The Ultimate Guide to Budgeting for Architecture and Engineering Firms Part 2

The operating budget of an Architecture and Engineering firm is a dynamic, ever-changing organism with many interconnected pieces. Part 2 in a 4 part blog series by industry expert, Ian Denny.  To read part one click here.

Part 2:  The Architecture & Engineering Firm Budget “Top-Down”

By Ian Denny, A&E Industry Expert

The following is part two of a multi-part blog series on budgeting for architectural and engineering firms.  Part one provided an overview of the architecture and engineering budget and outlined what's to come in this series. 

Revenue Goals

The very first line items in your company budget are related to revenue. Architects and engineers, in a very broad sense, have essentially three classes of revenue:

• Labor (professional services)
• Reimbursable or incurred project expenses
• Revenue collected on behalf of or incurred for consultants

In most firms, revenue collected for expenses and consultants is marginally profitable at best. Your best hope for making a profit comes from your professional services revenue, and that is the most important variable to focus on when building your company budget.

To take a top-down approach as an initial stab at a company budget, take a look at prior years’ history and trends. You may be able to identify a pattern of a particular growth rate, or, in these times, shrinkage rate, or perhaps an indication of relatively steady revenue year-over-year.

Assess whether you believe (or want) this trend to continue, and create a number to use as a revenue goal. This number will likely change as you get deeper into the process, but it will help to have a goal in mind to compare your more detail-driven forecasts to as you get closer. Derive your goal based on professional services revenue, not necessarily expense and consultant revenue.

To determine expense and consultant revenue, if your accounting software for engineers and architects is setup properly, you should be able to identify these major revenue centers in prior year financial statements, and you will be able to identify a relationship to the labor revenue. For example, for every $1,000 in labor revenue, your firm may tend to incur and collect $25 of expenses and $100 of consultants. You will likely find this ratio is largely consistent within your firm, based on the way you do business and the clients and market sectors you tend to work in.

Now you should have a big-picture revenue goal. It should be realistic, but it doesn’t need to all be accounted for in your detailed forecasting, such as project workload or business development, yet. In a future installation, we will discuss how to use those mechanisms to refine the budget and determine any gaps that need to be filled.

Direct Costs based on previous year trends

For this first crack at your company budget, which we’ll continue calling a “top-down” approach, you want to estimate your direct costs. Here again, proper architectural and engineering accounting software will allow you to break your costs up into three major cost centers: labor, expense, and consultant.

To estimate expenses and consultants, you will want to do some analysis of your prior history again. For example, do we always markup consultants 10%? Or do we mark them up on 50% of jobs, and pass them through at cost on the others? Prior year trends will indicate an overall markup (weighted average) by comparing consultant revenue to direct consultant costs. You should be able to budget your direct expenses and consultants based on this generalized markup, except in periods where you expect to have a big change in the way to collect revenue for those costs.

Much more volatile is the amount of direct labor cost to place in your company budget. At this initial stage of the game, you will want to utilize an AE-industry metric called the direct labor multiplier.  Architects and engineers who have contracted with government agencies will be very familiar with this term, and most firms know what it is instinctually even if they use different names for it.

What we’re talking about here is the relationship of labor revenue to direct labor cost. This is one of the single-most important reasons to make sure your architecture or engineering accounting software is setup appropriately, and especially your fee-based projects are budgeted appropriately. We need to be sure that we are recognizing labor revenue as distinct from expense and consultant revenue, or the direct labor multiplier will be overstated.

To arrive at this multiplier, divide labor revenue by direct labor cost. Look back at multiple years of trends to see how that multiplier changes for your firm over time and to make an educated guess at what you think that multiplier will be in the next year or so. Then divide your labor revenue goal by this number to estimate your direct labor cost.

Indirect Costs as a remainder of known split costs

What the heck do I mean by that? Well, there are a few costs that you already probably have a firm handle on the grand total of, but they are to be separated into direct cost and indirect cost. The major example of this is labor cost. You can know, for example that your company’s gross wages paid to all employees last year was $500,000. You also know what your direct labor multiplier is, and therefore how many dollars you plan to spend on direct labor, based on your revenue goal. The remainder of the $500,000 would then be budgeted as indirect labor costs.

There are various ways that architecture and engineering firms manage their indirect wages, so I won’t get overly specific here, but you may wish to break this up into general indirect, vacation, sick, holiday, continuing education, etc.

If in your revenue goals you have planned for a significant amount of growth, you will need to plan for a similar amount of growth in your total labor costs, so don’t forget to factor that in first and then do the splitting between direct and indirect.

One way you can cross-check to see if the split you’ve come up with is realistic is to compare the relationship of direct labor cost to indirect labor cost from prior years and from your current working budget. If you have a major swing between years, it should be because you believe there will be a major shift in staff utilization rates (either a much higher percentage of billable time or a much lower one).

Lastly here, some firms split up fringe benefits into groups of accounts, some representing those incurred for direct personnel or due to direct utilization, and some representing costs incurred for indirect time. Examples would be employer taxes and company-paid health insurance, etc. I will say 90% of my clients do not split those hairs, but if you do, be sure to roll those variables into this split-up of direct and indirect labor costs.

Overhead Items as a known factor

And here we are at the easy part! Known overhead factors are things like rent, utilities, company-paid benefits, telephone, etc. Slapping these items onto the end of the budget will feel like a cake walk compared to the pretzel above.

So now you have a “top-down” company budget for your architectural or engineering firm. It will likely look fairly similar to last year’s actual, but with some generalized plan for growth. In the next chapter, we will discuss ways you can refine this big picture using detailed information from your projects and proposals, which are the heart of your business.

Read Part Three of the Ultimate Guide for Budgeting for A&E Firms Now!

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