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$. Introduction to Design Firm Economics aka “ Introduction to Architecture & Money for the Financial Novice ”. Brian Kenet Lecturer, Harvard GSD Consulting Principal, EFCG bkenet@gsd.harvard.edu. QUESTION:
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Introduction to Design Firm Economics aka “Introduction to Architecture & Money for the Financial Novice” Brian Kenet Lecturer, Harvard GSD Consulting Principal, EFCG bkenet@gsd.harvard.edu
QUESTION: How much revenues do we need to pay ourselves $75,000/yr each + benefits + have some profit? ANSWER: Need to Start with Understanding/Assumptions about: Salaries, Utilization Rates, Multiplier, Overhead Factors
Base Case % of NR
Do you want to start your own firm or become a partner? Do you want to be appropriately rewarded for your talent, skill, education? Afford family, mortgage, kids, college . . . . Many design firms who do great work are weak from a financial perspective. This is not “fate” and a little bit of knowledge make a huge difference. Your clients are likely to be shrewd and savvy – so you should be too! Design Firm EconomicsWhy/How Relevant?
Know how to read a design firm’s: -- Income Statement -- Balance Sheet -- Cash Flow Statement And tell the difference between a financially “strong” firm and a “weak” firm. Know the Key Performance Indicators (KPI) and understand how they impact a firm’s Income, Balance Sheet and Cash flow. Come to your own conclusions about relationship between Design and Business. Design Firm Economics – For Non-SpecialistsObjectives:
Easier to “get” the key financial ideas than to become a great designer. NOT need to be an expert or an MBA-type to have strong finances. Big-picture common sense + key concepts and ratios go a very long way. Larger firms tend to have a Chief Financial Officer (CFO) but if you have a small firm, you have to be your own CFO. My Point of View
On the Left . . . . Assets Assets on the left = things of value that a company owns and uses to operate its business: Cash Accounts Receivable – what your clients owe you . . . Fixed Assets Are all the “things of value” of a design firm included in the balance sheet? Assets, by definition, must be “financed” with Capital so that the two are in Balance Balance Sheet = snapshot of the financial position at a point in time.
On the right . . . Capital = Liabilities + Equity Liabilities = obligations a company owes to others, e.g. creditors, suppliers, tax authorities, employees, shareholders, Are all the firms “obligations” on the balance sheet? Equity = Assets - Liabilities What is Equity? Ownership Interest aka “stock”, “book value”, “net worth” , “shareholders equity” Balance Sheet = snapshot of the financial position at a point in time.
Common-Sized Balance Sheet Typical for Design Firms based on Annual EFCG Survey (Gross Revenues = 100)Strategy: For a given amount of revenue, squeeze the left hand side (Assets) to be as small as possible b/c Assets must be financed with Capital and you want to use Capital as efficiently as possible, ie. as little as possible. So, timely A/R collection is crucial. Currently slow A/R collection is the Achilles Heel of the industry.
Not all capital is equal. A/P and A/L is Free Debt is expensive Equity, is very expensive The Less Capital Needed/Used the Better! -- so keep your Assets as small as you can . . . “Free” Capital is better than “expensive” Capital
AKA “Profit & Loss Statement” or “P&L” Covers a “Period” of time (typically one year) versus the Balance Sheet which is a “Point” in time Revenue minus Expenses to identify Profit or Loss Does NOT reflect actual generation of Cash or the ability to pay bills and meet other obligations This is crucial for you to understand! Income Statement Strategy: Maximize Profits as long you dont “cut corners” that may impair the long term health of the business
Shows how Cash is flowing in and out of the business for a specific period of time – where the cash is coming from and where it goes What are the “sources” of cash? Operations e.g. customers, Financing, e.g. borrowing from a bank, or Investments, e.g. interest from a bank account, stock dividends Reflects changes in Balance Sheet and Income Statement and shows how these changes the firm’s “Cash Position”, ie. firm’s ability to pay its bills. Just because a firm is “profitable” doesn’t mean it has sufficient “cash on hand” to pay its obligations (wages, A/P, taxes, insurance, etc.) in a timely fashion Cash Flow Statement
Design firms tend to collect bills slower pay bills – causing “negative” cash flow Negative Cash Flow requires “working capital” Working Capital = bank loans (line of credit), investors, shareholders, etc. If A/R = A/P then NO WORKING CAPITAL The best way to “manage” working capital is to not need any But it is typical for firms to need 20 cents per dollar of revenue Ideas for speeding up A/R collection? Beware Negative Cash Flow!
Cash flows from operating activities Cash receipts from customers $27,500 Cash paid to suppliers and employees (20,000) Cash generated from operations (sum) 7,500 Interest paid (2,000) Income taxes paid (2,000) Net cash flows from operating activities $3,500 Cash flows from investing activities Proceeds from the sale of equipment 7,500 Dividends received 3,000 Net cash flows from investing activities 10,500 Cash flows from financing activities Dividends paid (12,000) Net cash flows used in financing activities (12,000) Net increase in cash and cash equivalents 2,000 Cash and cash equivalents, beginning of year 1,000 Cash and cash equivalents, end of year $ 3,000 Add Cash Flow Statement Here
Divide Profit by Income = Operating Margin (Earnings Before Interest Bonus and Tax, “EBIBT” Divide Profit by Assets = Return on Assets Divide Profit by Equity = Return on Equity These are measures of financial efficiency Key Performance Indicators (KPI) “drive” efficiency of ratios What are KPI’s in Design Firms and how to Optimize? Financial Ratio AnalysisBetween Numbers on Balance Sheet, Income Statement and Cash Flow Statement
KPI = MU Factor = Multiplier X Utilization Median MxU = 3 x .60 = 1.8 , Highest Profit firms have M x U = 2.0+ Product is what counts. Not either Factor. Each is meaningless on its own Multiplier aka “Net Revenue Multiplier” = Net Revenue as % of labor Difference between what designers are paid and what firm charges set by competitive environment influenced by quality of work, “brand value”, uniqueness Utilization = % of hours spent on billable projects vs. the total number of hours worked. Median is ~60%, some firms up to 80% “Control” the utilization rate by carefully adjusting staffing levels. What “drives” Operating Margin?Operating Profit = Earnings Before Interest Bonus and Tax (EBIBT) Operating Margin = EBIBT/ Net Revenues = 15% median, some 30%+
Multiplier too high? Vulnerable to being on the losing side of price competition but as long as you can “defend” it, the higher the better! Ask yourself? What will the market bear? How much do you want/need the work? What is the risk associated with this client or project? Some clients are riskier than others, you should charge them more . . . Utilization too high? Can burn out staff and loose them Overhead too low? Spending enough to ensure long-term success, e.g marketing, technology, recruiting/retention, continuing education, insurance If ~15% operating margin is median – firms with above 30% should ask themselves whether they are sacrificing long term success for short term profitability – no reason the answer has to be “yes” but should ask . . . Is there such a thing as being too profitable?
Same for both = Profit/Assets & Profit/Equity – best strategy is to keep assets and equity to a minimum – less you have on left, less needed on right . . . On the right side there are three forms of “Capital” – Use as much of the free kind! Cheap/Safe “leverage” A/P – “free” Capital Debt – “expensive” Capital Equity – “very expensive” Capital Question – If you own Equity in a design firm, ie. are a shareholder. Which would you prefer: High ROS but low ROE or Low ROS but high ROE? What Drives Return on Assets and Return on Equity?
Common-Sized Balance Sheet Typical for A and A/E Firms based on Annual EFCG Survey (Gross Revenues = 100)Strategy: For a given amount of revenue, squeeze the left hand side (Assets) to be as small as possible b/c Assets must be financed with Capital and you want to use Capital as efficiently as possible, ie. as little as possible. So, timely A/R collection is crucial. Currently slow A/R collection is the Achilles Heel of the industry.
Return on Sales aka Operating Margin – 15% Median Net Revenue Multiplier X Utilization – 3.0 x .60 = 1.8 = Medians Overhead – 25% of Net Revs = Median Return on Assets – 20% = Median “Days Sales Outstanding” (DSO) ie. how many days to issue and collect bills – 90 days = Median Return on Equity – 75% = Median Ratio of A/R to A/P, lower better – try to keep at 1 to 1 ratio Prudent use of bank debt when needed But Don’t aim for the Median . . . . Aim Higher! Summary of KPI’s for 3 Financial Ratios
In Your Groups Talk About • # of Hours in Work Week • Target Salaries & Fringe Benefits • Target Multiplier • Target Utilization (firm and indiv) + How you will use your unbilled time . . . • Overhead Factors • How to Collect A/R asap • When/How to Monitor These (more is better) • Then Build Your Own Scenario
Definitions • Salaries (excluding benefits) = Total Labor • Utilization = Direct Labor / Total Labor • Direct Labor = Total Labor X Utilization • Indirect Labor = Total Labor - Direct Labor • Multiplier – Net Revenues / Direct Labor
Definitions • Net Revenues = Gross Revenues – Subcontractors & Reimbursables • Gross Margin = Net Revenues – Direct Labor • Non Labor OH% =Rent, Supplies, IT, etc. • Fringe = health insurance, paid time off, etc.
Definitions • Total Overhead = Indirect Labor + Non-Labor Overhead + Fringe • Operating Profit = Gross Margin – Total Overhead • Operating Margin = Operating Profit/Net Revenues • Net Income = Operating Profit - Tax
