Business Management Q&A -- October

October 2004 » Business
Dear Dave, How much overhead is too much? What should a firm's overhead be? O.C., Texas
David M. Wahby

Manage the gap

Dear Dave,

How much overhead is too much? What should a firm's overhead be?

O.C., Texas

Dear O.C.,

Each firm's circumstances, and therefore overhead rates, are different, based on a wide range of factors, including overall size, strategy, and location. By itself, comparing overhead rates from one firm to the next does not tell you all that much.

A better measure of the appropriate overhead is the margin, or gap, by which the firm's effective multiplier (net fee revenue divided by direct labor) is greater than the firm's overhead multiplier (indirect expenses plus direct labor, divided by direct labor). The financial key is to manage your practice in such a way as to maintain the widest possible margin (or gap) between the two ratios. A firm's overhead rate is never too high if the effective multiplier also is high, resulting in a healthy gap.

You can improve the gap by reducing overhead expenses or increasing the effective multiplier, or some combination of both. Reducing the overheard multiplier requires cutting nonproject related indirect expenses (the numerator in the overhead calculation). You can increase the effective multiplier in a number of ways, including selecting better clients in the first place, charging higher hourly fees, tightening project management controls, or completing project design and documentation more efficiently, especially on projects with lump sum or otherwise fixed-fee type contracts.

According to the 2003 Wind2 A/E Financial Survey, the industry median effective multiplier was 2.86, and the overhead multiplier was 2.52, resulting in an average gap between the two key ratios of 0.34. The wider the gap, the more profitable the firm.

I routinely come across firms with gaps of 1.0 or higher. Interestingly, the firms with the largest gaps generally have higher than average overhead rates. Seems the old cliché may indeed be true that you sometimes need to spend more to make more. So, don't become overly fixated with your firm's overhead rate - keep your eye on the gap.

 

A new partner

Dear Dave,

We are a very successful, 80-plus-person environmental consulting firm. Our founding shareholder always has accepted that he cannot do it all on his own and has been willing to share management duties and to make stock available for purchase to key individuals who have contributed to our success over the years.

We have been in quiet talks for several months with a very senior environmentalist to leave his firm and join us. His expertise is in an area of service we currently do not offer, and having him establish this new line of work at our firm would not only complement our current services, but also open up a lot of new project opportunities.

However, this individual is not willing to come to our firm unless we sell him stock, on day one, as part of his initial employment package. His current employer has been promising him stock for years, but has never followed through, which is one of the major reasons why he now is talking to us. Are there alternatives you could recommend?

T.S., Calif.

Dear T.S.,

Since I am not familiar with all the specific details, I can only answer you in broad generalities. As a rule, no one should come through the door as an owner. Any senior-level person worth his or her salt knows that to be a truly effective leader in a new organization, they must earn the respect and confidence of others.

It cannot be purchased, it cannot be given, and it takes some time to achieve. In a culture like yours, where hard work and contribution always have preceded the opportunity for ownership, selling stock to an outsider breaks all the understood rules of order, creates uncertainty, and could illicit some serious negative feeling.

Newcomers must be seen to pay their dues for a year or so (at least), building up their credibility capital before joining the ranks of owners. This time gives the organization and the newcomer each the opportunity to mutually adjust and make sure the eventual “marriage” will be good for both parties.

I appreciate the feelings of the individual you're trying to lure away. After all, this person is ready to leave where he is as a result of unfulfilled promises, so why should he rely on promises alone from your firm? He shouldn't.

Working with this person, create a mutually agreed list of key objectives to be achieved during the first 12 months after he joins the firm. If the objectives are met, and the relationship is positive, make the stock purchase effective as of his one-year anniversary, but agree to freeze the price of the stock at the value on the day he joined the firm. Also, create a bonus incentive package, tied to the first year objectives, to replace, in the form of compensation, that which he would have received had he been an owner from the first day. This way, there is a specific promise to sell stock, and any financial loss as a result of waiting has been made up.

Both the new potential partner and the firm will benefit from this go-slow approach. ¦

Get answers to your questions about design firm and project management, finances, marketing, and related topics by sending them to Q&A c/o:

CE News
, 775 One Premier Plaza, 5605 Glenridge Drive , Atlanta , GA 30342, or faxing them to CE News at 404-497-7899. Include your name and telephone number in all correspondence. Your name will not be used in connection with published questions.

David Wahby is president of Wahby & Associates (www. wahby.com), a management consulting firm serving A/E clients. He can be reached at 616-977-9756 or via e-mail at wahby@wahby.com.


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