Understanding finances and financial terms are a big part of the professional practice of architecture. They're justifiably important for passing your Practice Management and Project Management exams, potentially showing up in 4 or 5 of the 9 content areas between these two exams. Please keep reading to learn what I think are the most important financial terms for PCM and PJM. (Side note, I hate SEO)
This is such a wide-ranging topic that I have an entire course dedicated to ARE 5.0 Financial Formulas, which includes 28 different terms you may encounter. But studying for these exams is always an exercise in triage…you are not going to learn everything so you need to try to focus on the most important things.
The seven financial terms I’m covering here are the most common financial terms you will encounter on the exam. These are efficient…you have a good chance of seeing all of these ones, so it’s a good idea to master them. If you can learn the rest, that's great. But really understanding these financial terms will take you far on the exams.
Important Financial Terms for PCM and PJM
The seven key ARE 5.0 financial terms we’ll be covering, with sample problems, are
Net Operating Revenue
Direct Labor
Indirect Labor
Utilization Rate
Overhead Rate
Break Even Rate
Net Multiplier
Learn these seven things well and you’ll be in a great position to deal with financial questions on your ARE 5.0 exams.
Net Operating Revenue (NOR)
Architects’ Handbook of Professional Practice (AHPP) Definition: The net dollars remaining after deducting invoiced outside consultant fees and expenses, all reimbursable and direct (non-reimbursable) project related expenses.
Think of NOR as the money you have to actually run your firm. Start with gross revenue…all the money you have coming in. Then subtract what you have to pay your consultants, money that was received as reimbursement for things you paid for on behalf of your client and non-reimbursable expenses that you can’t directly bill to the client. What’s left is your Net Operating Revenue, i.e. the money you have to run your firm. From your NOR you pay rent, insurance, salaries, marketing, supplies, etc.
Net Operating Revenue Sample Problem
You have four projects for the third quarter with a total cost of construction of $325,000,000. Your design fee for each project is 8% of the cost of construction. Your consultants receive 25% of the design fee. You will spend $500,000 marketing and promoting your firm in relation to these projects. You will also pay an average of 2% of the construction cost for permits on behalf of your clients, to be reimbursed with your final invoice.
What is your NOR?
Answer:
Start by finding your total fee, 8% of $325,000,000, which is $26,000,000. Then you have to pay your consultants 25%. Or the easier math way, you KEEP 75%, which would be $26,000,000 * 0.75 = $19,500,000
The $500,000 marketing spend comes OUT of your NOR, it's not used to calculate the NOR. And the 2% permit fees are not counted…you will spend $6,500,000 on permits and then get paid $6,500,000 by the client as reimbursement, so it's a net of 0. This is why reimbursable expenses are not counted when figuring out NOR.
Final answer, your Net Operating Revenue is $19,500,000
Direct Labor
AHPP Definition: The time charged to projects, whether invoiced or not.
This is closely related to Utilization Rate, which we’ll cover here soon. Note that this includes salary, payroll tax and benefits…the total compensation for that employee for the portion of time they’re working on projects.
You personally encounter direct labor costs when you complete time tracking sheets for projects. When an architecture firm pays employees to design and produce construction documents for a specific job, those expenses are direct costs. Direct labor is billable to a specific project and client. It includes payroll taxes, company-paid medical/dental insurance, life insurance, workers’ compensation, company-matched retirement contributions and other benefits.
Direct Labor Sample Problem:
Employee A costs your company $75/hour, not including 7.65% payroll taxes. They worked 500 hours of billable work (only 450 of which was actually invoiced to the client) and 250 hours of non-project related work. What is the Direct Labor cost for Employee A? Round up to the nearest hundred dollars.
Answer:
For Direct Labor, and by association Utilization Rate, it doesn't matter whether work is actually billed to the client, or even if the architect is doing the work they said they are doing! As long as the work is being done toward a project it counts as Direct Labor. In this case, we will multiply the entire 500 hours by the $75/hr rate, for a total of $37,500. Then we add the 7.65% payroll tax, because the total cost of that employee is included in Direct Labor costs. The easiest way to math this is $37,500 * 1.0765 = $40,368.75. Then we round up to a final answer of $40,400.
Indirect Labor
Indirect Labor, on the other hand, includes the wages or salaries paid to employees who support the firm's operations but are not directly engaged in producing specific products or services. This might be admin staff, the Chief Financial Officer, maintenance works, or Architects when they’re not drawing stuff for buildings.
Indirect Labor Sample Problem:
A firm employs administrative staff who work an average of 20 hours per week and are paid an hourly rate of $25. Calculate the total monthly indirect labor cost for the firm, assuming there are four weeks in a month.
Answer:
Ok, maybe I got lazy on this one, but we all need a break sometime. On the ARE you are likely to encounter a more confusing question, where you first have to determine WHICH hours are direct and which are indirect. In this case, we're just doing some multiplication. (20 hours/week) * ($25/hr) * (4 weeks) works out to Indirect Labor costs of $2,000
Utilization Rate
AHPP Definition: The ratio of direct hours charged to projects to the total hours reported. Can also be calculated as the ratio of direct salary expense to the total salary expense.
If I had to choose just one, Utilization Rate would probably top my list of most important financial terms for PCM and PJM.
The Utilization Rate measures the efficiency of a firm's workforce by assessing the percentage of billable hours worked compared to the total available hours. It helps identify if the firm is utilizing its staff effectively to generate revenue. Note that this is an imperfect metric in that it doesn’t account for the efficiency of the worker, just whether or not they were billing time to a project.
From the AHPP it’s also important to note that you can find Utilization Rate with hours OR salary. Direct Labor is hours spent working on a project and Direct Salary is the money paid to the employee for the portion of time they were working on a project.
I have a whole separate post with more detail on How to Calculate Utilization Rate.
Utilization Rate Sample Problem:
Employee A worked 32 hours on a project, six hours on admin tasks and spent two hours studying for the ARE. Of the 32 hours on a project, the employee had Revit open on one monitor but was actually reading Hyperfine blog for 4 hours and another 20 minutes watching Ben’s backstory on Bryn Young’s podcast.
Employee B worked 24 hours on a project, including 8 hours of time the client won’t be billed for. They also took two days of paid time off to pass Practice Management.
Assuming a 40 hour work week, what was the combined Utilization Rate of these two employees?
Answer:
Ok, I got my effort back on this one! Remember, Direct Labor counts as long as you are working on a project. So if you work 40 hours and they company only bills 20 of them, it still counts. If you work 8 hours on a project, but you spent 30 minutes watching me talk about the backstory of Hyperfine on Bryn Young's podcast and then another 20 minutes listening to me talk about self-employment and confidence on Katerina Burianova's podcast, that still counts!
For this project, we figure out the Utilization Rate as follows:
(Employee A Direct Labor + Employee B Direct Labor) / Total Hours =
(32 + 24)/80 = 0.7
80 because there were 80 total work hours between the two. You could also do [(32/40) + (24/40)] / 2
Either way, Utilization Rate is 70%. And I'm 99% positive that PTO counts as Indirect Labor, though maybe I tricked myself.
Overhead Rate
AHPP Definition: The ratio of total indirect expenses to total direct labor.
Of all the terms, we probably have the most intuitive sense of what this one is about. I also have a whole separate post about Calculating Overhead Rate and Break Even Rate.
Most simply put, it is a measure of the cost of doing business. For every dollar you pay your employees, how much do you have to pay to keep the lights on?
The Overhead Rate represents the indirect costs associated with running a business that cannot be directly attributed to a specific project or activity. It is expressed as a percentage of direct labor costs and is used to allocate these indirect costs to projects.
Examples of overhead include: accounting and legal expenses, insurance, rent, utilities, property taxes and administrative salaries
Costs that can be attributed to a specific project are not considered overhead and are included in Cost of Services (Cost of Goods Sold). For example, if printing expenses can be attributed to a specific project, they are not considered part of the firm’s overhead.
Large firms with a human resources division will have a higher overhead rate than a small firm with less indirect costs. A target overhead rate is between 1.3 to 1.5.
Overhead Rate Sample Problem
A firm has total overhead costs of $500,000 and total direct labor costs of $375,000. Calculate the overhead rate.
Answer:
Simply divide the total overhead cost by the total direct labor dollars. Overhead Rate then becomes $500,000/$375,000 = 1.33
In words, for every $1 your company pays for Direct Labor, it spends $1.33 on overhead to operate the business.
In words, it costs the firm $1.33 for every $1.00 that is paid to employees.
Break Even Rate
AHPP Definition: The Overhead Rate plus the unit cost of 1.00 for an hour of salary.
The Break-Even Rate is the billing rate at which a firm's revenue covers all its expenses, resulting in neither profit nor loss. It considers both direct and indirect costs to determine the minimum billing rate required to break even.
Break Even Rate will always be 1.00 higher than Overhead Rate.
If the Overhead Rate is 1.3, the Break Even Rate is 2.3.
This is because if an employee costs $100/hr, for them to do 1 hour of work will cost the company $133 in overhead plus the $100 in salary, for a total of $233.
This is just to break even. To actually make a profit you need to decide on the profit margin and then divide the Break Even salary by the inverse. For a 25% profit you would do $233/0.75 = $310.67. This means you need to bill your clients $310.67 for each hour of work by this particular employee. To check the math, assume you receive $310.67 from the client. $233 goes to overhead and salary expense. The remaining $77.67 is your profit. 77.67/310.67 = 25%
Break Even Rate Sample Problem
Your firm has an Overhead Rate of 1.55. You cost the firm $95/hr. What is the break even rate for one hour of your time? To achieve a 20% profit what does the firm need to bill clients for your time? Round profit up to the nearest whole dollar.
Answer:
Break Even Rate = Overhead Rate + 1.00. In this case, it's 1.55+1.00 = 2.55. Then multiply that by $95 to find a break even cost of $242.25. This is what needs to be billed to break even, no loss, but also no profit.
To find the amount to charge to earn a 20% profit you divide by the inverse of 20%, which is 0.8. $242.25/0.8 = $302.8125 and we round up to $303. This is the amount your company needs to charge to earn a 20% profit on your time.
Check your math by finding the profit and verifying what percent it is of total revenue.
That would be (Billing Rate – Overhead Rate) / Billing Rate. In this case $303 – $242.25 = $60.75 of profit. Then $60.75/$303 = 20%, so we know we did it right.
Net Multiplier
AHPP Definition: The ratio of Net Operating Revenue to Total Direct Labor, indicating the return on every dollar of direct labor.
This one cuts through a lot of the other metrics in order to get a simple value of how profitable a firm is.
Simply put, it is a multiplier that says, for every dollar we spend on labor, we will bring in X dollars.
If the Net Multiplier is greater than the break-even rate the firm will be profitable.
Net Multiplier Sample Problem:
A firm has net revenue of $800,000 and direct labor costs of $250,000. Calculate the net multiplier for this firm.
Answer: I'm running out of steam. Take your Net Operating Revenue (NOR) and divide by Direct Labor costs. In this case, $800,000 / $250,000. You get a Net Multiplier of 3.2, which means that for every dollar you spend on Direct Labor, you will bring in $3.20. If 3.2 is above your Break Even rate you'll make a profit.
Next Steps
Keep going! Read more into these terms to really master them. It will serve you well on the ARE.
And if you want to check out some of the study material I made, view the Teachable homepage for my ARE 5.0 study material.
Got a question on anything? Just send me an email.