled by our overhead multiplier, OM. That would change our PTM equation to an hourly based equation as follows:
As mentioned above what we are truly trying to establish in this equation is our Billing Rate with Profit (BRwP). Let’s solve the above equation for BRwP and see what we come up with using our algebra skills from back in the day.
Step 4 gives us our ultimate equation for determining our Billing Rate with Profit (BRwP). Since this equation was directly solved from the PTM equation we know that this is the proper way to calculate and establish our BRwP. Let’s use the same example numbers as the previous incorrect BRwP equations and compare the results:
As you can see, if we used the other two equations we would have been cutting ourselves short. If we established a BRwP with the other two equations we would create a false hourly rate with profit that would be perceived as making the company a 15% PTM, but in reality a PTM of 13%, or even worse 6.1%, would be achieved, depending on which incorrect equation you used. This points out why it so important to be sure, as businesses, that we use the correct equations that make the dollars reflect our understanding and intentions when running the business.
The equation for Billing Rate with Profit is important, so let’s present it here one last time:
When a company establishes a BRwP, that rate can be used for time and material projects or it can be used to a set a minimum price for a lump sum project that is estimated on an hourly basis. Utilizing the above equation allows the leaders of a business to pick a PTM goal and apply that goal during the proposal process. If an AE consulting firm’s goal is to make a 15% PTM on the year, this equation is the way to do that. When it comes to running our AE businesses and estimating pricing for projects, we now know what it will cost us to do the project and how much we are going to make.
This concludes the multipart part series Overhead, Profit, and Everything in Between. After reading through and understanding the entire series you should feel confident in establishing your company’s breakeven rate and billing rates, including profit. You can now truly move past the fog clouding your company’s progress and feel confident you are leading your company’s ship to where you want it to go.
This miniseries established and defined the accounting vocabulary words so important to understanding how an AE consulting business runs. We also introduced employee utilization and determining a company’s utilization ratios. Once we laid the ground work, we established how to determine a company’s overhead multiplier and finally we brought it all together establishing our billing rate with profit.
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Aaron Mitchell, PE, SE
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