Business Metrics

Learning Series

May 04 2016 // 6:00 AM

Overhead, Profit, and Everything In Between: Part 2

Written by Aaron Mitchell | @PAEVENaaron

Part 2: Utilization Ratio 

Overhead, Profit, and Everything In Between is a multipart miniseries aimed at providing guidance to understanding, quantifying, and anticipating your AE firm’s overhead and profit.  This will help you clear the fog impairing your financial 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 businesses need to be aware of and understand in order to begin to clearly quantify overhead.

In Part 1 we differentiated between direct and indirect labor costs for employees who are generally billable.  These are the employees, or even principals, that spend time working on design projects which deliver the end product to the client.  You and I both know this as “billable time.”  It may come as a shock to you, but it is extremely rare for a worker to be 100% billable.  Hopefully everyone at your company is at least given the chance to take a vacation or spend some time at home while they are sick.  PTO (paid time off) is just one example of unbillable time you and your employees spend.  Marketing and administrative tasks are also big players in the unbillable time that falls under the category of indirect labor.

The next aspect of clearing the financial fog involves marketing.  Marketing is pretty important for your company, isn’t it?  If not, you’re either very fortunate or are struggling to get by.  Marketing is considered an unbillable task because it is not a task which you can generally tie to any particular project.  Sure, you could track your marketing time and expenses on a single client and then count that time proportionally to the projects that clients give you, but generally marketing is a broad effort with results that are not quantifiable towards specific projects.  Marketing is typically considered to be an unbillable endeavor across the board in order to conservatively simplify the accounting aspect of determining your overhead.  There will be some cases where your firm spends a noticeably high amount of time and expense on some potential projects.  In those cases it would be wise to track that time and expense so that if you so desire you can lump those costs into your final proposal number.

So, what about small business owners who wear multiple hats?  You’re probably multitasking right now as you read this article.  In the course of a day you spend your time on a billable task, then an unbillable task, then some other task that you can’t remember: “was that billable or not billable?”  And that’s just one day.  Imagine a whole week, or an entire month.  It would be almost impossible to differentiate and track your ever changing activities without planning ahead of time. 

One solution to this is to estimate or identify a utilization ratio for each type, or level, of billable employee.  A utilization ratio is the comparison of indirect labor to direct labor.  The simple formula for the utilization ratio is as follows:

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The utilization ratio is something you must plan for before starting your business and adjust at least once a year.  Already started your business and still don’t know what in the heck I’m talking about?  That’s okay, because it’s never too late to get on the right track. The best time to determine your company’s ratio is when you are business planning for the start of your new business or planning for the upcoming fiscal year.  The ratio can first be estimated and then refined by looking back on past time sheet data, and will also be influenced by your company’s future plans to grow and become more efficient.

This ratio can and should be tracked periodically throughout the fiscal year.  This tracking will serve as a litmus test of how the company is performing and how well the original estimated ratio is standing up to the real numbers.  The ratio isn’t final until the end of the year, so take your periodically tracked ratio with a grain of salt.  Understand that the data is provided to help you clear the fog. 

Knowing now how to track a utilization ratio you should know how to determine indirect and direct labor of your direct labor personnel.  That is, identify non-billable time spent by your generally billable work force.  The easiest way to do this is to break things down in terms of hours.  Hours are of course how we consulting AE types keep track of everything we do at work, so why stop now? We will base our numbers on a 40 hour work week.  The fiscal year has 52 weeks.  That brings us to:

2.PNG

Next, we identify planned and anticipated unbillable time throughout the entirety of the year.  That requires knowing, or projecting, vacation, sick time, time spent on marketing, administrative time, and other time spent on similar duties you and your employees are going to spend throughout the year.  Some of those items are already established and known.  Some need to be established based on a business plan in order for the firm to be successful.  Others may not be so easy.

This can be easily understood by organizing this information in tabular form.  The following is an example of a fictitious small firm with 6 total employees, one of which is completely unbillable and considered indirect labor.
 
3.PNG

Only three equations are used in the example table shown above.  Total overhead hours are simply the sum of all hours input for each labor type.  Total billable hours are equated by subtracting total overhead hours from 2080 hours/year.  The utilization ratio equation is calculated as follows:

4.PNG

Note that the full time indirect labor does not need to be listed.  In this example the administrative assistant was shown for example purposes, but this exercise is intended for a billable work force.  It is now painfully obvious that the administrative assistant is going to have a utilization ratio of 0.00 since that individual spends, or at least is planned to spend, no time on billable projects.

You can go as crazy into the data mining detail with this as you want, but sometimes it’s best to look at the overall picture and make somewhat conservative generalizations of your company’s utilization ratios.  I’m specifically talking to you, Mr. or Ms. Engineer.  This is one case where an engineer’s passion for crunching numbers may unnecessarily exhaust themselves. We don’t need a ratio to the 10 millionth decimal.

A small business owner who just kick started their business may estimate their average utilization ratio for the year at 0.50 (or 50%).  This means that half of their time throughout the year is spent on billable tasks and the other half is spent running the business and finding more work.  As that company grows and hires employees, those employees may be estimated to have a 0.85 utilization ratio. This may lower your overall ratio from 0.50 down to 0.35.  As that employee grows in your company, they may take on more marketing tasks or administrative tasks, which would justify estimating a lower ratio for that employee at that time.  Over time the utilization ratios for owners and different level of employees will bear themselves out and level off for each labor type.

Now that you’ve calculated the utilization ratio, we can take one more step forward determining and tracking our company’s overhead.  In the upcoming 3rd part of this miniseries, we are going to put our knowledge to work and run through some examples to determine a company’s overhead ratio and breakeven number.  From there we can discuss how to leverage that information into making smart and competitive business decisions.  This article, Part 2, merely armed you with a very important tool.  Stay tuned and we will put that tool to work and continue to clear the fog.

Until next time,

Aaron Mitchell, PE, SE
amitchell@paeven.com

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