Part 3 - How Should I Calculate Profit on my AE projects

Part three of a three part series, by Michael McCaffrey, Deltek Consultant

After working with hundreds of firms in the architecture and engineering industry, I can tell you one thing for sure; profit and how it is calculated is the most elusive of all moving targets. What some in the A/E industry seem not to understand is that it is feasible to produce breathtaking work that your clients will sing from the mountain tops about and still obtain a quality monetary return on that investment.

Profit is certainly not a four letter word and should not be avoided like the plague. Now that we are all in agreement of its importance, what does profit look like?

The following is the third of a three part series that will take you through the components of the profit equation and provide recommendations for how profits should be calculated on fee billing projects. If you had not had a chance to read parts one and two, you can find them here:

Part 1:  How should I calculate cost on my architecture or engineering projects?

Part 2:  How should I calculate profit on my time & expense billing projects?

Part Three:  How should I calculate profit on my fee billing projects?

When you bid to win a fee billing project you do it with the expectations that you will at least be able to make some profit. But opposed to a time and expense billing project where the profit you can earn is tied directly to a percentage built into the hourly labor billing rates or a markup on expenses or consultant charges, profit margin on a fee project is much more up in the air. If you bring your project in under budget then your profit percentage can be higher than initially planned. Conversely, if you blow the budget on a fee billing project you can end up losing money in the process. So a tight project management control is needed to help make sure we are hitting or exceeding the initial profit percentage intended.

Typical fee project billing types include but are not limited to:

-Percent Complete

-Percentage of Construction Cost

-Lump Sum (Fixed Fee)

Here are some helpful hints to assist you in calculating and controlling your profit margin on a fee billing type project.

What is my cost amount?

Project costing was discussed in the first of my three part series on profitability. It is crucial to understand the cost on your projects prior to being able to come to a correct project profit figure. Follow this link below to review our cost conversation: Click here for part 1

Once burdened cost has been calculated you can then move on to the other portion the profit equation (X – Burdened Cost). But what is X? That depends on the scenario and what is your definition of profit. Use the examples below to help you through this decision making process:

What is amount spent?

Amount spent can be viewed as the cost of effort expended on a project if you are able to achieve your assigned billing rates.

Commonly the billing rate tables are used to determine the amount spent. In this way, the rate used to calculate amount spent can be unique to a project, phase, activity, employee, and employee type.

Example 1: Labor

An employee is set up with an employee type of Project Manager. Project 1, Phase 1 uses the standard rate table, which specifies billing rates by employee type. The billing rate for the employee type of Project Manager is $150. When the PM enters one hour of time to Project 1, Phase 1, this billable time generates an amount spent of $150.

Example 2: Expense (same concept for consultant charges)

A vendor invoice is entered for your project related blueprinting. A line item is charged to Project 1, Phase 1 for this expense activity. Project 1, Phase 1 uses the standard rate table, which specifies that expenses are billed at cost plus 15%. The line item on the vendor invoice specifies that there is 1 unit and that your company was charged $20 per unit for a total amount of $20. Using the rate table calculation of cost plus 15%, the resulting amount spent is $23.

The amount spent can change when you:

• move time from one project to another project (depends on the rate table for that project).

• change the rate table on a project and recalculate rates.

• change the status of the labor, expenses or consultant charges in  work-in-progress (WIP) to nonbillable.

What is amount billed?

Amount billed is a more straight forward figure than the spent amount. It represents the total labor, expenses or consultant charges you have billed to the client. This is the subtotal for your project client invoices billed plus or minus any invoice adjustments that were applied.

Another concept that can affect the billed amount on a project is A/R write-offs. If a credit memo is applied to outstanding A/R, does that count against my final billed total? A couple things to keep in mind:

Reducing Project Billed Amount – It is in your best interest if your accounting and project management software can accommodate the option to either reduce the total billed amount or not when a credit memo is applied. Sometimes you want your reports to reflect that an amount billed really did not happen; we invoiced when we should not have. In this instance you can decide to lower the total amount billed, hence potentially lowering the bottom-line when your profit is calculated on that project.

Not Reducing Project Billed Amount – If you choose to not reduce my project billed amount when a credit memo is applied against outstanding project A/R this is indicative of a true write-off. You want to show that this amount was billed, but for some reason you could not collect on the A/R so I have to write it off. The profitability of a project would not be affected in this instance if you are using the standard calculation of project billed minus project cost.

What is amount WIP?

Work-in-progress (WIP) is billable labor, expenses and consultant charges that have not yet been included on a final client invoice. Although the work was already completed or the expenses were already incurred, it is called work “in progress” because it is in progress of being billed.

You can create WIP when you enter:

• Timesheets.
• Expense reports.
• Vendor invoices.
• In-house expenses.
• Beginning balance unbilled work-in-progress.

In addition, you make adjustments to WIP when you:

• Change time, expense reports, or vendor invoices.
• Adjust, move or split WIP on a draft Client Invoice.
• Change billing rates and recalculate rates after WIP is created.

For example, an employee entered time, and WIP was calculated based on a billing rate table. You raise your rates and change the rate table. You want to bill the previously-entered time at the new, higher rate. If your software allows for it, you can recalculate the billing rates on this labor after the time was entered and bill at the newer rate.

What is the relationship between Spent, Billed and WIP?

To decide which amount described above you want to use for your profit calculation you must first understand how these three figures are related. When a labor, expense, or consultant item is entered against a billable project it generates a spent amount. This amount is calculated at the billing rate value.

At the same time the spent value is generated a WIP value (same amount) is also generated. When that time or expense is billed on a final invoice to the client, the WIP is cleared as it is no longer work in progress, but the spent amount remains. When that final invoice is created and the WIP is cleared, there is a billed amount that is created.

An Example:

1)    1 hour is entered against a billable project on a timesheet. The billing rate table says this time is billed at $150.00 per hour.

Spent = $150

WIP = $150

Billed = $0

2)    Time is billed on a final client invoice.

Spent = $150

WIP = $0

Billed = $150

How and why would I use the following options (w/ cost) to calculate my project profit?

Spent

• [Spent amount] – [Burdened Cost]

Use the project spent amount in your profit calculation on fee billing jobs when you want to look the potential profit assuming all labor, expense and consultant charges will be billed. Spent is calculated at time entry and does not require billing to be completed in order to calculate.

If your accounting software for architects and engineers gives you real time accounting and project reporting, this allows you to analyze your profit at any timeframe, meaning profitability can be a weekly or even daily metric depending on the need.  Controlling the spent amount against a project not only allows you to calculate profitability on your project at any moment but simultaneously gives the Project Manager a powerful tool to control the budget, schedule and scope.

*If your accounting software allows for a cap to be included in this calculation that would in your best interest. The most common example would be a cap at the total contract (Fee) amount. Spent – Cost would be used to calculate profit up until the spent exceeds the contract amount, then Contract – Cost would be used.

Billed

• [Billed amount] – [Burdened Cost]

Use the project billed amount in this calculation on fee billing jobs to get the true letter-of-the-law profit. This is the standard cash basis financials definition of what project is, what I billed minus what my costs were. This takes the mentality that what I haven’t billed yet cannot be included as profit because who really knows if I will be able to bill it. This profit calculation waits for the billing cycle before new project profitability can be calculated. So most often this calculation can only be done monthly.

**Best Practice – Use the billed amount for calculating project profit on fee billing jobs when the project is completed and closed. This is your true profit.

Billed + WIP

• ([Billed amount] + [WIP amount]) – [Burdened Cost]

Under most circumstances on T&E jobs the figure you will get for spent and billed plus WIP will be the same. Spent is everything you have worked against the project at the billable rate. Billed plus WIP is everything you billed plus what you have not billed at their billable rates. So what is the potential difference?

The answer is write-offs. If labor, expenses, or consultant charges are written off prior to being billed then they will still have a spent amount attached to them, but they are not billed and they are no longer WIP. Write-offs are used when you should have been able to bill for that charge, but for some reason you could not. An example of this is a Time and Expense with a Not-to-Exceed project (commonly referred to as a T&M to a Max). You can spend past that not to exceed amount, but you cannot bill for it. You have to write this remaining amount off prior to invoicing. In this case it would be in your best interest to not use spent for the project calculation because I cannot bill what I write-off.

*AE Best Practice – Use the billed + WIP amount for calculating project profit on fee billing jobs when the project is still being worked on and is not yet closed.

*If your accounting software for architects and engineers allows for a cap to be included in this calculation that would in your best interest. The most common example would be a cap at the total contract (Fee) amount. (Billed + WIP) – Cost would be used to calculate profit up until the (Billed + WIP) amount exceeds the contract amount, then Contract – Cost would be used.

Hopefully you now have more information to help you pin-point exactly what profit on fee billing jobs looks like to you. Once you have decided which method or methods work the best for you, in is in your best interest to stay consistent with how you calculate profit. If you lose this consistency, then your past trending and any forecasting you might do lose their validity.

Download the whitepaper: Top Considerations for Adopting an A&E Industry Specific Accounting Platform Understand the limitations of generic accounting systems and how an A&E industry specific solution with integrated accounting and project management helps A&E firms grow their business and increase profitability.