These randomly scheduled missives will opine on a variety of topics, mostly intended to be germane to design, construction, capital program management, and other related issues.

Notes from the Road
March 2010
Why does it cost so much?

On more than one occasion (like hundreds), I have had to explain why Architect’s hourly billing rates are “so high”.  I’ve even had to do this to people in the very offices generating the billings.  Many Owners, particularly, are unclear on the factors driving the compensation rate.  The diatribe often goes like this: “I know the intern architect is barely earning $50,000 a year.  Why is the billing $80 an hour?  That’s over $165,000 a year!!!”
There is an answer, of course, to the demanding question.  Unfortunately, that answer is not as absolute as some people would like.  Understanding is helpful, whether you’re selling or buying the service; or even innocently observing the tension sometimes swirling around the issue.
The time and expenses related to employee compensation fall into broad categories.  So, let’s parse the numbers…

  Mandatory and Customary BenefitsBenefits

 First, the Mandatory
Laws and regulations vary around the country, but employers are obligated to fund various set-asides when paying employees.  These may include:

  • Workers Compensation Funds
  • Unemployment Compensation Taxes, both Federal and State
  • Social Security
  • Medicare

And whatever else the local government wants to fund on the back of employers paying salaries

Then, the Customary
These can also vary widely, and the ‘Benefit’ is the amount paid by the employer, not the employee.  The core ones are often:

  • Medical Insurance
  • Dental Insurance
  • Life Insurance
  • Pension Plans (where the contribution is not at the discretion of the employer)

Those are the ones which are straight monetary expense, and then there are the ones that entail time away from the job which are paid for by the employer (sometimes called ‘Benefit Time’).  These typically include:

  • Holidays
  • Vacation
  • Sick Leave
  • Jury Duty

and, sometimes:

  • Family emergencies
  • Religious observance

On top of the Personnel Expenses, each office has a large subset of additional expenses.  These include:
Indirect Time
Virtually no employee actually works full time only on billable client work.  Many activities pull at an Architect’s staff:

  • Continuing Education (Now, often legally mandated)
  • Marketing
  • Presentations
  • Pro-bono projects
  • Competitions
  • Office Management
  • Etc., etc., etc.

In fact, particularly in medium to large-sized firms, any number of support people can be 100% Indirect, with no billable activities.

It’s this issue of Indirect Time that often separates Architects from the other members of a typical design/construction team.  More later…
Direct, Non-Billable Time.

Although, no Architect wants to do much of this, there remain some elements of project-related work which cannot be billed to clients.  This may be because the contract prohibits their billing (often the case with Lump Sum contracts), or the Architect chooses to do the work without compensation.
All the expenses incurred by an Architectural firm, not paid for by a contracted client are ‘Overhead Expenses’.  Too many bullet points – light, heat, power, rent, paper, insurance (Professional Liability, plus all the normal business ones), etc.  Not to mention, unreimbursed project-related expenses.  As you might imagine, the list is quite long.
The Calculations:
Direct Salary Expense (DSE)
Now let’s see how that $50,000 per year staff Architect (let’s call him Arch) costs a client perhaps $80.00 an hour.
Direct Salary Rate (sometimes called Direct labor) = Base Salary/Standard Yearly Hours
For a standard 40 hour work week, Arch’s Direct Salary Rate is $24.04/hour.
Direct Personnel Expense (DPE)salary
To the Direct Salary, all the Mandatory and Customary Benefits must be added to total to the Direct Personnel Expense (DPE).
It’s not unusual for the Mandatory and Customary Benefits to be anywhere from 25 to 40% of Direct Salary.  Consequently
DPE = DSE x 1.25 to 1.40
Using a theoretical 35%, Arch’s DPE = is $32.45/hour.

Now, the heavy lifting starts.
In order to fully cover expenses, the Architectural firm needs to get compensated for all DPE plus all Overhead.  Some sources refer to this as “Job Cost”.
It’s not unusual for the total of all Overhead to amount to 150% of the DSE of the firm. i.e., for every dollar of Direct Salary there’s $1.50 of Overhead, although there is large industry-wide variance in this factor.
So, to breakeven on Arch’s billing, the calculation is:
Breakeven Rate = DPE + Overhead
Breakeven Rate = (DSE x 1.35) + (DSE x 1.50)
Breakeven Rate = DSE x 2.85
Breakeven Rate = $24.04/hour x 2.85 = $68.51/hour
What’s a fair profit, and should all clients be expected to pay it?  Without profits, of course, Architects won't be around long to support the Client years after the project is complete.  Now that you mention it, what’s Profit?  Most architectural firms target a profit margin ‘before discretionary distributions’.  These discretionary distributions usually include bonuses and contributions to profit sharing plans.  The actual ‘Profit’ shown on the tax return is a different number, but that’s the subject of a different conversation.
In the computation of Billing Rates, Architects commonly seek 15 to 25% profit.  (Lately, it’s less, perhaps much less)  So, back to Arch.  To make a 20% profit on the billings for Arch’s time, the following calculation is used:
Billing Rate – Profit = Breakeven Rate
or, in this case,
Billing Rate – (.20 x Billing Rate) = Breakeven Rate
Billing Rate x (1.00-.20) = Breakeven Rate
Billing Rate = Breakeven Rate/(1.00-.20)
Billing Rate = Breakeven Rate/.8
or, Finally!
Billing Rate = ($68.51/hour)/.8 = $85.64/hour
It’s useful to point out that for this example the simple multiplier is:
Billing Rate = (DSE/hour) x 3.56
To complicate matters, some Architects prefer to calculate mark-up on Job Cost (not Profit on Billings) to set the Billing Rate.  For a 20% mark-up, the calculation for Arch would be:
Billing Rate = Breakeven Rate x 1.20 = $82.21/hour

How is knowing this useful?
For Architects
At a minimum, be familiar your firm’s procedures; and be especially prepared to explain yourself to Owners.  Some require more backup than others, but many ask.  Governmental Agencies, for example, often poke into the details, disallowing any number of individual line item charges.
Tracking the various multipliers is the lifeblood of any Architectural practice business analysis.  As Indirect Expenses and Overhead Expenses climb, Profit margins shrink (when billing rates are fixed), or Billing Rates also climb (when tied to multipliers), leading to potential client dissatisfaction.
For Owners
Architects have a tough row to hoe.  Compared to other consulting professions, their Indirect Expenses and Overhead costs are commonly higher than other disciplines.  They have pressure to keep abreast of industry developments, and have many marketing, presentation and other operation expenses not borne by other consultants.  These expenses ultimately benefit the Architect’s clientele.
One nuance to point out, by the way, is that the billing rates of top-level firm principals are often reduced below the calculations shown above, effectively adding to the Overhead burden of their offices.
In any event, knowing the make-up of the rates is worthwhile when negotiating services.  Not so much for Lump Sum agreements - more for Additional Services or Hourly Contracts.  Sometimes, Architects who are ensured compensation for all hours worked may be willing to reduce rates when settling on terms.
For Others
If you are not normally in the business of charging for your services by the hour, you may be unfamiliar with the costs that must be covered by income.  Or, at least, unfamiliar with how Architects ply their profession.  Hopefully the information is insightful.  Comparing and contrasting your business to that of the Architect is perhaps minimally entertaining.
Bottom Line the whole thing
First, apologies to readers who are totally conversant with this subject.  Hopefully, you’ll be enlightened by other newsletters.  Nevertheless, don’t forget that those who don’t deal in this material every day may need to have the subject brought down to basics, as I have tried to do here.  Also, please be aware that different mathematical formulae can be used to arrive at the same end result.
Unfortunately, except for the government Mandatory Benefit contributions, many of the background assumptions in these calculations vary firm to firm.  The retrospective periods, and the inclusion of overtime services can also skew the numbers.  Consequently, the analysis of this subject is great fodder for the audit industry.

Bottom line(s):  Understand your firm, understand your consultants, understand your teammates.

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Missed earlier newsletters? Find them here:
January 2010 “Design/Builders show us your softer side.”
November 2009 “What the Facilities?”
September 2009 “Why Do Architects Make Good Owner’s Reps?”

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