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How Should I Calculate Profit On My AE Projects?

How to calculate profit on architecture and engineering projects


Part one of a three part series by Michael McCaffrey, Axium Consultant

After working with hundreds of firms in the Architecture and Engineering industries, I can tell you one thing for sure; profit and how it is calculated is the most elusive of all moving targets. What some in the AE industry seem not to know is that it is feasible to produce breathtaking work that your clients will sing from the mountain tops about and still obtain a quality monetary return on that investment.

Profit is certainly not a four letter word and should not be avoided like the plague. Now that we are all in agreement of its importance, what does profit look like?

The following is the first of a three part series that will take you through the components of the profit equation and provide recommendations for how profits should be calculated on time & expense and fee type projects.

Part 1:  How should I calculate cost on my architecture or engineering projects?

Part 2:  How should I calculate profit on my time & expense billing projects?

Part 3:  How should I calculate profit on my fee type billing projects?

Part One:  How Should I Calculate Cost On My Engineering or Architecture Projects?

To derive profit from your projects, you must first understand the variables that are in play in the profit equation. The baseline in this equation is always cost, but what cost looks like depends on your method of thinking.

The first of my three part series on profitability focuses on cost and what is referred to as “burden.”

While my employee might make $25.00 per hour, we all know that it costs much more than this to have him or her working for an hour. I pay taxes and benefits on their behalf and I have overhead costs that must be covered to have him or her able to do their job. Factoring in these to my labor cost helps me truly quantify the real overall cost on my projects.

So, now I’ll ask – what does this “burden” look like? It is a product of two components: DPE (direct personal expense) and overhead.

DPE

Direct Personal Expense, also known as payroll burden, is personnel-related overhead costs (such as vacation, sick leave, insurance, payroll taxes, pension expenses, and other benefits) that you add to labor cost for project reporting purposes.

Overhead

Overhead, which is not part of DPE, includes any operating expenses not directly related to employees. For example, these expenses can include rent, office expenses, utilities, business taxes, insurance, and so on.

Understanding, estimating, and tracking the cost of DPE and overhead is essential in running the day-to-day operations of all firms. It will allow you to obtain a true picture of your projects and to determine if your projects are PROFITABLE.

Methods for calculating DPE and overhead

You can calculate DPE and overhead in a variety of ways, with the most commonly used being:

Based on fixed percentages

-       w/ Direct labor + DPE as the base

Use this method if you want to calculate DPE separately from overhead. This method is most commonly used by architectural and engineering firms.

-       w/ Direct labor as the base

Use this method if you want to include DPE and overhead as a single calculation.

Calculating DPE and overhead based on fixed percentages

Although each accountant may have somewhat different methods for calculating DPE and overhead, here are some common guidelines. FAR (Federal Acquisition Regulation) requirements may also need to be considered for firms that work on government projects.

DPE % Calculation- Typically, DPE percent is calculated as follows:

Annual staff-related benefit cost total divided by direct salary cost

Example

$750,000 Cost of firm’s entire direct salary

$250,000 Cost of benefits

The DPE percent for the firm is:

(250,000 / 750,000) = 33.33%

DPE (cost value to project, using DPE % calculated above) – Project DPE is calculated as follows:

Direct labor cost X DPE percent

Example

$15.00 Hourly cost of an employee

33.33% DPE

The DPE is:

15.00 x .3333 = $5.00

Calculating Overhead – Separately From DPE

(using direct labor + DPE as the base)

You can track DPE separately from overhead when reporting project cost. In this way, you can evaluate your projects using burdened cost, which provides a more accurate picture in determining actual project profit. Use this method if you want to track your DPE separately from your general overhead expense when generating project cost:

Overhead percent – Overhead percent is calculated as follows:

Firm’s total operating cost (not including taxes or discretionary bonuses)

Minus direct labor, DPE, and direct expenses

Divided by direct labor cost + DPE

Example

$2,600,000 Firm’s total operating expenses

$750,000 Total direct labor

$250,000 DPE (cost of benefits)

$100,000 Direct expenses

The overhead cost is:

2,600,000 – (750,000 + 250,000 + 100,000) = 1,500,000

The overhead percent is:

(1,500,000 / 1,000,000) = 150%

Overhead (cost value to project, using % calculated above) – Overhead that is added to project labor cost is calculated as follows:

(Cost amount + DPE) x overhead percent

Example

$15.00 hourly cost of an employee

$5.00 DPE

150% Overhead

The overhead is:

(15.00 + 5.00) X 1.50 = $30.00

** Total “burdened” project cost – Burdened project cost is calculated as follows:

Cost amount + DPE amount + overhead amount

Example

$15.00 Employee’s hourly cost

$5.00 DPE

$30.00 Overhead amount

The total burdened cost rate for the employee is:

15.00 + 5.00 +30.00 = $50.00

Calculating overhead with DPE (using direct labor as the base)

Use this method if you do not want to track DPE separately from general

overhead expense when viewing project cost.

Overhead percent – Overhead percent is calculated as follows

Firm’s total operating cost (not including taxes or discretionary bonuses)

Minus direct labor and direct expenses

Divided by direct labor cost

Example

$2,600,000 Firm’s total overhead expense

$750,000 Total direct labor cost

$250,000 DPE (already included as part of total operating cost)

$100,000 Direct expenses

The overhead cost is:

2,600,000 – (750,000 + 100,000) = $1,750,000

The overhead percent is:

(1,750,000 / 750,000) = 233.33%

Overhead (cost value to project, using % calculated above) – Overhead is calculated as follows:

Cost amount x overhead percent

Example

$15.00 Employee’s hourly cost

233.33% Overhead percent

Overhead is:

15.00 x 2.3333 = $35.00

** Total “burdened” project cost – Burdened project cost is calculated as follows:

Cost amount + overhead amount

Example

$15.00 Employee’s hourly cost

$35.00 Overhead amount

The total burdened cost rate for the employee is:

15.00 + 35.00 = $50.00

To be able to put the arrow through the bulls eye of the moving target called profit, you must first qualify how and what you classify as cost.  Once you have used the simple calculation illustrated above, or a similar method, you have taken the first step to doing so.

You can read part two of our three part series on how to calculate profitability for architecture projects or engineering projects:   How should I calculate profit on my time & expense billing projects?

About the author

Michael McCaffrey has written 3 articles for Axium411

Michael has been with Axium for over four years, working in a variety of positions in that time. He began in the support services department as a help representative, then graduated into the role of a certified Axium consultant before taking over all internal training and professional development of Axium support staff. Most recently, he has rejoined the professional services team in his previous position as a certified Axium consultant. Along the way he has also been able to teach in the form of facilitating training webinars as well as in person at the annual Axium and AUA conferences. Michael graduated in 2003 from the University of Oregon with a Bachelor’s degree in Business Administration/Finance and a minor in Economics. Axium provides him with the perfect forum to utilize his education and training in conjunction with a seasoned customer service mentality.

9 Responses to "How Should I Calculate Profit On My AE Projects?"

  • Tom Senne 07:24 PM 12/9/2010

    Your article didn’t say where D.L. and Overhead should come from – firm history, budgets, actual? I like to use a mix of history and budgets/forecasts.

    One of the biggest challenges in determining DPE and Overhead multipliers is effectively estimating direct labor costs and overhead. Firms that are too optimistic/aggressive in forecasting their chargeability may find their factors are incorrect. Labor costs that can’t be billed end up as part of overhead. This is a “double whammy” on overhead percent, as the numerator grows while the denominator shrinks. Realistic budgeting is important, as many overhead costs are fixed in the short term (rent, insurance, etc.). Incorrect costing will create incorrect pricing, too.

    It is important to carefully monitor overhead percent at least monthly!

  • Michael McCaffrey 11:41 PM 13/9/2010

    Great point, Tom. The first time a firm calculates their DPE and Overhead percentages it is my opinion to use historical financial figures. Since there are fluctuations in overhead that happen over the course of the year, I usually have the client take their last reconciled closed-year financials and calculate the percentages off of that.

    Once that baseline is set, a firm should, at bare minimum, review and adjust these percentages annually. I recommend either quarterly or bi-annual reevaluations of these figures. They can be reviewed monthly, but I would only recommend that if you have very distinct changes in overhead or DPE that happen from month to month.

    The perfect scenario is to have a software that will accommodate changes retroactively to these DPE and Overhead percentages to adjust prior periods burden based on updated figures. If this is not available, then you are correct in needing to use budgeted GL balances to calculate what the potential burden on your cost might be. In that instance, it is absolutely in your best interest to be realistic with these estimates to get the most out of your project reporting.

  • Marie 09:19 PM 15/11/2010

    I have a question… in calculating overhead separate from DPE… in your example you listed 100,000 in direct expenses. What items are included in direct expenses? Also, then in your example, to get the overhead percentage, you divided 1,500,000 by 1,000,000. Where did the 1,000,000 come from?

    • Michael McCaffrey 12:52 AM 18/11/2010

      Marie,

      Your direct expenses include all expenses that are charged against a project. That will include billable salaries, reimbursables expenses, and consultant charges. This can also include project related expenses that are not passed on to the client, such as Nonbillable salaries or sunken expenses. Basically anything, billable or nonbillable, that is charged against a project.

      As for the $100,000 that is referenced in the Overhead % calculation, that is the direct labor amount plus the DPE amount ($750,000 + $250,000). Basically you have your total overhead figure divided by the cost it takes to have your direct employees working.

      • Marie 12:37 AM 19/11/2010

        Michael,

        Thank you for your reply. I’m sorry but, I need to clarify one more question to make sure I understand that I’m using the correct data to calculate from. You mentioned direct expenses includes billable salaries. In the example, 750,000 is shown as direct labor. So would I be correct that the 100,000 is everything else.. like you mentioned reimburseables, consultants? Or, am I confusing billable salaries with direct labor?

  • Michael McCaffrey 07:40 PM 22/11/2010

    Marie, I am using the example at the bottom (from the blog article):

    The $100,000 for direct expenses are separate from direct labor, so you are correct, these would be direct reimbursables or consultant charges. Basically everything that can be charged against a project besides your direct billable labor.

    ——————————————————————————

    Overhead percent – Overhead percent is calculated as follows:

    Firm’s total operating cost (not including taxes or discretionary bonuses)

    Minus direct labor, DPE, and direct expenses

    Divided by direct labor cost + DPE

    Example

    $2,600,000 Firm’s total operating expenses

    $750,000 Total direct labor

    $250,000 DPE (cost of benefits)

    $100,000 Direct expenses

    The overhead cost is:

    2,600,000 – (750,000 + 250,000 + 100,000) = 1,500,000

    The overhead percent is:

    (1,500,000 / 1,000,000) = 150%

  • Charlie 07:38 PM 16/6/2011

    How do the different methods of allocating overhead burden apply to AE firms subject to unicap tax rules of Sec 263A? What allowable methods are best for tax considerations for a small firm or a large firm? We have one existing firm and one new firm. Our firms both qualify for the exception for a qualifying small business taxpayer for inventory or WIP under Rev Proc 2002-28 (IRB 2002-18), but I think the exception method of accounting for overhead may not be the best for taxes in the long run.

  • Pat Chase, Axium Consultant 10:57 PM 23/6/2011

    Hi Charlie,

    I just did a quick review of unicap tax rules of Sec 263A and seems these rulings (it was a quick read and I am no CPA) apply to inventory and production costs and activities. As most A/E firms inventory is services – labor not billed and not physical inventory – I would think the CPA has to determine what makes the firm subject to the rules.

    There are several articles about this on the web and many have calculation examples – very similar to the overhead calculation method we have in this post. The document I looked at talked about the LIFO method of calculating inventory.

    Your CPA would be the source of this, as how they calculate the overhead value would be based on those terms.

  • [...] of all the performance factors. If it is unknown or calculated incorrectly, it is impossible to accurately determine the architecture or engineering firm’s profitability. The lower the overhead rate, the higher the profit margin. A target of 150 percent to 175 percent [...]

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