Business Metrics

Learning Series

June 01 2016 // 5:00 AM

Overhead, Profit, and Everything In Between: Part 4

Written by Aaron Mitchell | @PAEVENaaron

Part 4: Overhead Multiplier Alternates & Benchmarks

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 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. We fully lifted away the fog clouding your understanding by outlining how to establish your company’s Overhead Multiplier and breakeven number, and how to leverage those metrics.

In Part 4 of this series we are going to take one final look back at the Overhead Multiplier (OM) equation and point out some important items surrounding it.  We will also discuss possible approaches that can be used when calculating your Overhead Multiplier and typical Overhead Multipliers for the AE industry.
 

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The most important distinction to be made in the OM equation is that we divide total expenses by direct labor only.  We need to understand that our OM is meant to be multiplied only by direct labor hours.  Direct labor hours are the only time a consultant is actually generating revenue.  The Overhead Multiplier is then set up to attach a definable cost of services to every revenue generating hour, which is direct labor.  Initially when first approaching this topic I mistakenly thought that the Overhead Multiplier equation should be as follows:
 

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In this case Labor Expense would include all associated expenses for billable employees, which would be direct labor + indirect labor + payroll burden, but this didn’t make sense when it came to apply the multiplier by billable time.  With this approach, in order to determine your breakeven you would have to multiply an employee’s hourly rate times a utilization ratio for billable time and then multiply by the Overhead Multiplier. This approach wouldn’t relate all of the company’s expenses to revenue generating hours, just a portion of it based on the utilization ratio.

With that said there are approaches out there that use either payroll burden expense and/or indirect labor expenses in addition to direct labor expense base when calculating an Overhead Multiplier.  Typically, the cited reason for making these adjusted calculations is to lower overhead, but if were being honest with ourselves, when this is done we are not lowering anything, just playing around with the numbers.  If we take a moment and think about what exactly happens when we add another category of expense to the denominator of the OM equation, we can see that the OM number would get smaller.  Our OM from Part 3 was 2.29, but if we applied payroll burden to the direct labor base we would get an OM of 1.71.
 

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In this example approach of including payroll burden with direct labor in order for the OM to work properly, you would have to adjust your billable employee billing rates to include payroll burden.  So if your aggregate hourly billing rate is $34/hr. you would increase that aggregate rate by a factor of 1.34 (=2.29/1.71).  That would give you an aggregate hourly rate of $45.53/hr.  As you can see there is no difference between multiplying 2.29 x $34/hr. and multiplying 1.71 x $45.53/hr.  Both equations give you a breakeven hourly rate of $77.86/hr. The easiest, most efficient, and industry accepted approach is to determine your Overhead Multiplier with direct labor expenses only.

Now that you have a full understanding of the Overhead Multiplier equation and have established your own multiplier, how does your company compare to the industry?

Industry average OM for AE firms varies between small and large businesses from about 1.5 for small companies to 3.0 or more for larger companies.  Typically, you’ll find a company’s multiplier between 2.0 and 3.0. Most established firms are comfortable with a multiplier between 2.5 to 2.75. Obviously, the lower your OM, the more competitive your company can be. Also, the lower your OM, the greater profit margins your company can obtain when bidding on jobs at or below market value. This allows you to make more money, while also adding a competitive option for your current and future clients.

A low Overhead Multiplier could also be a sign your company is not providing something other companies do. That could be related to employee benefits, office environment, technology upgrades, or other fringe benefits. These are all things an owner needs to consider when trying to attract and retain top talent.  Sometimes employees may prefer more money in their pockets rather than increased medical benefits.  You need to constantly ask yourself how the company can be more efficient without causing detriment to your employees and operations.  This is the only true way to lower your OM, rather than shuffling around the numbers as discussed above.

Looking back on what we’ve mastered throughout this multipart series we now understand not only what an Overhead Multiplier is, but how to determine it within our own business.  We also should have an idea how our Overhead Multiplier compares in relation to industry averages. The most successful business men and women in the consulting industries will be those that can figure out creative ways to reduce expenses, but at the same time attract and retain top talent.

I hope you’ve found this summary helpful and aren’t left with more questions about how to utilize your Overhead Multiplier. If you still have questions, read the last and final step in our series Part 5, as I will tie everything together by factoring profit into your Overhead Multiplier through a careful pricing process aimed at positioning your business for financial success.  

Aaron Mitchell, PE, SE
amitchell@paeven.com

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