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AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS Specific Learning Objectives: 1. Identify basic concepts of Economic Cycles in the practice of Architecture. NAVIGATING ECONOMIC CYCLES Kermit Baker, Ph.D., Hon. AIA Architects serve an extremely cyclical s...

AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS Specific Learning Objectives: 1. Identify basic concepts of Economic Cycles in the practice of Architecture. NAVIGATING ECONOMIC CYCLES Kermit Baker, Ph.D., Hon. AIA Architects serve an extremely cyclical sector of our economy. To thrive, therefore, they need to be able to adjust to the regular ups and downs of the construction industry. THE IMPORTANCE OF UNDERSTANDING ECONOMIC CYCLES Whether architects like it or not, they are extremely exposed to economic cycles. Since architects receive most of their revenue from services provided to the construction sector of the economy, and since the construction industry is one of the most cyclical industries in the economy, architects are vulnerable to the regular ebb and flow of activity in the economy. The impact of the economy on architecture practice has been particularly apparent with recent cycles. The past national economic expansion that began in late 2001 reached a peak at the end of 2007. The tail end of that expansion saw healthy growth in the economy, and with it even stronger growth in most nonresidential construction sectors. However, at this phase of the upturn, the overall construction sector was seeing more modest growth. The housing market peaked much earlier in the cycle-the beginning of 2006 was the high-water mark of the cycle for home building-and declines after that offset gains in the nonresidential construction sector over the 2006-2008 period. Once the downturn hit in early 2008, the construction sector of the economy experienced steep declines. And even though over all economic output began recovering nationally by the middle of 2009, construction activity continued to spiral downward. Total construction spending levels, which exceeded $1 trillion in 2008, fell to under $800 billion by 2011. With less construction came less building design. In addition, there were efforts by owners and developers to more aggressively manage design and construction costs of the projects that were built, creating pressure on design fees and construction bids. As a result, gross revenue at architecture firms declined from over $44 billion in 2008 to $26 billion by 2011, a 40 percent decline over this three-year period (Figure 7.1). This decline in revenue was also felt in employment-in the economy, in the broader construction sector, and at architecture firms. Such a significant reduction in firm revenue produced a comparable reduction in employment. Nationally, the decline in overall business payrolls throughout the economy over this period was one of the steepest since the Great Depression. From its high in early 2008 to its low in early 2010, almost 8.8 million payroll positions, or 6.4 percent of the workforce, disappeared. However, by the end of 2011, over a third of these losses had been recovered. Construction, being a more cyclical sector of the economy, saw even steeper losses proportionately. Construction payrolls peaked in early 2007 due to the housing downturn, and steadily declined through midyear 2011. Since that time, there has been hardly any recovery. Between 2007 and 2011, payrolls in this industry declined by over 2.1 million-almost 28 percent-double the number of construction positions added during the 2003–2007 upturn. Positions at architecture firms have generally followed the path of the broader construction industry. Due to the heavy reliance of architecture firm revenue on non-residential construction activity, payroll positions continued to grow through midyear 2008. They then dropped sharply through early 2011, and have hardly recovered since that point. Between 2007 and 2011, over 28 percent of positions at architecture firms disappeared, a share that greatly exceeded the gains during the prior upturn (Figure 7.2). This dramatic upheaval at architecture firms has had dramatic implications on professional practice. One change is the mix of projects at firms. Surveys of architecture firm activity over the past decade show that there has been considerable fluctuation in the share of project activity across the major construction sectors. Residential projects tend to increase early in a cycle, commercial/industrial projects in mid-cycle, and institutional projects later in the cycle. Billings for residential projects averaged 14% of total firm billings over this past decade, commercial/industrial 27%, institutional 53%, with the remaining 6% divided between other construction and non-construction activities. By 2011, residential billings had returned to their decade average, having grown to 18% in 2005 during the peak of the housing market, and fallen to 11% in 2008 as the housing market was crashing while the non-residential construction sector was just beginning to peak. Week 01 Prelims Page 1 of 8 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS Even though housing remained relatively weak through 2011, multifamily activity-a critical residential sector for architecture firms-was building momentum, and was a growing share of design activity for residential projects. Commercial/industrial design activity tends to be extremely volatile over the cycle. Activity fell off sharply with the overall economic downturn, and was still near its bottom in 2011. As a result, the share of design billings from this sector was below its decade average that year. Institutional activity tends to be more stable over the cycle. This means that shares are generally a bit lower during upturns and higher during downturns. By 2011, the institutional share was near its decade high, mostly because other sectors had fallen off more dramatically (Figure 7.3). The overall decline in project activity during the downturn, coupled with the changing mix of projects, produced an expansion of services that the typical firm offered to its clients. During upturns, larger firms typically continue to offer a full range of design services to clients, while smaller firms often niche their services in a smaller number of specialties. During downturns, firms of all sizes tend to investigate new areas in the process of looking for new work. So, even though firms had fewer employees on average in 2011 than during the boom years, higher shares responded that they offered such services as sustainable design, planning, interior design, and space planning than in prior years. A related secular trend is that a growing share of firms categorizes themselves as multiple-discipline design firms, up almost 10 percentage points over the past decade. The share of payroll positions lost during this downturn has been proportionately greater than the share of architecture firms closed. As a result, architecture firms have shrunk: The average number of payroll employees at a typical firm declined from 10.3 in 2008 to 8.8 in 2011. Currently, according to AIA estimates, almost a quarter of architecture firms nationally are sole practitioners, and over 60 percent have fewer than 5 employees on their payrolls. In contrast, only 1.4 percent of offices have 100 or more employees. In 2008, 51 percent of firm offices had fewer than 5 employees, while 2 percent had 100 or more. Even though firm counts are heavily weighted toward smaller businesses, a large share of design professionals works in a larger- firm environment. Firm locations with 100 or more employees account for over 20% of all staff at architecture firms nationally, and 50+ person firms account for over a third of all employment. Since revenue per employee tends to be higher at larger firms, 100+ person firms account for over one-quarter of professional fees generated nationally, while 50+ person firms account for well over 40%. Net revenue per employee averages almost twice as much at larger firms than it does at smaller firms, in part reflecting the greater use of part-time staff at smaller firms, but also likely reflecting higher chargeability rates at larger firms, as well as higher levels of staff productivity due to generally greater levels of capital investments (Figure 7.4). Like previous recessions, this downturn has produced greater fragmentation at architecture firms. Firm layoffs have pushed down average firm sizes, and unemployed architects are a common source of new start-ups. Due to the ongoing “feast or famine” in project revenue for architecture firms, there are unusually high shares of start-ups and failures in the profession, reflected in the low average age of firms. According to The Business of Architecture: 2012 AIA Survey Report on Firm Characteristics, over a third of firms nationally were founded since 2000, and 60 percent were founded since the last significant downturn in the profession in 1990. Only 10 percent of firms at present were in existence prior to 1970. In an era where access to credit is very difficult (particularly for businesses without a long track record), where repeat clients and established institutional relationships are important sources of new project activity, and where staff development (including formal intern development programs) extends for many years, high levels of staff turnover and business failures can have a devastating long-term effect on the profession. The general downsizing of firms has also produced a change in their staff composition. In the AIA Business of Architecture 2009 report (reflecting staff composition at the beginning of that year), 60 percent of payroll positions were architecture positions (in cluding interns and students), 21 percent were other design professionals- with engineers and interior designers accounting for the largest shares-while Week 01 Prelims Page 2 of 8 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS the remaining 19 percent were technical and support staff. By the beginning of 2012, there were some significant changes to this composition. The largest share of losses was among the technical and nontechnical staff, positions that generally were not directly billable on projects. Architecture staff positions increased their share somewhat over this period, while the share of other design professionals remained essentially unchanged. FIGURE 7.4 Even with Benefits to Scale in the Profession, Most Architecture FIGURE 7.5 A Significant Share of Downsized Workers are Not Likely to Return Firms Remain Small to Profession after Great Recession These summaries of payroll staff composition may somewhat overstate the actual changes in staff composition that occurred over this period. Many firms replaced or converted payroll positions to contract positions. Contract positions generally don’t offer benefits and typically limit the number of hours worked to the immediate project needs. In other cases, full-time workers were cut back to part-time, or full-time positions were replaced with part-time positions. Many of these part-time and contract positions may be converted to full- time when workloads recover. Regardless, many architecture positions were lost during the Great Recession beginning in early 2008, and many occupying thes e positions may never return to practice architecture. A survey conducted by the AIA in late 2011 asked architects their sense of what had happened to full-time architectural staff that had been downsized during the recession, and to speculate what would likely happen to these former employees in the future. Their sense was that about 30 percent of these former employees were still working at architecture firms on a part-time or contract basis, about 30 percent were working outside the profession, and the remaining 40 percent were not employed as of that point, including some who had retired or had returned for additional schooling. Looking to the future, this group estimated that about 40 percent of these downsized workers would never return to architecture practice (Figure 7.5). UNDERSTANDING AND INTERPRETING ECONOMIC CYCLES The business cycle comprises the up-and-down movements in activity in an economy. It generally is not a regular, predictable, or repeating phenomenon, and is commonly identified as a sequence of four phases with four distinctive points that serve as metrics for defining them (Figure 7.6): Early expansion: The period of acceleration in the pace of economic activity. This is the phase in the cycle when the economy is recovering from the last downturn and expanding into a period of new growth. Peak growth: The point where the rate of growth reaches its high point for that cycle. Late expansion: After the economy reaches a point of peak growth, growth begins to slow. Market peak: The time when actual economic output (not the rate of growth) is at its peak for that cycle. Early contraction: The phase immediately after the market peak when the slow growth transitions to a period of accelerating decline. Peak decline: The lower turning point of a business cycle, where the rate of decline is at its steepest. Late contraction: The period when the pace of decline begins to slow. Market trough: The time when economic output is at its lowest point for that cycle. All industries are subject to business cycles, but some are more influenced by them than others. Consumer staples such as food and clothing or inexpensive consumer products tend to have fairly stable levels of activity across the business cycle. They are less influenced by changes in consumer income, or concern about future earnings. Industries that rely on major expenditures (e.g., cars and homes) or involve large investments (e.g., buildings and public wo rks projects) tend to have more pronounced business cycles. Households and businesses tend to put off these purchases if they are concerned about business conditions and move ahead with them with, they are more comfortable with the economic outlook. This often creates a boom or bust in the production of these products, which contributes to the development of business cycles. Week 01 Prelims Page 3 of 8 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS The construction industry is one of the most cyclical sectors in the economy. When economic conditions are unfavorable to some industries, they are often unfavorable to others, so fewer construction projects are undertaken. Conversely, when conditions are favorable to some, they are likely to be favorable to others, so a lot of projects that may have been on hold for a while are undertaken. FIGURE 7.6 Phases of the Business Cycle FIGURE 7.7 Most Years, Nonresidential Construction Sees Either Strong Growth or Strong Declines This pattern is easy to observe when looking at the change in construction activity over the past several decades. As shown in Figure 7.7, changes in the levels of construction activity from McGraw-Hill Construction data show the major cyclical upturns and downturns over the past several decades. There was a strong upturn in the early to mid-1980s, in part generated by tax code changes that encouraged business investment, including investment in structures. This period of healthy growth was followed by a fairly significant downturn in the early 1990s brought on in part by the collapse of the savings and loan system in the country. With weakness in these institutions, there were problems with financing residential and nonresidential construction, as well as with long-term loans to finance their acquisition. The mid-1990s ushered in an extended period of strong growth in construction activity. A technology boom helped moderate the rate of inflation yet produce strong job growth, which provided a supportive economic environment for construction activity. As a result, there were eight straight years of gains in nonresidential construction activity, four of them at a double-digit pace. The 2001 to 2003 construction downturn that resulted from the bursting of the tech bubble was fairly mild, particularly in comparison with the magnitude of the preceding upturn. Coming out of the early 2000s downturn was a fairly modest construction upturn from 2004 through 2007. No year over this period saw construction activity increase at a double-digit pace. The downturn following such a modest upturn would also be expected to be fairly restrained. Instead, with the rapid decline in house prices nationally, there was a near meltdown of the international financial system that produced the worst economic downturn since the 1930s Great Depression. It’s fair to assume that had the nonresidential construction markets been more overbuilt leading into the downturn, the Great Recession would have been even more dire for th e nonresidential construction industry. This review of recent cycles in nonresidential construction activity underscores one of the critical challenges for architecture firms: namely the chronic volatility in project activity in the profession, typically producing very uneven revenue streams. Since changes in construction activity can be assumed to generate comparable changes in design activity at architecture firms, it’s no surprise that managing an architecture firm is a terribly challenging undertaking. Looking over the 31 years of construction activity from 1980 through 2011, there are three major expansions and at least parts of four major contractions. Architecture firms are constantly managing through changes in business conditions, changes that create a number of challenges. Declines in activity present obvious challenges: potential staffing reductions, overhead adjustments, increased marketing initiatives, and potential credit issues. These periods unfortunately are not rare. Over this 31-year period, there were 14 years where construction activity declined. Eight of these 14 yearly declines were 10 percent or greater, which present serious challenges for an architecture firm. However, there are also challenges during the years where construction activity was increasing. For almost a third of these growth years, construction activity increased by 10 percent or more. Such rapid growth presents challenges for firms in terms of hiring and training staff and meeting project deadlines. Such challenges may be more desirable than those associated with downturns, but they remain challenges nonetheless. Combining the two categories-years with declines and years with strong growth- indicates that almost two-thirds of the years over this 31-year period presented challenges for architecture firms. Thus, for any architecture firm, being in a period with distinct challenges is significantly more likely than being in a period without them (Figure 7.7). All of this points to the need for architecture firms to monitor business conditions closely, so that they can anticipate a movement in the business cycle and begin to implement adjustments in advance of conditions actually changing. Economic indicators to monitor business Week 01 Prelims Page 4 of 8 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS conditions should relate to the market area served by the firm; firms that serve a local market should monitor local indicators; regional firms should monitor regional indicators; and so forth. Some of the best economic indicators to monitor include the following: Employment. Changes in employment are probably the best single indicator of the economic health of an area. Job growth generates other forms of economic activity, including construction. Consumer confidence. How comfortable consumers are with the economic environment is critical to their willingness to spend, which in turn drives economic growth and construction activity. Financial indicators. Interest rates, lending standards, and the volume of construction and mortgage loans are key to determining whether an owner or developer will proceed on a construction project. Housing indicators. While directly important to many architects, the condition of the housing market is a key leading indicator for the broader economy as well as for the nonresidential construction sector. However, an economic indicator that is closely connected to an industry will provide more precise information on likely future trends for that industry. For that reason, in 1995 the American Institute of Architects launched a monthly survey of design activity at architecture firms, now known as the Architecture Billings Index (ABI), to track business conditions across the profession. Using the ABI to Anticipate and Interpret Cycles Beginning in late 1995, the AIA assembled a national panel of architecture firms to participate in an ongoing survey to measure their business conditions. The principal purpose was to develop a database of national and regional business trends at architectur e firms so that an individual firm would have a better sense of how business at that firm compared with its peers. Architects are well positioned to report on the direction of the construction industry. Although decisions to build a nonres idential structure are made by hundreds of thousands of private businesses, nonprofit institutions, and government agencies, the first comprehensive indication of planned development typically shows up on an architect’s drafting board. Surveys conducted by th e AIA of its member firms, and information from McGraw-Hill Construction, indicate that about 75 percent of nonresidential buildings are designed by architects. A greater share of nonresidential activity is reviewed and approved by architects, but without complete design involvement. The ABI survey is conducted monthly across a national panel of architecture firms. Currently, about 750 architecture firms actively participate in this program. Firms included in this survey provide architectural services as their principal design service offered. Firms may also provide engineering, interior design, landscape architecture, planning, urban design, or related services. Most firms additionally provide pre-design or construction-phase services (e.g., construction management) in addition to their architectural design services. Firms that participate in the survey also provide the AIA with information on key firm characteristics, such as annual billings, construction sectors served, and number of employees. On the first business day of each month, participating firms are e-mailed a link to an electronic questionnaire. That questionnaire asks respondents to report firm billings for the just-completed month as compared to the previous month, as well as inquiries for new work over the same period. If a firm doesn’t bill monthly, it is requested to estimate the work that will be billed for that period. Firms are asked to report whether billings during the previous month significantly increased (5 percent or more), remained about the same, or significantly decreased (5 percent or more). The ABI is computed as a diffusion index, with the monthly score calculated as the percentage of firms reporting a significant increase plus half the percentage of firms reporting no change. Comparisons are always to the previous month. Diffusion indexes, centered at a score of 50, are frequently used to measure change in economic activity. If an equal share of firms report an increase as report a decrease, the score for that month will be 50. A score above 50 indicates that firms in aggregate are reporting an increase in activity that month compared to the previous month, while a score below 50 indicates that firms are reporting a decrease in activity. Certain months of the year-December is typically one of them-are slower at architecture firms due to holidays, weather, and other factors. Other months may show almost uniformly stronger business conditions for just the opposite reasons. To allow for meaningful comparisons among months, the monthly responses are seasonally adjusted using the Census Bureau’s X-12 program. The seasonal adjustment process regulates the ABI score each month based on typical scores for that month in prior years. So, for example, even though December scores may be weaker than November scores, the seasonal adjustment process compares this weakness to prior years to determine if the decline is stronger or weaker than it has been previously. Since architecture firms design the overwhelming majority of nonresidential buildings in the United States, we would expect a relatively consistent relationship between architectural design activities and nonresidential building construction. However, this relationship does vary from project to project. A recent AIA survey of architecture firms determined that the average time between the award of a design contract and the award of a construction contract for that facility was about a year. However, there is considerable variation from project to project. According to the aforementioned survey, for commercial/industrial projects the design phase up through contract award was less than six months for 40 percent of the projects, while for more than a quarter of projects this period extended beyond a year. Size and complexity of a project are key reasons for variation in design time, but three other factors also influence design time. Client decision making-and whether these decisions need single or multiple approvals-frequently Week 01 Prelims Page 5 of 8 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS influences the length of the design phase. Financing and funding for the project also can be a factor. Finally, regulatory approvals-land entitlement, special use permits, zoning, environmental issues, and historical considerations-also influence the length of the design phase. The ABI is designed to mimic the business cycle for design activity. The ABI scores are centered on 50, so a score above 50 indicates an increase in design activity, and a score below indicates a decrease. During the early phase of a recovery, we would expect to see scores accelerate to the mid-50s to even 60 range. During the late expansion, scores would likely settle back to the low 50 range. Moving into a contraction, scores would likely drop quite quickly to the mid-to-low 40s, before heading back up to the upper 40s as the market moved into the late contraction phase. This allows the user to anticipate the direction that scores are moving, and therefore the future direction of design activity (Figure 7.8). IMPLICATIONS OF CYCLES ON THE FUTURE OF PRACTICE Economic cycles are the most powerful business force facing the architecture profession. Successful firms learn how to manage their practice through cycles to minimize the long-term negative impact. Traditionally, diversification has been a strategy to allow firms to achieve more stable revenue across cycles. Firm diversification may take on one or more of the following three dimensions: geographic, building type, or services. Geographic Diversification Most small and midsize architecture firms serve a fairly focused geographic area. Urban firms may serve an entire metropolitan area, or a portion of the metropolitan area. Others may focus their practice in a single town or county, or portion of a state. Typically, the economic base of the markets served is relatively homogeneous, meaning that the economic health of these markets rises or falls with the performance of a relatively small slice of the economy. Typically, the big industries in these areas, such as a college or university, a hospital, an insurance company, a manufacturing facility, a government installation, or something similar, will largely determine the health of the local economy. By serving a larger geographic area, a firm can broaden the economic base on which it is dependent. While one sector of the economy may be dealing with difficult issues, it is much less common for several sectors of the economy to be moving through the same stage of the economic cycle. Some firms have taken geographic diversification one step further, into international markets. Even though the world economy is much more interconnected now than it was in the past-analysts refer to the world being “flat”- pursuing international projects does typically offer diversification opportunities for firms. For example, annual economic growth in China has been averaging close to double digits for many years, whereas growth for many developed countries has averaged in the low single digits annually. Countries with stronger growth would be expected to have a more vibrant construction industry to support that growth, and therefore diversifying a practice to include projects in rapidly developing areas should help to hedge against a domestic slowdown. Building Type Diversification As with geographical areas served, most small and midsize firms focus their practice on a few building types, such as single-family homes, offices, hotels, schools, or medical facilities. Generally, building cycles for major construction sectors occur at different phases of the broader economic cycle. Housing cycles generally unfold early in an economic cycle, followed 12 to 18 months later by commercial/industrial cycles, followed in turn 6 to 9 months later by institutional cycles. The risks of concentrating a practice on a limited number of building types can be almost as great as geographical concentration; weakness in certain sectors of the economy can affect demand for some facilities more than others. High mortgage rates can limit demand for new homes. High energy costs can limit travel, and therefore demand for hotels. Diversification can provide design opportunities in a sector of the economy when another sector is weak. Service Diversification While most architecture firms offer standard architectural design services, fewer offer related design services or expanded design services. According to The Business of Architecture: 2012 AIA Survey Report on Firm Characteristics, only about one-half of architecture firms offered interior design, space planning, planning, or sustainable design services. About a quarter offered historic preservation, design-build, or construction management services. Fewer yet offered landscape architecture or engineering services. A broader service package generally opens up more design opportunities and allows a firm to compete for a broader range of projects. Also, a broader service package-or a concentration in more specialized services-allows a firm to partner with other firms on a broader Week 01 Prelims Page 6 of 8 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS range of projects. The historical concentration of architecture firms generally means that firms need to grow more than may be desirable during upturns, and go through a painful downsizing process during downturns. For example, between the beginning of 2009 and 2012, the AIA estimates that there was a net loss of about 6 percent of all AIA member- owned architecture firms nationally. While this marks a fairly significant decline in the number of firms, it marks an even more significant decline in the distribution of firms. The number of 100+ person firms declined by over 20 percent, while the number of other midsize and larger firms declined by more than 10 percent. Conversely, the number of sole practitioners increased, accounting for over a quarter of all firms (Figure 7.9). While most firms downsized during the construction downturn precipitated by the 2008-2009 Great Recession, others went out of business. Some architects who were laid off started their own practices. The net result is that some older firms ceased operations, while some new firms started up. This process reduces the age of the average architecture firm in the United States. By early 2012, well over a third of all architecture firms in the United States had been founded since 2000, and over 60 percent had been founded since 1990, according to The Business of Architecture: 2012 AIA Survey Report on Firm Characteristics. Only about one in five firms-mostly larger firms-had been in existence since 1970. IMPACT ON ARCHITECTS The dynamic of architecture firm structure during downturns-most firms reducing staff, some firms disappearing, and new firms starting up-is even more dramatic for architecture staff positions. The AIA estimates that there were almost 110,000 architecture positions nationally (licensed and unlicensed graduates) in 2003 at the end of the construction downturn following the 2001 economic re cession, growing to almost 130,000 positions at the peak of the construction expansion in 2007-2008, and then falling to almost 90,000 at the low point of the construction cycle following the 2008-2009 national economic recession. These figures suggest very rapid growth in the number of architecture positions during construction expansions and very s teep losses during downturns. During the mid-decade upturn, the AIA estimates that there were over 20,000 architectural positions added nationally, generating close to a 20 percent increase in architectural positions. During the construction downturn following the Great Recession, however, between 35,000 and 40,000 payroll architecture positions were eliminated (Figure 7.10). FIGURE 7.10 During Upturns, There is Sufficient Architecture Staff; During FIGURE 7.11 Younger Architectural Staff Are Most Likely To Be Added and Eliminated Downturns, an Excess During Cycles While recent cycles have been more extreme, even normal cycles overwhelm the ability of the profession to adjust to changes in workloads. During upturns, there generally are not enough recent graduates of architecture programs to meet the growing staffing needs. Some firms outsource design work in an effort to meet project deadlines. Other firms may provide incentives to keep staff in the workforce, including older staff who may have been considering retirement. During downturns, in addition to staff layoffs, firms may freeze or even reduce compensation, furlough employees through unpaid time off, or convert some full-time employees to part-time status. Firms may convert some payroll employees to contract status, so that they only work when there is billable project activity. Historically, less-experienced architecture staff has disproportionately served as a balance wheel during periods of expansion as well as downsizing. These are the positions that may be easier and more affordable to fill during upturns, and candidates may be easier to train in the firm’s area of specialization. They also may have more current technical skills to operate the newest design software. Week 01 Prelims Page 7 of 8 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS By the same token, less-experienced staff has often been the first to get laid off during business downturns. More-experienced staff may have more ability to generate new project revenue during lean times. Also, experienced staff is likely to be more familiar with firm operations, and therefore more difficult to replace during the next upturn. A survey of architecture firms conducted by the AIA in early 2009 demonstrates the volatility of less-experienced positions at architecture firms. This survey was conducted during the heart of the downturn, and asked firms about positions that they would be adding or eliminating over the coming year. Many firms were expecting to reduce their staff size during the year, and less-experienced architectural positions (4-6 years) and interns were the most commonly selected as targets for downsizing. However, a few firms were planning on adding staff that year, and again the positions most commonly mentioned for addition were less-experienced staff and interns (Figure 7.11). CONCLUSION Economic cycles dramatically influence the financial condition of architecture firms and the staff employed by them. However, the ultimate health of the industry will be determined by the underlying growth of the construction industry, rather than merely how design activity cycles around that underlying growth trend. Here the outlook is more positive. According to information from McGra w-Hill Construction, the U.S. construction industry has added an average of 1.3 billion square feet of nonresidential building per year since 1980. Current construction levels in 2010 and 2011 were less than half this pace, so the prospects for strong growth in the years ahead- even during cyclical downturns-are very promising. Week 01 Prelims Page 8 of 8 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS Specific Learning Objectives: 1. Identify basic concepts of Financial Management in the practice of Architecture. FINANCIAL MANAGEMENT OVERVIEW Steve L. Wintner, AIA Emeritus Financial Management involves the ongoing monitoring of a firm’s financial resources to allow firm principal(s) to exercise sound business judgment in response to developing trends. INTRODUCTION The basic knowledge needed for the financial management of a professional design firm includes a clear understanding of the component parts of each of the two primary financial reports - the Profit-Loss Statement and the Balance Sheet - and how to interpret these reports. Knowing how to calculate the seven key financial performance indicators of the profit-loss statement and the four key financial performance indicators of the balance sheet will facilitate a firm leader’s response to developing trends, whether positive or negative. An in-depth knowledge of accounting is not required to develop the skills to learn any of the above. Two essential components of a financial management system are the Annual Budget and the Profit Plan. These two components are closely interrelated, and decisions about elements of one component will likely have an impact on the other component. For example, overhead projections made for the profit plan will play a key role in the development of the annual budget. Therefore, it is important that these two components be developed concurrently. Since these two components are developed for each new coming year, it would be advantageous for their development to begin before the coming year commences. Even if the final results of the current year are not yet available, it is acceptable, as a place to begin, to use the data from the latest of a firm’s 4th-quarter accrual-basis financial reports and their calculated key indicators. Once the final, previous year-end data is available, adjustments for the coming year can be made to the budget and profit plan and their key indicators. Getting an early start will enable firm leaders to respond more effectively to new opportunities using the most current data. These two components, when fully developed, provide a basis for comparing the anticipated financial performance of a firm with its actual financial performance in the periodic monitoring of its accrual-basis profit-loss statement. Distinctions Between Accounting Reports and Financial Management Reports A comprehensive financial management system is based on a firm’s accounting system, but there are distinctions between their respective reports. Accounting reports and their generated data are the responsibility and realm of a firm’s accounting personnel and its outside tax consultant. Financial management reports are the responsibility and realm of firm leaders, even though others might develop and compile these reports. While the basis (timesheets, incoming payments, and outgoing invoices) of the financial data is essentially the same for the accounting and financial reports, each report type is formatted differently to suit their respective purposes and use by each party. Accounting reports focus primarily on cash-flow management, accounts payable, and defining the firm’s quarterly and annual tax liability, which are identified in the cash-basis reports. A firm leader’s focus will be on reviewing and monitoring the key indicators from the financial data provided in the accrual-basis reports. Both reports facilitate making sound business decisions to enhance a firm’s effectiveness, efficiency, profitability, and the achievement of its professional goals. An understanding of the following basic accounting terms is also necessary for skillful financial management. Week 02 Prelims Page 1 of 7 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS FINANCIAL PLANNING Applications of the Cash-Basis and Accrual-Basis Reports Depending on the size of a firm, one or both types of reports may be used. The accounting process for most sole proprietors (those without any paid staff) would be on a checkbook-like basis (dollars received, dollars paid) and therefore would likely use only the cash- basis report. Almost all other size firms with employees would use both types of reports. The cash-basis profit-loss statement indicates only the income received and the amounts paid Nonpayment of invoices in excess of 30 out for expenses to others within a specific accounting period. Because certain expenses, such days is problematic and needs to be as salaries and most vendor invoices, are paid shortly after the obligation is incurred, and resolved as quickly as possible. Payment income from invoices may not be received for 30 to 120 calendar days, or more, after the work on invoiced project amounts ideally is actually done, there is no timing correlation between income received and expenses paid. should be received from the client within The cash-basis profit-loss statement establishes a firm’s cash-flow management effectiveness 30 days from the date of the invoice and and its tax liability, not its net profit. certainly not later than 60 days. Unlike the cash-basis profit-loss statement, the accrual-basis profit-loss statement does not consider the actual receipt or payment of any money. Rather, the accrual report reflects the invoices sent to clients for monthly revenue earnings, based on hours worked and expenses incurred to complete that work, in a given accounting period. The accrual basis profit-loss statement establishes the net profit for a firm and the calculation of its seven relevant key financial performance indicators. These two reports do, however, have a connection. For example, consider the relationship between cash available on-hand and the distribution of any net profit. Ultimately, the availability of cash-on-hand will have a significant impact on the decisions made about the size and timing of net profit distributions. Week 02 Prelims Page 2 of 7 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS For the sake of this article and in general, the “modified” accrual-basis is the Since the accrual-basis profit-loss statement defines net industry-accepted method employed for the accrual-basis profit-loss statement. profit and the cash-basis profit-loss statement (aka the The modified version records only the revenue from fees and expenses that have “income statement”) defines available cash, both types been invoiced to clients. It would also include the fee and expense amounts of reports will need to be consulted before any decision about the distribution of net profit can be made. With invoiced to the firm by outside project consultants and other vendor and general this in mind, it is easy to understand the importance of expense amounts that were incurred in a specific accounting period. It does not maintaining a “healthy” cash-on-hand balance include the value of earned fees unbilled (“work-in-progress”). throughout the year. Introduction to the Mattox Format The use of conventional accounting formats, while perfectly acceptable, nevertheless do not allow for an easy calculation of the seven key financial performance indicators for the profit-loss statement. As an alternative to conventional accounting formats, there is a unique format that was developed by Robert F. Mattox, FAIA, (retired) designed to facilitate easy understanding of financial performance indicators. While conventional accounting systems are capable of providing these same performance indicators, the results will be more laborious to calculate and will not necessarily provide as accurate a result for some of these key indicators. The reason for this is that conventional accounting systems are set up with certain data shown in portions of the report that make it necessary to extrapolate and reorganize these data to allow for the calculation of these seven key financial performance indicators. Performance Goals Every professional design firm would do well to establish specific goals for its financial performance for each coming year. In order to provide a realistic set of performance goals, these goals need to be reviewed and modified to suit the current status of the firm’s finances and the current and anticipated condition of the market for the firm’s services. Because each firm is unique, these goals will vary from firm to firm. For many firms these goals are based on established mission and vision statements. Among the financial performance goals to consider are the following: Projected net billing and revenue Project consultant fees (as a percentage of total billing) Project-related expenses Week 02 Prelims Page 3 of 7 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS Staff size and salary expense Overhead expense and break-even rates (as a percentage of direct labor) Net profit (as a percentage of net operating revenue) Included in these goals will also be the development of a competitive hourly billing rate for every member of the firm and their respective, targeted utilization rates for the coming year. It is recommended that every firm establish these performance goals before the start of the coming year. Once established, these performance goals will provide firm members with an opportunity to be as efficient and effective as possible through regular monitoring of daily project activities and the accurate tracking of time spent each day on projects. Projected Net Billing and Revenue Financial planning begins with the projection of what the firm principal(s) believe to be a reasonable expectation of how much net billing (fees billed exclusive of expenses and consultants) and revenue the firm can create for the coming year. This would entail identifying current projects under contract that will carry over into the coming year and the balance of fees remaining to be billed on those projects in the coming year. This is commonly referred to as “backlog.” Most firms maintain an ongoing backlog report to facilitate this process. Then, taking into consideration all outstanding project proposals and categorizing them as either a “prospect” (better than a 50 percent chance of being awarded) or a “suspect” (less than a 50 percent chance of being awarded) it is possible to assign a percentage of them being awarded to the firm and calculating their respective projected fee values. In addition, a firm’s marketing plan will identify potential new prospects and suspects, based on the current and anticipated market conditions and the opportunities to submit future proposals for these yet to be identified new projects. With these resources identified, a realistic, conservative net billing and revenue projection goal for the coming year can be established within the profit plan. Project Consultant Fees (as a Percentage of Total Billing) A firm’s total revenue generally also includes other fees to be billed in addition to their own. Most common among these are the fees for project consultants. Refer to industry guidelines for what would be an appropriate percentage of a firm’s total billings allocated to the fees of their project consultants. It is also advisable for each new prospective project, prior to submitting a fee proposal, to send a comprehensive request for proposal (RFP) to each of the required project consultants to be retained. Then, adding the project consultant’s proposed fees to the firm’s calculated net fee, the total fee can be established and the actual percentage of the total fee allocated to the project consultants can be determined. This percentage would then be compared to what the industry guidelines suggest to be reasonable and fair. This process will enhance a firm’s ability to be more responsive to an existing or new client’s request for a fee proposal for future work and result in the potential for increased profitability. Project-Related Expenses Each project, based on the fee basis stipulated in the contract, will have expenses that can be invoiced and subsequently reimbursed or expenses that will be a part of the total fee, as in a lump sum fee basis and not individually reimbursed. In addition, even for those projects Week 02 Prelims Page 4 of 7 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS that have reimbursable expenses, there likely will be other expenses that will be non-reimbursable (e.g., in-house reproduction expenses for coordination, local mileage, unauthorized overtime, etc.). Because these common, project-related, non-reimbursable expenses reduce a project’s profitability, they should be identified as a part of the fee-setting process and a unit cost established for each such expense. Doing so will result in establishing a more accurate net operating revenue and net profit for the prospective project. Staff Size and Salary Expense One of the performance goals to consider is a strategic plan for the staff size of a firm. The impact of the market and its economic condition will almost always play a role in establishing the number of employees in a firm. The great majority of firms in the United States are considered to be small firms. “Small,” in this reference, is defined as fewer than 10 people, including the principal(s). Regardless of a firm’s staff size, it is still important to plan for the annual cost of its employees and principals. Propor tionally, annual salaries are the single largest expense for any firm. For most firms, approximately two-thirds of their total annual salaries will be project- related and will be the primary source of a firm’s generated revenue and income. Of critical importance is the balance between staff size and the available project work. This balance is reflected in one of the seven P-L statement indicators: the ratio of the total direct labor expense to net operating revenue (net multiplier). To best reflect this balance, the total direct labor should be in the range of 28 to 32 percent of net operating revenue. If the ratio is considerably lower than 28 percent, it is a possible indication that there are insufficient hours being charged to project-related assignments. This might be the result of a reduction in project workload caused by a client stop-work order, or something affecting the entire industry like an economic slow-down. Whatever the reason, there will be times when the project workload is insufficient to allow staff to charge their “normal” number of direct hours (based on their respective, targeted utilization rates) and this will reduce the percentage of direct hours to NOR. If the ratio is considerably higher than 32 percent, there are several possible explanations: 1. Hours in excess of those budgeted or allocated are being charged to project-related activities. Potential negative impact is that a project’s total fee is being used too quickly and profit is being consumed to cover these additional hours. 2. A large volume of overtime hours are being charged to project-related activities. This would be added to the project fee if the client authorized and was paying for these overtime hours at regular or premium billing rates. If not, since firms usually do not pay overtime for salaried professional staff, these overtime hours, while still charged to the project, would not have any cost related to them. They are charged as hours with a zero-cost impact on the project budget or overhead burden. While these hours do not increase direct labor expense (in dollars), they should be recorded for an accurate measure of direct hours required for project completion. This is important for establishing reliable historical data on how many hours it actually takes to complete a certain project type. 3. A business decision was made to spend the hours to “catch up” with the project schedule. If no compensation is made for these hours, it is the same as the situation described in number 2 above: zero-cost. If compensation is being provided, it is similar to number 1 above: potential fee drain and profit loss. For any and all of these above reasons, it is essential that the project hours charged are accurately and timely entered on each respective employee’s daily timesheet. Overhead Rate and Break-Even Rate (as a Percentage of Direct Labor) The overhead rate and the break-even rate are inextricably related: The overhead rate comprises two components: indirect labor and general and administrative (G&A) expenses. Even though many G&A expenses are common to most firms, what these expenses specifically include will be a reflection of a firm’s uniqueness in its operations and the types of discretionary benefits it offers its employees. Refer to the sample accrual profit-loss statement and the most common G&A expenses. The break-even rate is equal to the overhead rate plus an assigned unit cost of 1.0 for hourly salaries. A firm with an overhead rate of 1.30 would have a corresponding break-even rate of 2.30 (1.30 + 1.0). Once a firm’s overhead rate has been established, the break-even rate for every employee can also be calculated, based on their respective hourly salary rate. Example: For an employee who is paid a salary equal to $20 per hour ($41,600/2,080 hours) in a firm with an overhead rate of 1.30, the break-even rate for such an employee would be: $20.00 × 2.30 = $46.00 per hour. That means for the firm to break even on this particular employee’s hourly salary and their respective portion of the firm’s overhead cost, the hourly billing rate for their direct labor can be no less than $46.00 per hour. To include profit at a targeted percentage of 20 percent, divide the break-even rate by 80 percent (the complement of 20%). This will establish an hourly billing rate of $57.50 ($46.00 ÷ 80% = $57.50; to check: $57.50 × 20% = $11.50 + $46.00 = $57.50). Net Profit On the accrual profit-loss statement, the net profit is considered to be a firm’s “bottom line.” It is the total dollars earned after all salaries and expenses have been deducted (regardless of payment) from the net operating revenue. The only thing remaining at this point, if a profit was earned, is the decision about its distribution to the staff and principal(s). Week 02 Prelims Page 5 of 7 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS The need to define the actual available cash-on-hand that would cover such distributions was previously discussed. There are examples of firms that, in spite of having earned a net profit, did not have adequate available cash-on-hand to make the distributions they deemed appropriate. To supplement their available cash-on-hand and pay for these distributions, the principal(s) sometimes decide to tap into the firm’s line of credit. In the case of firms that do not have a line of credit, some have been known to apply for a loan. While these are individual business decisions, they need to be considered carefully as to the wisdom and soundness of this course of action. If the firm is extremely well-managed, the repercussion of such decisions might never be negatively experienced, but for most, taking on debt to pay bonuses is a decision laden with risk. Sometimes a firm has available cash-on-hand, but does not have any earned net profit at the end of the year. In this scenario, some may decide to go ahead and make modest distributions. Again, this is a business decision, but not necessarily a prudent one. Planning for profitability and its eventual distribution is a process to engage in before the start of each coming year to provide a firm with the best advantage to succeed. PROJECT CONTRACT–RELATED FINANCIAL MANAGEMENT ISSUES Most project contracts contain information that will require a keen awareness of its impact on potential project profitability and the periodic monitoring of a project’s progress. Among the information to review and monitor carefully is the fee basis type, the basic scope of services, scheduled invoices, and other opportunities that might lead to supplemental/additional services, revenue, and income. Fee Basis Types Every project will have a designated type of fee basis. There are several types, and each basis has its own nuances and financial management implications. The following are the most common types: Stipulated lump sum Fixed fee + expenses (with or without a cap limit on expenses) Percentage of construction cost Hourly to a maximum + expenses Hourly—open-ended (no established maximum) + expenses Fee per unit/sf (mostly used on residential projects) + expenses For most project contracts the client will stipulate the type of fee basis. Public sector (government, institutional) projects will almost always be on a stipulated lump sum or a percentage of construction cost fee basis. Private sector projects could be any one of the above types, depending on the client and the project type. Regardless of the fee basis type stipulated, each type affords a certain number of benefits and disadvantages, all of which n eed to be considered as one part of a “go/ no-go” decision to respond to an RFP. Scope of Services The scope of services is a portion of the project contract that bears careful scrutiny. The scope of services in many project contracts is not clearly defined, which leaves too much to interpretation by the reader. This can lead to disastrous results for the architect, primarily in the area of lost revenue and subsequent lost income. To keep this from happening, it is advisable to have at least two senior members of the firm read and review the scope of services requirements to ascertain if any portions are unclear. There may be a need to stipulate the number included of a certain kind of meeting or the number of design scenarios per design phase to be prepared for client approval. Anything that is left open-ended and subject to interpretation may lead to a “bottomless pit” of expectations by a client. In addition to the above, certain words that are used in contracts with owners are likely to result in a difference of interpretation of what the client was requiring, or what the legal implications might be, and/or how the requirement might affect the professional liability insurance carried by the firm. The most detrimental example is the words used in the indemnification clause of the contract. It is advisable to have a firm’s legal counsel and their professional liability insurance carrier’s representative review the contract to avoid any potentially expensive surprises. CONCLUSION Since each professional design firm is unique, so will be its respective operational policies and procedures. Therefore, prior to adopting any of the contents of this article, it is recommended that firm leaders seek professional input from trusted outside sources familiar with the firm. At a minimum, firm leaders are urged to review and discuss this article with accounting advisers, both in-house and outside. Once discussed, any decisions to adopt specific changes to their current accounting system should be implemented by the accounting staff and as much outside professional guidance as is available. As a summation, the following are the main points of each of the major subtopics in this article: Week 02 Prelims Page 6 of 7 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS Accounting and financial management reports: The essential distinction between accounting reports and financial management reports relates to the parties for whom these reports are created. Accounting reports serve to identify the external realm of a firm’s financial performance as it relates to tax liability. Financial management reports serve to facilitate the internal decision-making process by a firm’s leader(s). Cash-basis and accrual-basis reports: The two types of financial reports - cash basis and accrual basis - respectively serve a firm’s accounting and financial management needs. These reports are interrelated in that they share the same data for time and money, but organize these data in different formats and with a different focus and purpose. In accounting parlance, the use of these two types of reports is referred to as “double-entry bookkeeping.” The Mattox Format: This article introduces a different approach to the accounting process and the concepts of financial management for professional service firms. The Mattox Format is a proven viable alternative methodology to what is generally commercially available for AE financial software systems. The Mattox Format has a 30-plus-year legacy since its introduction in the late 1970s and early 1980s by its designer and developer, Robert F. Mattox, FAIA (retired). Performance goals: With planning and monitoring as two critical elements in any successful business operation, it is essential that a set of performance goals be established and reevaluated on an annual basis to allow for developing trends, operational and po licy changes, and to remain competitive and profitable. Week 02 Prelims Page 7 of 7 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS Specific Learning Objectives: 1. Identify what is Financial Management Systems, Annual Budget and Profit Planning in the practice of Architecture. FINANCIAL MANAGEMENT SYSTEMS Steve L. Wintner, AIA Emeritus The primary function of financial management systems is to provide firms with numerous effective financial and project reports and supporting techniques to enhance the achievement of a firm’s long-term financial goals. INTRODUCTION To ensure the financial success of any firm with at least one or more employees, it is essential to have a comprehensive financial management system that includes a number of types of reports and resources. These reports and resources will facilitate a firm leader’s ability to manage the financial operations of the firm. Every firm leader needs to understand and be responsible for this process of management. This is one responsibility that is not to be delegated to anyone lacking this understanding and knowledge. The reports and resources providing basic information as a part of this financial system include the chart of accounts, the annual budget, the profit plan, daily timesheets, project contracts, financial management reports, key financial performance indicators, and project reports. CHART OF ACCOUNTS The development of a chart of accounts is the foundation of every accounting system and its means of organizing a firm’s financial data. The chart of accounts, reflecting the Mattox Format, represents sets of properly organized, multi-tiered, interrelated, numeric codes and/or account numbers. Each one serves as the repository and record for every dollar received, paid, and billed by a firm as shown on a profit-loss statement and balance sheet. The hierarchy of the numeric codes and/or account numbers starts with a “major” code or account and then is further defined by a series of sub-codes or accounts. Most comprehensive AE accounting software systems provide for a four-digit numeric code and/or account number. Each account number and designation will match a firm’s general ledger listing of the income, expense, and asset accounts. It is recommended to seek the guidance of an outside consultant (management, software representative, and accounting) to assist with establishing these numeric codes and/or account numbers, especially if applying the Mattox Format (see Table 7.1). A “master” chart of accounts is developed for the profit-loss statement and the balance sheet. The accounting software will provide a means for switching between the cash-basis and accrual-basis reports for these two documents and their respective numeric codes and/or account numbers. Week 03 Prelims Page 1 of 17 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS ANNUAL BUDGET The chart of accounts and the annual budget are interrelated resources. Each chart of accounts numeric code and/or account number represents a specific type of financial data that corresponds to a specific annual budget line item. PROFIT PLAN The “bottom line” of the accrual-basis profit-loss statement is the line item identified as “net profit.” In order to arrive at a desired net profit at the end of each year, it would be a sound business decision to plan in advance for that to happen. The profit plan ning process entails a number of significant components, each one having an impact on establishing a certain number of parameters to be achieved. The achievement of each of these parameters helps to enhance the chances that a year-end, targeted net profit would be realized. RECORDING DIRECT AND INDIRECT TIME Are timesheets generally treated as though they are one of the most important financial resources of every professional design firm? Sadly, the answer is a resounding “No!” Yet this is the only “commodity” that firms “sell” to their clients. Unfortunately, timesheets are seen by many employees as some form of diabolical, arbitrary ritual created by their bosses. At the same time, principals are often the worst offenders in terms of not filling out their timesheets in a timely and accurate manner. Clearly, few firm leaders and staff recognize that the timesheet is, in fact, one of the most important financial resources of every professional design firm. Here are some facts that confirm this assertion. The time reflected on a timesheet becomes the single most significant component of the accounting data-entry process. This is true because the hours charged to projects become the basis for the decision of how much to invoice for each project and subsequently, affect a project’s eventual profit or loss. The amount invoiced and payment received is the lifeblood of every firm. In addition, timesheets allow for tracking of effort spent on each project, which is critical to comparing project progress to the project budget and to allow timely adjustments as appropriate. Time spent on every project should be aligned with the allocated number of hours budgeted for each phase and task. Without timely, accurately completed timesheets, there is a real possibility of a disparity between the time spent and the dollars billed. Ideally, the fee amount value of each project invoice will be determined by the hours spent on each project each month. With untimely, inaccurate timesheets, there is a potential for a reduction of the targeted project profit. On a firm-wide basis, the total hours charged to projects is the denominator used in the calculation of a firm’s net multiplier and overhead rate. The calculated overhead rate can then be extended to reflect the corresponding break-even rate, both of which are essential elements of developing hourly break-even rates for every employee. Further, this data provides historical information for project fee budgets during the fee-setting process, in response to a client’s request for proposal (RFP). If the time entered on a timesheet is at best just an approximation, then the data-entry process compounds the problem by the incorporation of this unfortunate estimate of hours in the development of project, accounting, and financial management reports. The resulting totals and indicators will then provide misleading, erroneous information to the project managers and firm leaders. This is further compounded and harmful to the financial well-being of a firm when multiples of these guessed-at hours charged to projects on numerous timesheets become the basis of future overhead rates used in the fee-setting process for new projects. Measured over multiple active projects for a firm, it is easy to comprehend the increased magnitude of the problem and its potentially negative impact on each project and, overall, on a firm’s annual profitability. Obviously, none of this is done with malice, just a lack of understanding about the true nature of what a timesheet represents in the total process of the financial management of a firm. With less than an hour’s worth of training, every member of the firm can develop a better daily timesheet completion discipline. This would go a long way to enhancing a firm’s efficiency, effectiveness, and profitability. These kinds of “savings” in lost revenue could mean the difference of a year-end net profit vs. a net loss. As such, it might also mean the difference in whether or not there will be a distribution of year-end bonuses and/or salary increases. All this exposure to undesirable outcomes results from a lack of understanding about the true nature of a timesheet and its critical role in every professional design firm’s long-term success. The following are some simple techniques to adopt as a discipline for the completion of a timely and accurate timesheet. Develop a personal log and record the time spent before you start a different task, or phase. Record time in not less than 15-minute increments. Twice a day, enter on the timesheet the time spent in the morning, just before taking a lunch break, and again in the afternoon (evening), just before leaving the office for the day. All authorized overtime hours spent are to be recorded. The local or state agency that governs the state labor standards and the terms of the project contract will be the determining factors in the hours having any cost to the project. Regardless of any cost impact, the hours must be reflected on the project reports. In any scenario, overtime hours do not incur the cost of any overhead burden. The overhead burden is only applied to the first 40 hours per week. Therefore, any overtime to be charged to a client, in accordance with Week 03 Prelims Page 2 of 17 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS the state labor standards and the project contract, will likely be at a lower hourly rate than the regular hourly billing ra te, due to the absence of the overhead cost burden. FINANCIAL REPORTS The focus of this portion of the article will be an overview of the two most common financial reports: the profit-loss statement and the balance sheet. For the purposes of this discussion, the reference to the profit-loss statement and the balance sheet is to the accrual-basis report for each. The profit-loss statement and the balance sheet reports are developed at least once on a monthly basis. Each report provides firm leaders with different types of financial information for uniquely different purposes. The P-L statement reflects the results of a firm’s operations in terms of its revenue, direct labor, indirect labor, indirect expenses, and net profit for a given accounting period (generally the current month and the year to date). The balance sheet provides a description of a firm’s current financial condition for any given accounting period, even as short as a single day, of its assets, liabilities, and equity. In the review of each report, there are specific line items that are more significant than others and will provide tell-tale trends of how the firm is doing financially. Together, these two reports describe a complete picture of a firm’s current financial status. Profit-Loss Statement (P-L) The P-L statement is the financial management report that will provide firm leaders with 7 of the 11 total key financial performance indicators. On the P-L, the four most significant line items are these: Net operating revenue (dollars available for supporting daily operations and the baseline 100 percent value of the rest of every line item in the report) Total direct labor, as a percentage of net operating revenue Total expenses Net profit (before distributions and tax and referred to as the “bottom line”) Developing an annual budget for these line items and their respective subcategories is advisable. The Key Financial Performance Indicators backgrounder article explains what to look for and how to interpret the implications of the developing trends for each of these line items. This understanding is essential to making sound business decisions to offset negative trends and to repeat activities that produce positive trends. “Executive Summary” Format The P-L statement that is provided to a firm leader needs to incorporate the same three “Cs” that are taught regarding the quality of construction documents: information that is “clear, concise, correct” - for all the same reasons and then some. A firm leader’s time is of the highest value to the firm and its clients and therefore needs to be spent doing only the things that only they can do. As stated early on in this section, the management of a firm’s financial operations should not be delegated to just anyone. The reading, review, and interpretation of the P-L are the first and most important aspects of managing a firm’s financial operations. To make this process as effective and efficient as possible for the firm leaders, it is essential to create a single-page “executive summary” of the P-L. This condensed version includes every part of the full P-L, but not in detail. The chart of accounts numeric codes or account names should be condensed into a limited number of relevant line items for each of the four component sections of the statement. This will allow for the report to fit on just one page. Mattox Format P-L Statement The Mattox Format for the P-L statement includes the following four vertical component (row) sections (see Table 7.2): Revenue Direct Labor (Salary) Expense Indirect Expenses Miscellaneous Revenue and Expense Each of these four components has a group of line items that serve as a major description for its respective component. Each of these line items has, in turn, a limited number of subcategory line items for each description. The subcategory line items are up to the discretion of the firm leader(s), who can decide what line items they want to review for each major category. Awareness is required to maintain the single-page format. In the event that any subcategory line item comes into question, all of the supporting financial details are available from the firm’s accounting system. The Mattox Format also includes six columns for component sections: Current Month Percent for Current Month Week 03 Prelims Page 3 of 17 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS Year-to-Date (YTD) Percent for YTD YTD Annual Budget Percent for YTD Annual Budget Each of these six columns reveals a specific detail about the firm’s current and cumulative (YTD) quantitative data in dollars and percentages. Together, these horizontal and vertical components provide a very comprehensive summary of the firm’s financial activity for the current month, the year-to-date, and a comparison to the corresponding year-to-date annual budget. Revenue Component of P-L The Revenue component establishes the baseline value for the net operating revenue (NOR) at 100 percent. Every other line item in the P-L is a corresponding percentage of the NOR. The Revenue section is further divided into four sub-major line items: Fees Billed, Reimbursable Expenses Billed, Outside (Project) Consultants (O-C), and Project-Related Expenses. Each of these sub-major line items is further defined by a number of sub-categories. 1. Fees Billed for: a. Architect b. Outside Consultants c. Markup on O-C fees to be billed Fees Billed are shown as positive dollar amounts. 2. Reimbursable Expenses Billed for: a. Architect b. Outside Consultants (equal to the invoice amounts received from the O-C for the billing period) c. Markup on all expenses to be billed Reimbursable expenses billed are shown as positive dollar amounts. Week 03 Prelims Page 4 of 17 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS Week 03 Prelims Page 5 of 17 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS 3. Outside Consultants: Equal to the fee invoice amounts received from the O-C for the billing period Outside Consultants is shown as a negative dollar amount (debit to Net Operating Revenue). 4. Project-Related Expenses (for the following five types): a. Architect’s reimbursable expenses, markup not included b. O-C reimbursable expenses (amount invoiced to architect), markup not included c. Project-related expenses included in all of the lump sum fee projects billed d. Project-related non-reimbursable expenses for the firm that are not allowed by clients, per the contracts e. Project-related reimbursable expenses that exceed any contract-stipulated maximum Project-Related Expenses are shown as negative dollar amounts (debit to Net Operating Revenue). Notes: Items 4a + 4b equal items 2a + 2b less markup. Items 3 and 4b represent the dollar values of the invoiced amounts received from the O-C for the billing period. Balance Sheet The balance sheet is the second of the two primary financial management reports and represents an opportunity to look at the firm’s financial condition at any time. Because the report is updated every time financial data is entered into the accounting system, it is capable of providing an “instant snapshot” of the firm’s financial condition. On the balance sheet, the four most significant line items are these: Current Assets: Those easily converted to real dollars Week 03 Prelims Page 6 of 17 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS Current Liabilities: Items that must be paid within the current 12-month period, irrespective of the calendar year, that diminish the value of a firm’s retained earnings and thereby reduce equity Long-term Liabilities: Items that must be paid beyond the current 12-month period and diminish the impact of the value of a firm’s retained earnings (and thereby reduce equity) Equity: The value of shares of stock, invested capital by shareholders, and the firm’s cumulative retained earnings (or loss) Current Assets (Cash-on-Hand, Accounts Receivable, and Fees Earned Unbilled [Work-in-Progress, or WIP]) are line items that need careful, regular scrutiny to ensure that the firm is maintaining a proper margin over its liabilities. The Current Liabilities to monitor and manage are Accounts Payables and Short-Term Notes Payable. Equity will reflect the cumulative Earnings (or Loss) over the life of a firm, based on each year’s Current Earnings (or Loss) from the year-end P-L reports. The term “Balance” reflects that Total Liabilities and Total Equity always equal the Total Assets. This report will provide the remaining 4 of the 11 total key financial performance indicators. “Executive Summary” Format Format The balance sheet is less complex in its format than the P-L statement. Because this report is in a state of almost constant change, only a single column of figures is required. If a firm leader desires, the subtotals and totals for each section can be offset from the body of line-item figures. Like the P-L, maintaining the single-page Executive Summary format is also an important consideration. The balance sheet and the profit-loss statement share certain financial data. Among these are: From the profit-loss statement to the balance sheet: Bad Debt, Current Earnings, and Accrued Bonus From the balance sheet to the profit-loss statement: Accumulated Depreciation/Amortization Balance Sheet Components and Line Items There are two key words on the balance sheet that require a definition to clearly understand their respective meanings. The words “current” and “long- term” are referred to in connection with all three of the major components: assets, liabilities, and equity. These words occur throughout the balance sheet, both as major components as well as a number of different line items. Each time these words occur, they carry the same meaning. “Current” is the current 12-month period, irrespective of the calendar year, and “long-term” is any time frame beyond the current 12-month period. Specific examples: “Notes Payable - Current Portion” in Current Liabilities “Notes Payable - Long-Term Portion” in Long-Term Liabilities Mattox Format Balance Sheet The Mattox Format for the balance sheet consists of five vertical component (row) sections, which include: two groups of Assets (Current and Long-Term), two groups of Liabilities (Current and Long-Term), and a single Equity component (see Table 7.3). The differences between the Mattox Format and a conventional balance sheet are related to subcategory line items and are minimal. Like the P-L Statement, each of these five component sections is further divided into a group of line items that serve as a major description for the component. Each of these major descriptions has a limited number of subcategory line items for each description. These subcategory line items, unlike the P-L statement subcategory line items, are not discretionary. They represent essential data that need to be shown to allow the report to be effectively reviewed and understood. In the event that any subcategory line item comes into question, all of the supporting financial details are available from the firm’s accounting system. Week 03 Prelims Page 7 of 17 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS FREQUENCY OF DISTRIBUTION FOR FINANCIAL REPORTS The frequency of distribution for the Executive Summaries of the two financial reports is a decision to be made by the firm l eaders and, in many situations, is a function of the size and complexity of the firm. In general, however, even in small firms, most firm leaders will expect to receive an updated set of financial reports on a monthly (30-day) basis, if not more frequently. This timing rarely occurs at the end of a calendar month. Rather, it is related to the completion of the accurate entry of all of the relevant, current financial data into the accounting system. Firm leaders need these data as quickly as possible to allow them to have the best opportunity to respond in a timely manner to developing trends. Obviously, those firms with an integrated, computerized accounting system will have a distinct advantage over those using less-sophisticated software. In addition to the firm leader(s), there may also be a need to provide a current report to governmental agencies, insurance companies, banks, and perhaps even new prospective clients. Having accurately completed daily timesheets once again becomes a key factor in the efficiency and accuracy of the accounting systems data-entry process and its final, monthly distributed reports. CONCLUSION In general, any well-designed and properly integrated financial management system will enhance a firm’s opportunities for financial success. To do so requires the development of a number of properly formatted reports and data-tracking components for use in these reports. The regular, periodic monitoring of these reports will facilitate the necessary adjustments to maintain a firm’s financial success. Prior to adopting any of the contents of this article it is recommended that each firm seek professional input from trusted outside sources familiar with the firm. At a minimum, firm leaders are urged to review and discuss this article with accounting advisers, both in-house and outside. Once discussed, any decisions to adopt specific changes to their current accounting system will need to be implemented with its accounting staff and as much outside professional guidance as is available. DEVELOPING ANNUAL BUDGETS AND PROFIT PLANNING Steve L. Wintner, AIA Emeritus Developing an annual budget is an integral part of a firm’s strategic planning process. When developed in concert with the profit plan, an annual budget is an essential resource that will allow firm leaders to compare a firm’s actual year-to date (YTD) financial performance to its YTD annual budget. DEVELOPING ANNUAL BUDGETS Introduction The annual budget, developed concurrently with the profit plan, affords firm leaders the best possible method of establishing guidelines for the firm’s operations and financial effectiveness over the course of the coming year. The annual budget utilizes numerous financial components that are developed by the profit plan. For this reason, among many others, it is important that these two financial “tools” be developed concurrently to ensure the seamless sharing of essential data needed by both. The chart of accounts provides a foundational format for the annual budget, in that the budget will, in its most detailed for m, utilize most, if not all, of the established major and subaccount line items. In fact, it would be advisable to use the chart of accounts as the primary organizing element for the annual budget. A detailed explanation and example follows. Because the development of the annual budget, like the profit plan, is an annually recurring process, it is advisable to begin its development in the latter stages of the fourth quarter of the preceding year. Mid-October, for those who have never developed an annual budget before, would not be too early to start the process. Starting early will allow sufficient time to thoroughly and methodically go through each step without the pressure of the coming year commencing before the budget is completed and can be approved. Annual Budget The annual budget, when properly developed, will include the chart of account numbers and data from the profit plan. In its initial format, the annual budget will resemble an expanded version of the profit-loss statement (P-L). This expanded version (Tables 7.4–7.7) includes both fixed and variable expenses. This format allows for every known or anticipated expense to be included. This level of detail ensures a greater possibility of capturing the expenditures for the coming year. Once this level of budget is as complete as possible, it would be reviewed by the appropriate firm leaders to make any final adjustments and to reach consensus on its approval. Once approved, the fixed and variable indirect expenses for the same major account numbers can then be combined in a “collapsed” version (Table 7.8) of the completed, expanded version. The major accounts shown in this collapsed version would then be used to develop the approved final annual budget version (Ta ble 7.9). The approved final annual budget would also be used as the basis for a third set of figures (dollars and percentages) being added to the Week 03 Prelims Page 8 of 17 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS monthly P-L format, representing the YTD annual budget for each of the respective P-L line items. The purpose and benefit of including a YTD budget in the monthly P-L is to provide a comparison with the firm’s actual YTD financial performance. Refer to the Financial Management Systems article (7.3) to see an example for the Profit-Loss statement with the YTD budget included. The annual budget, combined with the projections for revenue, direct expenses, and indirect expenses developed in the profit plan, creates a strategic financial plan illustrating the optimum results anticipated for the coming year. Reviewing the P-L every month on a line-by-line basis will indicate how the firm is doing compared to the respective YTD budget. This will help firm leaders become better stewards of their financial resources. It will also facilitate sound business decisions in response to negative or positive trends that develop over the course of each succeeding month. Without the budget in the P-L, the YTD actual figures represent only numbers and percentages “in a vacuum.” There isn’t any relevant basis for evaluating these results, other than how they might compare to the empirical standards of the design industry. That will not provide greater relevance, meaning, and impact than seeing the actual results side-by-side with its respective YTD budget. Annual Budget Format and Components The annual budget is formatted in four primary sections: Revenue, Fixed Expenses, Variable Expenses, and Miscellaneous Revenue and Expense. Each section, with its own components, is similar to Mattox Format of the profit-loss statement. Section One: Revenue. Includes the exact same four components as the P-L: Fees Billed, Reimbursable Expenses Billed, Outside Consultants, and Project-Related Expense Section Two: Fixed Expenses. Includes Direct Labor Expenses and certain fixed Indirect Expenses Section Three: Variable Expenses. Includes only variable Indirect Expenses Section Four: Miscellaneous Revenue and Expense. Includes line items for each of the above two categories The accumulation of all of these line items will culminate in the determination of the projected net profit/(loss). Initially, the annual budget is best formatted as a 13-column document, with one column per month and the last column as the Total for the year. This allows the designation of expenses to be shown for each line item, in respective months, rather than just a single total amount for the year. This will accommodate certain expenses that occur periodically, rather than monthly. Section One: Revenue In Section One, the four Revenue line items (Fees Billed, Reimbursable Expenses Billed, Outside Consultants, and Project-Related Expenses) will be determined by the projections developed in the Profit Plan. Also, refer to the “Revenue Component of the P-L” section of the Financial Management Systems article (7.3) to see the breakdown for each of these four major account items. In budgeting for revenue, keep in mind that some of this revenue will come from available backlog remaining at the end of the year. This is revenue that has already been “captured” by signed contracts for existing, active projects and will likely be billed to cl ients in the coming year. Therefore, the projected revenue needed for the coming year, anticipated to be generated by new project contracts, will be reduced by the amount of the applicable backlog. Once the revenue amount is determined, it could also serve as a minimum target for the coming year’s marketing plan. Section Two: Fixed Expenses In Section Two, the Fixed Expenses, consisting of Direct Labor Expense and the fixed portion of Indirect Expenses, are also determined by the projections developed in the profit plan. Week 03 Prelims Page 9 of 17 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS Fixed expenses will obviously be easier to determine than variable expenses (see Table 7.5). Generally, these will include Direct and Indirect Labor (as established in the profit plan) Payroll Benefits (mandatory and customary) Nondiscretionary Benefits (pensions, IRAs, professional dues, and licenses) Office Lease & Facility Expense (rent, utilities, security, and maintenance service) Office Expenses (telephone systems, Internet, website hosting) Business Insurance (professional liability, general liability, auto liability) Auto Expenses (lease payments, registration, licenses) Tax Expenses (franchise, business margin, local property) Every firm is unique, and it is advisable to discuss all possible qualified expenses in this category with the firm’s legal, tax, and management consultants. Respectively, they would identify the impact created on some of these expenses by the firm’s legal structure, its geographic location, and any local, state, and federal governmental regulations imposed by these jurisdictions. It is important to be aware that some of the above expenses might also include a variable component. Section Three: Variable Expenses In Section Three, the Variable Expenses consist of a firm’s remaining Indirect Expenses. Some of these variable expenses will also have a fixed component to them, as noted in Section Two above. Only the variable portions of such expenses are to be included in this section. However, the total budgeted line item for these expenses will need to include its respective fixed component. (See Table 7.6.) It will likely be more difficult to determine the dollar value of some of these variable expenses. Using the average of the prior three years of expenses in each of the line-item categories will help to identify an appropriate amount to budget. For start-up firms without any past history, it will be even more difficult. Initially, a “best guess” might have to suffice for some line items. Careful monitoring each month would be advisable to observe any significant trending upward or downward to determine any effect these best-guess budgeted amounts might have on the firm’s net profit-loss. Week 03 Prelims Page 10 of 17 AR 542: BUSINESS MANAGEMENT AND APPLICATION FOR ARCHITECTURE 2 PRELIMINARY LECTURE HANDOUTS Section Four: Miscellaneous Revenue and Expense In Section Four, each of the two components, Miscellaneous Revenue and Expense, will comprise line items that relate to the daily operations of the firm. Some of them are project-related while others are not. (See Table 7.7.) Miscellaneous Revenue might include any interest earned on funds placed in financial instruments, investments, or other such accounts. This component would also include any gain on assets, as established by the firm’s accounting people. On occasion, this could also include amounts collected and not refunded for unreturned and/or damaged, distributed project bid documents. There might also be other, small i