Financial Management

in Architecture
Managing a successful architectural practice relies on a number of
immutable, longstanding truths. Yet there's an equal influence of new
trends, techniques, and tools that separate the reasonably well-run firms
from those that excel.

Yet even the smallest firms—those with fewer than 10 employees—earn a

large share of the national total of architectural billings, at about 20 percent
of the total according to the AIA survey. Expand the sample to firms with up
to 20 employees, and you have the lion's share of billings. That's millions
and millions in revenue for these firms, and a key reason to keep careful
tabs on firm financial operations.

Part of what makes great and successful design firms is purely

organizational. These firms are able to quickly and efficiently provide
principals, project managers, and entire staff essential information they
need. They've reduced the amount of time needed to manage project
tasks, billings, and documentation so that they have more energy and
creativity for the core activity: design workflow.

Their invoicing is clear and meets client expectations. They're using the
leading edge of technology to automate processes, manage tasks and
phases, eliminate misfiled documents, and run reports easily and quickly.
“It's not an architect's fault that after all the years of
education and training one must endure to become an
architect that the resulting firm leader doesn't know the
first thing about how to run a business. But in addition to
designing and detailing structures, the architect who is a
firm leader must also truly understand the difference
between income and revenue, and between
a credit and debit, just to name two key pairs of
accounting terms. The firm leader has to know what
a minimum billing rate and an overhead factor are,
and why these two measures are so critical to successful
practice management.”
According to the AIA publication The Architecture Student's Handbook of Professional Practice, firm
financial planning can be described as a six-step process. Starting out the full analysis, an
architecture firm's financial health is best considered by looking at the firm's estimated
operating budget—also known as a profit plan. “Financial guideposts come from a profit plan,”
according to the AIA textbook. A simple, essentials-only version of a profit plan follows, which is
helpful to any small or emerging firm. The plan is based on three steps:

▶ 1. Estimating expenses. This includes the firm's salaries and benefits as well as payroll taxes. It also includes approximate
office expenses but not client reimbursable expenses or consultant project fees that are passed through to the client.
▶ 2. Establishing a profit goal. This may also be described as the firm's return on investment (ROI), and is usually stated as
percentage of net revenues, after expenses and before taxes. All the effort and money the firm puts into its business should
return a profit. This is what one would expect if money were invested in something else, such as stocks, bonds, or real estate.
“Architects pour their life into these building projects, so the return should be commensurate with the effort,” says
Burns. “Otherwise, they might as well take the money and invest it in the stock market.”
▶ 3. Determining the net revenue goal. It's a net figure because it omits all reimbursable expenses listed earlier. The net
revenue goal has another important function in the life of an architecture firm: It represents what the firm plans to invoice
clients for their architectural services rendered.
Architects earn their revenue (and profit) by working on building projects. So it should come as no
surprise that the most common denominator for planning and measuring financial performance is
the direct salary expense (DSE). This is the salary cost of the hours charged to projects—in other
words, the firm's billable time. Knowing the staffing level and overhead, a firm's profit goal can be
used to determine how much direct salary must be charged in order to hit that profit target at the
end of the year, according to the AIA publication

To illustrate, the firm can apply the sample profit plan developed above to calculate the DSE
multipliers, which are numbers that can be used to determine the values such as the target break-
even, profit, and revenue amounts. But in order to do this, the firm must first determine its Efficiency
Ratio. The efficiency ratio is calculated by dividing direct salary expense by total salary expense. This
also means that:
Direct Salary Expense = Total Salary Expense x Efficiency Ratio

So how does an architecture firm determine its efficiency ratio? They can do the math above, or they
can assume a profession-wide benchmark. For example, there are statistical surveys showing that,
on average, architectural firms achieve about 65 percent efficiency ratios. This averages all
employees—not only principals but also all staff members—even though efficiency ratios may be
different for principals than they are for interns or others. For example, national benchmarks show
that principals may be only about 50 percent efficient, for example spending 20 of their 40 hours/week
on work billable to projects, while architectural interns may be 95 percent efficient.
Using the results from Chart 2, the firm knows that its total salary is $270,000. But since it operates only with
a 65 percent efficiency ratio, the firm's DSE or direct salary expense is $270,000 x 0.65, or $175,500. Next, the
firm must determine its break-even multiplier (determined by dividing direct labor plus overhead by direct
labor) and its planned net multiplier, a measure of the revenue required for each dollar of direct labor spent
on projects.

Adding together the multipliers for the

firm yields the planned net multiplier—in
this case, of 2.85. Like a utilization rate,
this is a measure of the firm's efficiency
at producing work and yielding a profit.
And this is a magic number, specific to
the firm. Once the firm knows it, they can
make a number of financial planning
decisions.
Setting Ideal Billing Rates

Why is the planned net multiplier so magical? First, it's an

incredibly important number to help the firm determine what
the minimum hourly billing rates should be for the firm's
staff. To show how this works, have a look at each type of
staff member in the firm in Chart 4.

So taking into account all the factors for professional salaries

and benefits—and how many hours the firm's staff members
will work —provides a net cost to the firm for each hour
worked. The magical multiplier is then used to get the ideal
billing rate. And as long as this architecture office maintains
the 65 percent efficiency rate determined earlier, the firm
must bill accordingly to get the desired level of profit: the
principal at $191/hour, the project architects at $137/hour,
and the architectural interns at $67/hour.
Using these values determined above, the architecture
firm can then predict the likely potential value of the
employees. This calculation is called the projected
realizable income (see Chart 5), and it helps determine
a valuable aspect of how the firm must be managed.

The valuable information is also good news: It shows

that at the firm's planned billing rates, the potential
income is greater than planned. Specifically, the total
realizable income of $627,200 exceeds the $500,000
projected in the firm's profit plan. So the firm could
invoice 80 percent of its potential and still hit the goals
set forth in the profit plan.
It sounds like good news, and actually it's typical,
according to experts in architecture firm management.
This is a very common position for most firms, and
they obviously would like to bill the full potential of the
staffing and predicted efficiencies. Considering that
the principal will be spending half of his or her time
working on non-billable things, we would hope that
these efforts are what will continue to bring new work
into the firm.
Using Financial Systems to Keep Firms Profitable

▶ Accounting. “This may be obvious, but all firms need some form of accounting software,” says Burns, noting that a number of effective
and inexpensive accounting products are on the market. “Choose an accounting software that is both highly affordable and scalable.”
When used properly, the accounting products serve as an effective tool to help principals understand their own businesses. It also
provides a single platform for managing the company's basic accounting needs, such as taking care of the bills owed (accounts payable),
and to efficiently run common financial reports, such as the balance sheet and income statement.

▶ Payroll. The accounting software product is also used to handle payroll. However, once the architecture firm reaches a certain size—
typically 4-5 people employed, or more—many firms choose to migrate to an outside payroll system vendor. There are many of these
companies on the market, and even the largest international vendors work with very small businesses.
Note that they can do a lot more for the firm than just payroll, such as preparing reports. They are also responsible for making sure payroll
taxes and benefit contributions are paid on time, so the firm is never penalized for late payments. “It takes the burden away from you, the
firm owner, so you can focus on what you do best,” says Burns.

▶ Project management. One of the reasons why leading architecture firms use software to manage building projects is, when properly
used, the projects and people will be organized and efficient. PM software manages people and time over the course of specified project-
related activities. Being able to track these variables will make sure the firms are making the most productive use of its direct hours—in
other words, the hours employees and partners spend on projects, as opposed to hours spent on overhead activities.
END