What is the value of a firm?
How do we increase the value of our firm?
What financial information does the firm need to operate?
Why do these need to be separate questions?
These questions have probably been thought about—but may not have been answered—by every owner of every firm. What items determine value? More importantly, what operational information is available already that can be easily monitored and used to focus every manager in a firm—from project manager (PM) to owner—on achieving a firm’s financial goals, thereby increasing firm value?
Project-based accounting systems are capable of generating the information needed. The question for each business owner to ask is whether the information is being used.
Link Operations to Value of the FirmA firm can simultaneously manage its operations and increase its value by understanding, monitoring and focusing on two basic but critical indicators that intimately link operations with overall financial performance, and fundamentally determine a firm's value. These indicators are:
- Billing Multipliers
- Utilization Rates
To understand these indicators, it is necessary to recognize a key fact about the industry: the salaries of people and related expenses (e.g., taxes, health insurance, 401(k), bonuses, etc.) comprise upwards of 75 percent of a firm’s total expense. That should be no surprise as it is actually the hours and talents of people that each firm “sells.” As such, exactly how well people are trained, motivated and then utilized is the most important factor determining any type of value or profit a firm may produce.
There are certain points that are crucial to understanding the value of your firm and how to increase that value. I call these the “always remembers.”
Always remember No. 1: The primary job of any manager at any level of any firm is to efficiently and effectively utilize the people he/she manages to accomplish projects at least up to the quality standards established by the firm and the client. While financial indicators cannot measure or evaluate the 'quality standards' aspects of projects, at least not directly, they certainly do provide ways to measure and monitor the 'efficient and effective' aspects.
Every firm declares that, “Our people are our most important asset.” They are. But, no company has an asset called 'People' on any financial statement. Nonetheless, one certainly can see 'people' on financial statements. A simplified profit and loss statement is shown on the left side of Figure 1. Note that, of the seven major expense categories, four of them, those related to 'people' costs, are italicized.
Linking Managers to ValueSeveral ratios have been established by which firms within the industry are comparatively valued, be it for buying or selling firms, or other purposes. Among the most important ratios are:
- Value to Net Revenues
- Value to Gross Profit
- Value to Operating Profit
Net revenues are gross revenues minus direct expenses. Direct expenses include all expenses incurred specifically for a project, including travel, printing, copies, shipping, etc. If the firm is reimbursed for direct expenses, fine. If not, those expenses come out of the firm's fee. Either way, those monies go to someone else.
Net revenue is what is left for the firm itself. Net revenue is what a firm receives for its own operations—its own people, its own overhead and its own profits. As such, net revenue is a better comparative measure of a firm's size than gross revenue. But it only loosely relates to 'value,' as it is not an indicator of how much profit a firm makes on a given amount of net revenue.
Gross profit is net revenues minus direct salaries—salaries for anyone who puts any time into any client project, regardless of whether that time is billed. Gross profit is what is left over to pay for overhead and produce the profit, bonuses and distributions everyone expects. It also is an indicator of how effectively a firm uses its professional people to complete projects and generate revenue. Two firms may be the same size (generate the same amount of net revenue), but the firm with greater gross profit may be more effectively using its professional people and has more money with which to cover overhead and produce bottom-line profit. As such, gross profit is more indicative of 'value.'
Linking PMs to ValueRegardless of a firm's size, total net revenues, direct salaries and gross profit are nothing other than the sum of the net revenues, direct salaries and gross profit of each of its projects, and actually recorded in accounting systems by project. As such, each PM can be linked to 'value,' and the link is called the billing multiplier.
The billing multiplier is net revenue divided by direct labor. A billing multiplier shows how many dollars of net revenue are produced for each dollar of salary that is paid to someone working on a project (regardless of whether that time is billed). The higher the billing multiplier, the more gross profit earned.
Remember the old rule-of-thumb of three? “If we can bill out our people at three times what we pay them, we should be able to make money.” Essentially that rule still works. And, yes, there are firms that regularly earn overall firm-wide 3.50s to 4.00s. Where in that range a project—or a firm—is makes a significant difference on the bottom line.
Billing multipliers are the link between PMs and 'value.' Billing multipliers can be, and should be, calculated at the project level, even at the phase level, if projects are big enough, and should be checked monthly, quarterly, year-to-date and project-to-date. Add up all of a PM's, or group of PM's, projects and one gets billing multipliers by department, office and right up to the firm level.
Note that the direct salary numbers are raw amounts—the amounts actually paid to employees. None of the direct salary numbers have been 'burdened' by some overhead amount or multiplier that is often arbitrary, and over which the PM has no control. A PM only controls 'raw' numbers—actual direct expenses and actual direct salaries are what a PM approves. Overhead is the responsibility of other managers.
Linking Other Managers to ValueOperating profit is a firm's gross profit minus indirect (non-project) salaries, other salary-related expenses and other overhead expenses. Operating profit is the best indicator of how well a firm handles all aspects of its operation. Since bonus and distributions are frequently discretionary and related more to dispersing or reinvesting profit, operating profit is a better indicator than net income of a firm's 'value.’
Indirect salaries alone account for almost 25 percent of a firm's total expenses. Indirect salaries include all non-professional personnel and all vacation, holiday, sick/personal, etc., time. It also includes all administrative, marketing and training time of professional personnel. Lastly, it includes the time professional personnel have nothing to do.
Other salary-related expenses include the FICA, Medicare, FUTA, SUTA, 401(k), health insurance, etc., that add about 15 percent to the cost of salaries, and account for about 10 percent of a firm's total expenses. Together, indirect salaries and other salary-related expenses account for more than a third of a firm's total expenses and almost 60 percent of a firm's entire overhead.
Utilization rate is direct labor divided by total labor. It is a straightforward indicator of the proportion of a firm's total manpower that goes to project effort. Tracking utilization rates is not possible at the project level. PMs only have control over the direct labor on their projects. Control of indirect/non-project time of people, and therefore utilization rate, is at the next higher team/studio level, upwards through department, division and firm level. At those levels, utilization rate is the most important indicator of how employees’ time is being managed and how much of a firm's 'product'—the hours and talents of its people—is being 'sold' to clients.
Industry averages show firm-wide utilization rates in the 60 percent to 65 percent range. First, it must be recognized that no person can be more than 90 percent utilized, as vacation, holiday, sick, personal, etc., time alone averages 10 percent. Further, corporate and administrative departments have utilization rates of 0 percent. As such, operating departments and divisions need to have utilization rates in the 70 percent to 80 percent or higher range. And that leaves only 10 percent to 20 percent for necessary and appropriate administrative functions and time, marketing and client relations, and continuing education and training, all of which are necessary at all levels.
As mentioned in Always Remember No. 1: The primary job of any manager is to efficiently and effectively utilize the people he/she manages.
Always Remember No. 2: Billing multipliers measure the 'effective' and utilization rates measure the 'efficient.' Together, they are the critical determinants of operating profit. They reflect the management and use of up to 75 percent of a firm's total expenses, and can be measured and monitored at each and every organizational level.
Operating profit is what is left—finally. Operating profits rates of 10 percent to 12 percent of net revenue are just average. Many firms earn more, and too many firms earn less. Operating profits are what provide the return on investment to owners of the firm—and owners deserve their returns considering the risk inherent in the industry. Operating profits are also used to pay bonuses and allow for distributions.
Always Remember No. 3: Without operating profits, there are no bonuses or distributions, or even raises. In fact, eventually there won't even be jobs.
'Survival' Indicators: Additional Links to All ManagersBacklog is the total net revenues remaining from every project a firm already has, or expects to have, for billing tomorrow. Backlog is the net revenues that will cover tomorrow's payrolls and overhead expenses, and produce tomorrow's profits. It foretells tomorrow's financial health—whether there are billable projects on which people can work tomorrow. No backlog, no billings. No billings, no cash. No cash, no payrolls. “Our employees are our most important asset,” and backlog is the only way to retain, pay and reward them, not to mention keep the firm going.
Always Remember No. 4: Without backlog, there is no tomorrow. Regardless of how well a firm has done in the past, backlog represents the 'value' of a firm today to anyone looking at realizing operating profits tomorrow. Further, backlog, just like net revenues, come from individual projects, and, as such, can and should be measured and monitored at each organizational level—a link to all managers, from PMs upwards.
Accounts receivable (A/R) are as yet unpaid billings already sent to clients. Remember the process: work is done, it gets invoiced, invoices get paid (a process that easily averages 90 days). A/R, too, comes from individual projects, and, as such, can and should be measured and monitored at each organizational level—a link to all managers, from PMs upwards.
Always Remember No. 5: No salaries, no expenses, no bonuses and no distributions can be paid without invoices being turned into cash.
Putting the Pieces Together for ProfitYou want a firm with a good product and satisfied clients. Unfortunately, there is also the business-side of the firm. A firm must also produce a profit. And profits increase 'value' and lead to retirement.
It is important, if not critical, to a firm's success to implement use of these indicators into the everyday operations of the firm: every person, every day doing what he/she can to optimize/maximize the indicators, and thereby increase a firm's value.
Always Remember No. 6: Each person can (and without becoming an accountant).