How does your firm measure up?

In a compact new book, former Smith Carter Principal and C.O.O. Rick Linley describes a simple method for understanding the financials of any architecture firm—and what those financials mean for managing a practice. Here’s an excerpt from the book, explaining how to benchmark a firm’s performance using seven key figures.

It’s critical to understand how the Scoreboard numbers relate both internally to each other and externally to the broader industry. All the numbers used in the Strong Practice Scoreboard relate internally back to net fee. For external benchmarking to the industry, this book uses the 2021 Deltek Clarity A&E Industry Survey data set. The Deltek data is segmented in three basic ways. All firms, upper quartile firms only, and all firms excluding upper quartile firms. For a more detailed look by firm size and geography, you’ll need to delve more deeply into the Deltek data and also look at other surveys.

1. Full Time Equivalent

The number of FTEs is a measure of firm size, but isn’t a good indicator of firm strength. FTEs include all personnel—principals, leadership, project people, marketing, financial, and administrative folks—all employees of the firm. There is no benchmark for FTEs because there is no optimal number. The size of your firm as measured by FTEs should be a function of your goals, aspirations, and how effectively you’re deploying your people.

2. Net Fees

Net fees are also a measure of firm size, but practitioners are usually tight-lipped about this number. Like FTEs, there is no benchmark for net fees, but this single number is pivotal in making sense of your firm’s other metrics.

The Ratio—Net Fee per Full Time Equivalent

Dividing net fee by FTEs produces a very useful benchmark. In addition to the 7 numbers in the Scoreboard, this one ratio provides the best shorthand gauge of your firm’s strength. Upper-quartile firms in the 2021 Deltek survey achieved an average of about $174,000 NF/FTE. All other firms (excluding upper-quartile firms) averaged about $140,000 NF/FTE. This ratio is influenced by a range of factors, from how you price your work to how efficient your team is.

To help gauge where your firm is positioned relative to the broader industry, the 2021 Deltek data is used to create three performance bands based on the NF/FTE ratio. The performance bands also provide a reference point to track your firm’s performance over time.

• Struggling firms: less than $120,000 NF/FTE

• Strong firms: $120,000 to $170,000 NF/FTE

• Super firms: more than $170,000 NF/FTE

The dividing line between these ranges is somewhat arbitrary, but useful for comparison purposes. You may need to use more detailed benchmarking data to adjust the performance bands so they suit your discipline, firm size, type of firm, the geography you operate in, and other considerations. Adjustments will also be required over time as market conditions fluctuate and for inflation impacts. With a little benchmarking at budget time, you can establish performance bands to help determine targets appropriate for your firm.

3. Adjusted Payroll as Percentage of Net Fee

In a strong firm, adjusted payroll should be approximately 45% to 55% of net fee. This means that a strong firm should be spending about half its net fee on payroll for staff and principals—excluding fringe benefits. Payroll includes principal salary, but an adjustment may be required if principal salary is not aligned with the market. If principals are paid in salary supplemented by other forms of compensation such as bonuses and/or profit distributions, then a market-based salary needs to be assigned to principals as part of the payroll adjustment.

As an example, if the going market salary for the principal of a firm like yours is $140,000, but you are only paying yourself $100,000, then you need to increase the payroll number used in the Scoreboard by $40,000. It doesn’t mean you need to give yourself a raise, although you may want to consider that. It just means you need to make the adjustment when using the Scoreboard, otherwise your operating profits will be overstated.

4. Operating Expenses as Percentage of Net Fee

In a strong firm, operating expenses should be approximately 25% of net fee. Some firms run lean, employing strategies to keep costs low such as offshoring, minimal fringe benefits, and other strategies. For firms that commonly invest heavily in administration, marketing, professional development, benefits, etc., operating expenses may exceed 25%. Either approach is valid, depending on how your practice is positioned in the marketplace. The secret is to consider each expense as an investment in the future of your practice and to keep the overall operating expenses within your target.

5. Operating Profit as Percentage of Net Fee

For a strong firm, a reasonable target for operating profit should be between 20% and 25% of net fee. In the 2021 Deltek survey, the median profitability for upper quartile firms was about 27%. For all firms (excluding upper-quartile firms) the median profitability was about 11%. Think about that. If the median profitability for non-upper quartile firms was 11%, that means a large number of those firms had operating profits in the single digits. For small and midsized practices, single-digit profitability over the long term, usually spells trouble.

6. Pipeline as Percentage of Net Fee

A strong and reliable pipeline is critical. No one can predict the future with certainty, but a well-built pipeline will allow you to predict your future workload with a pretty high degree of certainty.

The median backlog reported for all firms in the 2021 Deltek survey is six months. That means the total of all contracted but unbilled future work if added together represents six months of annual net fees. This doesn’t include prospect projects, just work that is already under contract. The problem with using backlog only, is that it represents work that’s spread over many months or years in the future. The Scoreboard pipeline number is a rolling, twelve-month metric, and includes your estimation of both backlog and prospects. The twelve-month horizon makes for a more transparent crystal ball.

The pipeline of a strong firm should be slightly more than annual net fees in order to facilitate choice. Aiming for 125% of annual net fee for your twelve-month pipeline is a stretch for many firms, but well worth the investment of time and effort. That’s equivalent to approximately fifteen months of net fees. If your firm is growing, the pipeline may need to be larger to support your growth strategy. See Appendix B for a pipeline summary sample.

7. Cash on Hand as Percentage of Net Fee

In a strong firm, the amount of cash you should have immediately available will depend on a number of factors. They include but are not limited to, your tolerance for risk, the health of your pipeline, how predictable your profitability is, your WIP and A/R status, as well as the presence of any gorilla clients.

If growth is part of your strategy moving forward, you’ll have to decide to what degree growth will be financed by your own cash flow or financed by taking on debt. Again, it’s about your tolerance for risk.

Industry surveys of WIP and A/Rs over the years have consistently shown the median time from start of task to payment is about eighty-one days. Total WIP should be something less than one-twelfth (less than 30 days) of your annual gross fee. Total A/R amounts owing should be no more than approximately two-twelfths (60 days) of your annual gross fee. If you’re able to hit or beat those benchmarks, and if you’re generating healthy profits, you’ll have your cash flow under control.

Be cautious! Having more cash than you should inside the firm can also be a red flag. Cash provides a safety net. If the net is too large, it can encourage you to become complacent, deferring business decisions that need to be made in a timely fashion. Relying on a line of credit can promote the same ill-advised behaviour.

Ten to fifteen percent of annual net fee is a good guideline for cash on hand for a firm that is not experiencing significant growth. That’s equivalent to about two months of payroll and operating expenses. Cash on hand allows the firm to ride out small bumps in the economy or lulls between projects. That way firms can avoid dipping into a line of credit, taking out a loan, or relying on cash-calls.

To allow for major business disruptions, most principals hold funds outside the firm in their personal bank accounts and investments. With this approach, principals need to realize that if hard times befall the firm, they may be called upon to lend cash back to the business. Since a cash-call using after-tax dollars is painful, it acts as one more reason for leadership to keep the firm on solid ground.

Taking all the Scoreboard metrics into consideration will give you a quick overview of how well your firm is performing. You’ll be able to compare performance against previous reporting periods, as well as in comparison to the overall industry.

Remember This:

There are too many Key Performance Indicators in typical benchmarking studies and they’re too confusing. Staying focussed on the 7 Scoreboard benchmarks will keep the essential financials of your firm in context with the rest of the industry. For the latest Deltek benchmarks you can do an internet search for “Deltek Clarity A&E Industry Study” or go to www.strongpracticestrategies.com for a historical record of relevant Deltek benchmarks along with a current update.

Rick J. Linley, FRAIC, LEED AP leads Strong Practice Strategies, a consultancy helping leaders of emerging and evolving design firms who are focussed on building stronger practices. His work is informed by over thirty years of practice and business experience, culminating in his role as Principal/COO of Smith Carter Architects and Engineers Inc, a 200-person, multidisciplinary design firm (now part of Architecture49). Scoreboard Your Practice: 7 Numbers to Understand Your Design Firm’s Financials is available in eBook, paperback and hardcover versions at online booksellers including Amazon, Chapters Indigo, Apple Books, Google Play, and Kobo Store.