This is the time of year many firms do their budgeting. Unfortunately, many of them make the budgeting process far more difficult than it has to be.
Small firms may not know where to start the budgeting process, what to isolate, or how one number affects another. The most common tendency is to take the previous year’s numbers and gross them all up by some percentage. Or, to come up with all new numbers that show utilization jumping by 10% or the effective multiplier increasing by 20%— both unlikely scenarios.
Mid-sized and large firms (for whom the budgeting process is even more difficult) often make the mistake of trying to deal with the firm in its entirety, instead of breaking it down into manageable pieces. The biggest problem of all is that firms budget because they think they have to, not because they understand that it’s an important management tool and learning exercise.
The one person who probably knows more than anyone else about budgeting for design and environmental consulting firms is David Robertson, senior vice president and CFO of Reynolds, Smith & Hills, Inc., Jacksonville, Florida. David showed me a few tricks that I’ve used and refined over the years in a wide variety of firms, both large and small. This issue of The Zweig Letter comes with an extra insert that illustrates a no-nonsense budgeting process applied to a hypothetical A/E firm. Here’s an explanation of how the process works:
Break down the whole into manageable parts. Do a budget for each of these parts. Then roll them up into one consolidated budget for the overall firm. If you have multiple offices and/or multiple departments or units within the firm or offices, you need to separate out each office and each significant unit. Most smaller, single-discipline firms of ten people or less can skip this step.
Push overhead as far down into these units as you can. The cost of office space, company cars, local support staff assigned to the unit, and so on should be borne by the unit. Corporate overhead (overhead items that the entire company benefits from, such as corporate marketing support, professional liability insurance, etc.) needs to be pulled out separately. Ditto for office overhead (things that benefit the entire office but not other offices) like the receptionist, office supplies, and so on. In general, the overhead that can’t be pushed down should be isolated.
Once the units are identified and the overhead of each isolated, recast last year’s actual performance data for each of the units. Net service revenue or NSR (gross revenue less subconsultants and reimbursable expenses) should be the top line. Next comes raw direct labor (the total dollar value of raw labor charged to projects, whether it is billed or not) and total raw labor (in dollars, including all paid leave but excluding any other fringe benefits, payroll taxes, etc.). Using these figures, calculate the effective multiplier for the unit by dividing NSR by raw direct labor. Then calculate the real utilization rate, by dividing raw direct labor by raw total labor.
Now you need to identify the fixed costs (overhead, see item #2) for the unit. Calculate the “burdened” labor costs for the unit (including insurance, payroll taxes, etc.), then add unit fixed costs and burdened labor together to come up with total costs for the unit.
Subtract total costs from NSR to come up with the unit’s contribution. Then apply office overhead (unless you are doing the budget for the whole office or firm). Then apply corporate overhead (unless you are doing the budget for the whole firm). The result is the profit (or loss) for the operation.
Looking at each unit separately, start by agreeing on what the expected net service revenue (NSR) for the unit will be. This is the most important number in your budget! It requires a full understanding of what the backlog of the unit is (work under contract but not yet performed) as well as some reasonable predictions for new work that will come in and be performed during the budget period.
Once the likely NSR is agreed to, look at the historical effective multiplier of the unit (calculated in step #3 above) to come up with your raw direct labor budget. Most firms have effective multipliers somewhere between 2.5 and 3.5, depending on the clients they serve and services they provide. Unless there are some big “loser” projects that the unit is working itself out of, this number probably won’t change much during the course of a year (although it could). Most firm’s effective multipliers are largely set by the constraints of the marketplace— what clients will pay, how their contracts are set up, and so on. Dividing the unit’s NSR by its historical multiplier will tell you how much direct labor you need to produce the forecasted revenue during the budget period.
Develop the total raw labor budget for the unit. This is every professional service firm’s biggest single cost. Start with the current total raw labor assigned to the unit. Compare raw direct labor to total direct labor calculated above. This will give you the utilization rate you need to hit the desired NSR target. If this number is too high when compared with your historical utilization rate, you will have to add to your total raw labor budget during the year. If it is too low, you will have to cut labor during the year.
Review all overhead budgets. History is again the best indicator of the future. If NSR, multiplier, and utilization are all realistic, and the unit/office/firm still can’t produce the desired profit, then decisions on how best to cut overhead (out of the unit, the office, or corporate) need to be made. Each overhead expense item should be reviewed for cost reduction opportunities.
Finally, if the numbers still don’t work out, repeat the process until a scenario that you feel comfortable with can be developed. Is there any way to sell work which can be billed more quickly? How much money is being left on the table through inefficient project management (resulting in a lower actual multiplier from that which is targeted)? Should overtime payment policies for exempt staff be changed and the wick turned up to get more direct labor out of the same amount of total labor?
Where can overhead be cut?
This budgeting technique is the most straightforward one that I know of. As mentioned above, see the enclosed insert for an example of the process at work. The best thing about this process is that it requires the involvement of all of those who are responsible for producing the desired results to come up with the numbers. It allows for the consideration of an unlimited number of potential scenarios and makes it simple for anyone to see the effect a slight change in overhead, utilization rate, or multiplier will have on the bottom line. It makes tracking and problem identification simple. It makes it easy to see when adjustments are needed. And, finally, it’s a learning tool as well as a control device. Thanks, David.
Originally published 1/01/1993