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Billing Practices
Billing practices in an integrated software will have major ramifications for the accuracy of your project workload forecasting. For example, do you typically bill ahead of work performed or behind?
Proposals and Business Development
To effectively manage this volatile but critical part of your revenue forecast you will want a project management software that allows for the tracking of proposal effort and an easy-to-use project budget that lets you roll right into the billable project upon awarding of the contract.
Projects
This is the backbone of your firm’s budget. Ultimately, very few dollars will come into your firm by means other than projects, so particularly for near-term and medium-term forecasting, you will want to use your software to accurately and seamlessly budget and schedule your projects.
Resources
Within a project or a phase we will need resources to translate our project budgets into staffing information. Do we have the staff we need to perform the work under contract? Are any resources overburdened or underutilized? We will define what comprises a project resource and how to best utilize this tool to inform your big-picture budget.
Employee Workload
Even a modestly sized AE firm can benefit from understanding their Employee Workload. If project budgets are created appropriately, integrated AE project management software will allow an employee workload to be created, either by individual or employee type. This will tell you two major factors that will influence your company budget: direct cost, and implicitly or explicitly, indirect cost, which is extremely important to try to understand.
Overhead Items
Lastly, perhaps the easiest part of the company budget is overhead items such as rent and utilities. But don’t worry, we’ll talk about those too.
Sharpening the Saw
The best AE accounting and project management software will give you enough feedback as your work through your projects and proposals that you can appropriately revise all of your budgeting. In this industry, a single project can determine the staffing requirements and profitability of an entire firm, and your software should help you appropriately adjust your budget in the event of either a big win or a big loss, or as a result of several changes to your business development pipeline. A truly good budget needs constant attention, even if you may want to frame the first one out of nostalgia.
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Revenue Goals
The very first line items in your company budget are related to revenue. Architects and engineers, in a very broad sense, have essentially three classes of revenue: labor (professional services), reimbursable or incurred project expenses, and revenue collected on behalf of or incurred for consultants.
In most firms, revenue collected for expenses and consultants is marginally profitable at best. Your best hope for making a profit comes from your professional services revenue, and that is the most
important variable to focus on when building your company budget.
To take a top-down approach as an initial stab at a company budget, take a look at prior years’ history and trends. You may be able to identify a pattern of a particular growth rate, or, in these times, shrinkage rate, or perhaps an indication of relatively steady revenue year-over-year.
Assess whether you believe (or want) this trend to continue, and create a number to use as a revenue goal. This number will likely change as you get deeper into the process, but it will help to have a goal in mind to compare your more detail-driven forecasts to as you get closer. Derive your goal based on professional services revenue, not necessarily expense and consultant revenue.
To determine expense and consultant revenue, if your accounting software is setup properly, you should be able to identify these major revenue centers in prior year financial statements, and you will be able to identify a relationship to the labor revenue. For example, for every $1,000 in labor revenue, your firm may tend to incur and collect $25 of expenses and $100 of consultants. You will likely find this ratio is largely consistent within your firm, based on the way you do business and the clients and market sectors you tend to work in.
Now you should have a big-picture revenue goal. It should be realistic, but it doesn’t need to all be accounted for in your detailed forecasting, such as project workload or business development, yet. In a future installation, we will discuss how to use those mechanisms to refine the budget and determine any gaps that need to be filled.
Direct Costs based on previous year trends
For this first crack at your company budget, which we’ll continue calling a “top-down” approach, you want to estimate your direct costs. Here again, proper architectural and engineering accounting software will allow you to break your costs up into three major cost centers: labor, expense, and consultant.
To estimate expenses and consultants, you will want to do some analysis of your prior history again. For example, do we always mark up consultants 10%? Or do we mark them up on 50% of jobs, and pass them through at cost on the others? Prior year trends will indicate an overall markup (weighted average) by comparing consultant revenue to direct consultant costs. You should be able to budget your direct expenses and consultants based on this generalized markup, except in periods where you expect to have a big change in the way to collect revenue for those costs.
Much more volatile is the amount of direct labor cost to place in your company budget. At this initial stage of the game, you will want to utilize an AE-industry metric called the direct labor multiplier. Architects and engineers who have contracted with government agencies will be very familiar with this term, and most firms know what it is instinctually even if they use different names for it.
What we’re talking about here is the relationship of labor revenue to direct labor cost. This is one of the single-most important reasons to make sure your accounting software is setup appropriately, and especially your fee-based projects are budgeted appropriately. We need to be sure that we are recognizing labor revenue as distinct from expense and consultant revenue, or the direct labor multiplier will be overstated.
To arrive at this multiplier, divide labor revenue by direct labor cost. Look back at multiple years of trends to see how that multiplier changes for your firm over time and to make an educated guess at what you think that multiplier will be in the next year or so. Then divide your labor revenue goal by this number to estimate your direct labor cost.
Indirect Costs as a remainder of known split costs
handle on the grand total of, but they are to be separated into direct cost and indirect cost. The major example of this is labor cost. You can know, for example that your company’s gross wages paid to all employees last year was $500,000. You also know what your direct labor multiplier is, and therefore how many dollars you plan to spend on direct labor, based on your revenue goal. The remainder of the $500,000 would then be budgeted as indirect labor costs.
There are various ways that architecture and engineering firms manage their indirect wages, so I won’t get overly specific here, but you may wish to break this up into general indirect, vacation, sick, holiday, continuing education, etc.
If in your revenue goals you have planned for a significant amount of growth, you will need to plan for a similar amount of growth in your total labor costs, so don’t forget to factor that in first and then do the splitting between direct and indirect.
One way you can cross-check to see if the split you’ve come up with is realistic is to compare the relationship of direct labor cost to indirect labor cost from prior years and from your current working budget. If you have a major swing between years, it should be because you believe there will be a major shift in staff utilization rates (either a much higher percentage of billable time or a much lower one).
Lastly here, some firms split up fringe benefits into groups of accounts, some representing those incurred for direct personnel or due to direct utilization, and some representing costs incurred for indirect time. Examples would be employer taxes and company-paid health insurance, etc. I will say 90% of my clients do not split those hairs, but if you do, be sure to roll those variables into this split-up of direct and indirect labor costs.
Overhead Items as a known factor
And here we are at the easy part! Known overhead factors are things like rent, utilities, company-paid benefits, telephone, etc. Slapping these items onto the end of the budget will feel like a cake walk compared to the pretzel above.
So now you have a “top-down” company budget. It will likely look fairly similar to last year’s actual, but with some generalized plan for growth. In the next chapter, we will discuss ways you can refine this big picture using detailed information from your projects and proposals, which are the heart of your business.
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ICTUREIn the last two installments, we created an overview of an integrated budgeting process for architects and engineers, and we delved into making a rough sketch of what you think your company’s budget should look like. Now, we’ll get a little deeper and talk about the most critical piece of an AE budget: projects.
Scope – Schedule – Budget
You could call these either the Holy Trinity or the Bermuda Triangle of the project budgets of architects and engineers. The three points are always connected, and it’s virtually impossible to change one of these variables without also changing one or both of the others.
Fortunately for you readers, if you have a good industry-specific accounting and project management software, these three variables that you maintain on your projects will help you immensely when trying to translate those project budgets into a company budget, especially in the near term.
expressed in words and in a contract, the scope of a project will typically also have a major impact on its work breakdown structure, or the way the project is organized. For example, many architects bill a vast majority of their projects with phases such as schematic design, design development, etc. Each of those phases has a scope. Additionally, one project may be scoped to go through only certain parts of the standard AIA phasing. Many of my clients also have projects where they may do some initial work with one scope, with plans to potentially be awarded additional scope later, such as a feasibility study followed by investigations, planning, etc.
The scope will lead directly into determining the budget and the schedule. While a small minority of firms in this industry do a lot of their work on an open-ended, time and expense basis, most architects and engineers do the majority of their work within the constraints of a budget and a schedule, even if it is only an estimate and not a hard cap or maximum. It will be impossible for your accounting software to predict revenue on a job without knowing how much total revenue we expect the job will generate, and how long we think it will take to perform the work that will earn us the revenue.
So, long story short, be sure to setup your projects with a clear scope, a clear budget, and a clear schedule. They are often moving targets, but by providing these important details we can get back to the company budget with something a lot more concrete than a wish list of revenue dollars.
Resources: finite, schedulable, accountable
What is a resource? Different project management software may call these different names, but here’s how I see this: a resource is something we need to call upon, to perform the work needed on our projects, that is in finite supply, that is schedulable, and that is accountable.
An employee is the perfect example of what a resource is. That employee only has 24 hours a day, 7 days a week available to work on your project. Some of my architecture clients can appreciate that joke. But in all seriousness, there is a limit to what one person can do. So this is a good example of finiteness.
Another good example is an employee type – we may have only a certain number of civil, structural, or mechanical engineers in our firm, so we need to make sure, when we plan to take on new work, that we do not overextend that staff, or that we plan to add someone new in time to perform the work. Otherwise the quality of work will go down, or we will be stuck using the wrong kind of staff for the work, such as having a principal or project manager have to pitch in on something we could do at a much lower cost rate.
They are also therefore schedulable. They can’t do 500 hours in one month and none in the next. They have to keep their workload within a certain range, or all the Starbucks in the world can’t help them.
But guess what else are good examples of resources? Expenses and consultants. While we are not in complete control of a consultant’s time, much as we might like to be, we do need to make sure that we can schedule them as they are indeed in finite supply. They are also accountable for delivering a service to us, like our employees are, within a timeframe, within a budget, and with a certain goal achieved. (Scope-schedule-budget)
So, an Electrical Consultant is a resource. A drafter is a resource. How about expenses? In delivering a project, we will inevitably incur some expenses that we need to either bill to the client as reimbursable, or that we really ought to have included in our fee estimate if we
are billing on a percent complete or fee/lump sum basis. Good examples of this kind of resource are mileage, photocopies, travel expenses, permits, etc.
For the big picture we’re working towards in this blog series, why should we care about something as specific as resources?
It gets back to the difference between labor and other types of revenue in the AE industry. Labor is where we will make or break our firm’s bottom line. Expenses and consultants, while they may sometimes represent a large volume of the dollars that flow through our books, do not typically contribute a major source of profit to the bottom line, even if we’re charging markups, because of the administrative time associated with passing those items through.
We need to clearly identify the resources we plan to use on our projects, at the very least at the level of labor vs. expense/consultant. Otherwise our efforts to predict revenue and direct labor cost will ultimately be fruitless. Or at best, they’ll die at the top-down stage of the process.
Accounting managers are often, historically, left in the dark in this very important area. Clients will tell me “I don’t know how much we’re going to spend on expenses or consultants on this project.” All the more reason to get your project managers more involved in your integrated accounting software. I have found that 90% of the time, project managers actually did budget for expenses and consultants. That information simply didn’t make it all the way to the back office. Or the accounting system in use didn’t have a place to put it.
Business Development forecasting
Here’s another term that not everybody may be familiar with. Other terms used for this are proposals, job development, project development, client development, or direct marketing. Business Development is prospective work.
Over the last three or four years, I have seen a huge upwelling of interest in tracking this. Architects and engineers, due to the economy, are spending vastly more time on business development than in the past, and many firms are pursuing a broader range of projects than they have historically. There is also an increased interest among firms in doing business with the government at various levels, which often requires a more intense business development process than doing business in the private sector. As a result, firms are looking to integrate business development tracking with project management and accounting, and they want to forecast their revenue and costs based upon the progress of those business development efforts.
I’m going to come out and say it. Axium’s Ajera does an incredible job at integrating business development, project management, and accounting in a way that minimizes input and maximizes output.
Best practice: Have one job setup in your database from proposal to project. You need to capture the cost of that proposal in connection with the actual job, which will therefore give you much better insight into market sectors, clients, project types, and competitive
situations where you do well and not so well. You may even have multiple BD efforts within one job, if as I mentioned above, you have an initial job followed by the possibility of additional scope. Most importantly for the topic of the day, this practice of connecting proposal costs to the actual job will allow you to forecast your revenue based on business development efforts in progress in conjunction with projects already under contract. To accomplish this, during the business development process you will want to establish the
scope, schedule, and budget of the potential project. Of course these variables are subject to change as you progress from a request for qualifications to a proposal, interview, etc. But an estimate is much better than a blank.
Lastly, on your business development efforts, you can assign a percent chance of winning. This value will factor the potential budget of the project, allowing forecasting to take into consideration the likelihood that various proposals will actually turn into jobs. If you have only one proposal underway, this is somewhat irrelevant, but when assessing a broad range of BD efforts as most firms are, this factored forecast is a powerful tool.
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UTTING THE PIECES BACK TOGETHERFinally, now that we’ve parsed all this data and created a plan on each project, we need to digest it to see what the impact will be on the firm’s overall budget and forecast.
How to interpret a Project Workload report
The most powerful way to predict the revenue you will earn for your effort on projects is a project workload report. A good one will take all these plans you’ve set forth, based on your dates, and phases, and factored percentages on proposal opportunities, spreading out this projection over the life of the project.
What you can predict with an integrated workload report is: labor revenue for future periods based on project plans and completed work, number of hours required of your staff, and the estimated direct salary costs for that effort.
These key values can then be compared to your company budget and you can determine, if there is a gap, what needs to be done. Do we have enough work under contract to fulfill our budget goals? What if our proposals come in according to projections? And how does the projected direct labor cost from the workload compare to our initial estimate of direct salaries in the budget? Does this represent adequate utilization of staff time?
How to estimate direct and indirect labor costs
Specifically, we can take the estimated costs from the workload report and interpret them as our estimate of direct labor costs. There are then two different approaches you might take to budgeting the indirect portion of labor costs.
(1) Take the total direct labor costs from the workload report, and subtract them from your projected gross wages for the period based on current staffing levels. The remainder is your projected indirect labor. Then take the ratio of direct labor to total labor, and this is your projected utilization based on current staffing
(2) Take the total direct labor costs from the workload report and divide it by your desired utilization percentage to arrive at a desirable level of total gross wages, or in essence, an ideal staffing level. For example, if you expect your firm’s total labor costs to be 60% billable, and your workload projects $100,000 of direct labor, estimate that
100,000/.6 = 166,666, and compare that to your current projected gross wages. Do we need to cut or add staff to keep that utilization?
Understanding the impact of your billing practices on your budgeting process
Many firms already use a best-practice billing method without even fully realizing it. That intuitive idea pertains to the Billing Cutoff Date. It is most accurate to recognize your billed revenue on the cutoff date of the invoice. Meaning if it’s July 10 today, but we’re billing for June time, we recognize the revenue on June 30. This approach will keep your workload report working in your favor, because it projects earned revenue based on the period of the
work performed.
Secondly, and this is trickier, whenever possible it is best not to bill dollars ahead of the work performed. This can jeopardize the usefulness of workload-based forecasting, because the work still needs to be performed, but the revenue has already been booked. When we do need to bill ahead, accounting entries can be made to essentially defer the revenue to the correct period we expect to actually earn it in. This keeps your budget whole.
Understanding the impact of earned value analysis on your budgeting process
Earned value analysis is a powerful project management tool encouraged by PSMJ. Essentially, what it means is that we want to compare planned completion, to actual completion (earned value), to effort expended (“Spent” or “Earned” based on billing rates). Earned value analysis can be used strictly as a way for project managers to see whether their projects are on-track or not, but it can also be used as a method for accrual-based revenue recognition.
If your firm does use EVA as a revenue recognition method, you will need to consider this when budgeting and re-budgeting. It poses a similar challenge to the bill-ahead situation when trying to predict revenue based on the workload. For example, based on the workload report we may expect $10,000 of billable effort in a period on Job A, but if we have already “delivered” $15,000 worth of effort and recognized that as revenue, we would need to adjust our forecast accordingly. Similarly, the workload could indicate that only $5,000 of work is left under our contract value, but if we’ve only delivered $5,000 worth of results, we may need to recognize more revenue later in the job.
Even with these nuances, workload-based reporting is a potent mechanism for
understanding whether or not you will meet your goals, and an essential tool in managing your staffing levels.
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USINESSAt the end of the day, what this is all about is this: The bread and butter of your business is the projects you execute for your clients. You already know you must manage your projects successfully to manage your business successfully. What do you have to gain? Unlimited access to data you already manage on your projects in a way that can help you predict the viability of your firm in the near and medium term, and the ability to compare that picture to your goals.
