brian kenet lecturer, harvard gsd consulting principal, efcg [email protected]

Introduction to Design Firm Economics Kenet, Harvard GSD, 3/12/13

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Introduction to Design Firm Economics

aka “Introduction to Architecture & Money for the Financial Novice”

Brian KenetLecturer, Harvard GSD

Consulting Principal, [email protected]


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


What Can We Pay Ourselves?


% of NR Base Case


Build your Non-Labor Overhead from the Bottom UP


Design Firm EconomicsWhy/How Relevant?

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 Economics – For Non-SpecialistsObjectives:

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.


My Point of View

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.


Balance Sheet = snapshot of the financial position at a point in time.

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”


Cash 2 Accts Payable (A/P) 15 (Free Capital)

Accounts Receivable (A/R) 30 Debt 5 (Expensive Capital)(Including WIP)

Total Liabilities 20Net Fixed Assets (NFA) 5

Other (Goodwill, etc.) 3 Equity 20 (Most Expensive Capital)

Total Assets 40 Total Capital 40

Assets Capital (Liabs & Equity)

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.


Capital• 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”


Income Statement Strategy: Maximize Profits as long you dont “cut corners” that may impair the

long term health of the business

• 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!


Cash Flow Statement• 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


Beware Negative Cash Flow!

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?


Add Cash Flow Statement Here• 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


Financial Ratio Analysis Between Numbers on Balance Sheet, Income Statement and Cash Flow Statement

• 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?


What “drives” Operating Margin?Operating Profit = Earnings Before Interest Bonus and Tax (EBIBT)

Operating Margin = EBIBT/ Net Revenues = 15% median, some 30%+

• 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.


Is there such a thing as being too profitable?

• 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 . . .


What Drives Return on Assets and Return on Equity?

• 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?


Cash 2 Accts Payable (A/P) 15 (Free Capital)

Accounts Receivable (A/R) 30 Debt 5 (Expensive Capital)(Including WIP)

Total Liabilities 20Net Fixed Assets (NFA) 5

Other (Goodwill, etc.) 3 Equity 20 (Most Expensive Capital)

Total Assets 40 Total Capital 40

Assets Capital (Liabs & 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.


EFCG “DuPont” Analysis Profit Asset Leverage

Margin X Turnover = ROA X Multiplier = ROE(EBIBT/ (Gross Revs/ (EBIBT/ (Assets/ (EBIBT/

Gross Revs) Assets) Assets) Equity) Equity)

1 16.2% 8.88 55.6% 27.40 294.1%

2 12.9% 5.89 53.1% 7.00 138.5%

3 11.9% 5.16 48.5% 6.84 125.0%

4 11.6% 5.00 43.0% 4.62 100.0%5 8.3% 4.51 36.8% 4.00 96.2%

6 7.3% 4.08 28.6% 3.40 88.1%

7 7.1% 4.06 25.0% 3.39 87.0%

8 7.0% 3.97 23.6% 3.27 84.0%9 6.1% 3.55 20.8% 3.04 80.0%

10 5.4% 3.44 20.3% 3.02 66.7%

11 5.2% 3.37 19.1% 2.90 58.6%

12 5.0% 3.00 14.0% 2.89 42.7%

13 4.8% 2.88 13.9% 2.83 34.5%

14 4.8% 2.86 12.0% 2.67 32.9%

15 4.5% 2.86 11.9% 2.00 32.7%

16 4.2% 2.83 11.6% 1.89 31.0%

17 4.2% 2.72 10.8% 1.81 30.0%

18 4.0% 2.00 9.0% 1.73 28.0%19 2.1% 2.21 8.4% 1.72 23.0%

20 2.0% 1.80 7.2% 1.66 17.7%

21 2.0% 1.76 5.7% 1.65 12.5%

22 1.7% 1.59 3.0% 1.57 11.3%

23 1.6% 1.46 2.9% 1.34 9.7%

Median 4.9% 2.94 14.0% 2.86 38.6%

A B C

ROS


Summary of KPI’s for 3 Financial Ratios

• 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!


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

brian kenet lecturer, harvard gsd consulting principal, efcg [email protected]

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