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Part 3: 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 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.
Now it’s time to finally wrap a bow on the topic of expenses and overhead. We have laid the foundation in Part 1 and Part 2 for detailing how to establish an Overhead Multiplier. Now we are ready to finally track our progress.
Let’s continue our example from Part 2. There we calculated the utilization ratios for 6 employees in a fictitious company. Using that information, we directly related that company’s cost of doing business to the time they spend on their projects. For convenience the utilization ratio example table from Part 2 is provided below for quick reference.
We can establish our Overhead Multiplier 1 of 2 ways:
Determine Indirect and Direct labor expenses using Billable Salary and Overhead Salary, or
Determine Indirect and Direct labor expenses using the utilization ratios.
The table below, using the billable hours established in the utilization ratio table, determines billable salary and overhead salary.
Equations used in the table above:
My preference is to implement the utilization ratio we established. See the table below for Utilization Ratio approach.
Equations used in the table above:
Both approaches get you the exact same answer. The utilization ratio is established based on billable and overhead hours; therefore we do not need to re-incorporate the billable and overhead hours like we do in the 1st approach.
Note that both indirect labor expenses and payroll burden expenses are lumped together as one under the “Salary for Overhead Hours” column in both tables. If we want to separate the two types of expenses out of the Salary for Overhead Hours we can do so by looking at the proportion of total payroll burden hours to total overhead hours, and also the total indirect labor hours to total overhead hours. Below is a modified Utilization Ratio table that we saw in Part 2 of this series, which totals up the hours for payroll burden and for indirect labor separately.
Based on the hourly breakdown of overhead hours we can determine that 984 hours of the total 4,270 hours is due to payroll burden hours. Using that information, we can separate out the Salary for Payroll Burden and Salary for Indirect Labor from the total Salary for Overhead.
Now let’s use an example taking advantage of the data we have established above to finally illustrate how to determine an Overhead Multiplier.
The following are the anticipated annual expenses for the upcoming year for example company ABC.
Direct Labor Expense = $263,664 (Salary for Billable Hours, see table above)
Indirect Labor Expense = $99,746 (Salary for Indirect Labor, see above)
Payroll Burden = $29,869 (Salary for Payroll Burden, see above) + $60,000 (additional payroll burden expenses for group insurance, worker’s compensation insurance, 401k, payroll taxes, etc…) = $89,869
Overhead Expenses = $150,000 (office space rent, utilities, printer and plotter leasing, office supplies, etc…)
Overall the math is fairly simple, but it did take us a long time to finally reach the calculation of our Overhead Multiplier. It is important to fully understand the different types of expenses that go into your running an AE business. Now that you understand how to get from point A to B you can establish your own Overhead Multiplier. Want to take advantage of the tables we used in this article? Excel versions of those tables are free for your use in PAEVEN’s Tool Box.
Let’s continue the previous example and illustrate how the OM is best used.
We established in the previous example that our company ABC has an estimated OM=2.29 for the upcoming year. For conservativism and simplification, let’s use an OM=2.30.
Company ABC has an opportunity to bid on a project. They have broken down the scope of that project and believe it will take them a total of 200 hours to complete from start to finish. How much, at a minimum, does company ABC need to earn in fees to break even? Here’s how to find out:
Determine average hourly cost of each billable employee and owner. This reflects the hourly direct labor cost your company incurs every hour of work that is spent, regardless of who is going to work on this specific project. (Note: another and more detailed way of doing this is to establish what type of employee(s) will be working on this project and use the hourly rate of each employee and assign hours to each employee. This approach can give you a much more accurate project cost, but gives you less flexibility with which staff can work on the project in the event you are awarded the job.)
Let’s be conservative again and simplify the math by using $80/hr
Now, keep in mind that company ABC could bid on the project at $16,000, but that would only allow the company to break even. All expenses would be paid, employees would get their paychecks and benefits, but the company would generate no profit. Failing to generate profit could prevent you from growing the company, providing future employee bonuses, or having extra cash on hand. One cannot underestimate the peril that exists in not turning a profit.
It is likely that company ABC is a smaller firm, with fewer expenses, than their typical competitor for this example project. If the average bid prices from competing firms are estimated to be up near $25,000 in design fees, and if company ABC bid on the project at their breakeven price of $16,000, then company ABC would potentially be leaving $9,000 of profit on the table. At the same time, the company who issued the RFP for the example project may need a 10%, 20%, or even greater reduction in bid price from the average bid to justify going with a smaller, unknown firm. This is where a business strategy for obtaining work comes into play. Every business should explore and establish how they would approach the above provided example.
Hopefully now most of the fog clouding your business has been cleared. For AE firms who think about tasks on an hourly basis, an established Overhead Multiplier and a known Breakeven Hourly Rate for your company are extremely useful tools. In the next part of this series we will continue to discuss other ways of tracking your multiplier and start to think about incorporating profit into your estimating rates.
Aaron Mitchell, PE, SE
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