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Running an architectural firm is a bit different than other companies in the construction industry. You’re providing a service to your customers, but your contracts are often lump-sum, and billings are often determined by the percentage of completion.
However, like any other business, you need to maintain positive cash flow or you may find yourself unable to pay your workers and other expenses. Let’s take a look at the basics of cash flow and how architects can budget their expenses and forecast their income to stay in good financial standing.
Cash flow basics
You can think of cash flow as your business’s wallet. You track the amount of money coming in and going out on a cash basis. This is in contrast to an accrual basis, which is a form of accounting that tracks revenue and expenses when they are incurred, not when they are paid or received. The timing of these transactions can greatly affect the financial health of your company.
A cash flow statement analyzes the cash transactions within a given time period. This report can be used to help predict future cash flow, which helps improve the business’s decisions. This report is used to develop a cash flow projection, which is an informed guess of future cash receipts and expenses.
The projection is used to make decisions on expense payments. For example, if you’re expecting a $100,000 payment next week, you make decisions on what bills to pay based on that knowledge. If you didn’t know the payment was coming in, you would make a different set of decisions.
Having enough cash on hand to pay your bills is a sign of financial health. If you don’t have enough cash available for your expenses, you may need to look at some short-term financing options.
Successful businesses and organizations budget their expenses based on historic data and revenue projections. A budget guides the company in how it will spend its money and helps prioritize spending.
Architectural business consultant Lucas Gray of Charette Venture Group recommends creating budgets on an annual basis and tracking seven main categories of expenses:
- Business development and marketing
- General office (including software and IT equipment)
- Professional services (accountants, lawyers, bookkeepers, etc)
- Rent and building maintenance
- Payroll burden (payroll taxes, benefits, and bonuses)
Each of the categories above can be further broken down into a more detailed list that provides the structure for the business’ chart of accounts. Additional accounts can be added for expenses specific to your business but should generally fall into one of the above categories.
If you’ve been in business for a few years, you can use last year’s actual expenses to help you determine your budget. Typically you want to set an annual budget and break it down into quarterly and monthly expenses so you can track it throughout the year.
On either a monthly or quarterly basis, you should review your actual performance against the budget to see if you’re on track or not. And if you’re not, start analyzing why. From there, you can make appropriate decisions or revise your budget to reflect how much you’re actually spending.
Forecasting your revenue
While you can learn a lot about your company by looking at the past, the real power comes when you can project your revenue into the future. “If you’re not looking forward, it’s easy to not make necessary decisions in enough time to implement changes,” says Gray.
How to project revenue
Projecting revenue starts with determining how much to charge for a project. Two of the most common options are to charge an hourly rate or a fixed fee. An hourly rate works best for projects where the entire scope is not clear, or if you believe the client will be adding more work as you go. Most customers, however, want a fixed fee for their project, so they know how much it will cost upfront.
When it comes to projecting revenue, the first step is to determine your hourly billing rate. Gray recommends starting with your breakeven rate and then adding 20% to that as your profit margin. The breakeven rate is calculated as total operating expenses divided by direct labor expenses. Where direct labor is the percentage of salaries that are spent on billable work (rather than overhead time).
Example of revenue projection
For example, if a sole practitioner pays themself a salary of $100,000 and spends half of their time on billable work and half of their time on admin and marketing tasks, then their direct labor is $50,000. If the total cost of running the business is $200,000 (including salary, rent, insurance, etc.), divide $200,000/$50,000 and get a breakeven rate of 2.5.
That means in order to break even, they need to bill their clients at 2.5x their hourly cost rate (including burden expenses like employer taxes and benefits).
Their hourly cost rate would be their total salary divided by annual work hours. If they work full time that would be $100,000/2080, or $48. Simplifying the math, they would need to charge about $120/hour to breakeven. With a 20% markup, that goes up to $144/hour. This would be the minimal hourly rate they should charge, although typically we would recommend rounding up to, say, $150/hour.
From forecast to pricing
Now that you know how much to charge per hour, providing a lump sum price is as easy as multiplying your hourly rate times the number of hours you think it will take to complete the project. Everyone works at their own speed, so there’s no right or wrong answer here. Knowing that it’s difficult to estimate exactly how long a project takes, it’s a best practice to be very conservative with the estimated time needed, and add a buffer of 20% or more to the estimated total hours.
Another way to structure your pricing is as a percentage of total estimated construction costs for the project. For custom residential design, Gray recommends 8% to 15% of the cost of the project as the design fee, depending on the complexity and scope of work. Larger projects, multi-use, multi-family, or institutional projects could be at 5 to 8% of construction costs. If it’s a repetitive design, like a prototype hotel or restaurant, the percentage may be reduced to as low as 2%. These percentages can change based on the scope of work and which consultants are included in the design fee versus paid directly by the client.
Now that you know how much you’ll be charging for each project, you can look at the schedule for the project and estimate how much of the fees you can charge each month. Add this up, and you’ll get your estimated revenue for the month. For example, if you have a project that will earn you $100,000 in design fees and the project will take you four months to design, you can estimate your revenue at $25,000 per month. Or, if you know that most of the design work will take place in the first two months, you can weigh your projections to reflect that.
Once you have your budgeted expenses and forecast revenue, you can begin to analyze your cash flow.
Cash flow projections
A cash flow statement is an analysis of the cash coming in and going out of a company. It groups expenses and revenues and shows the net inflow or outflow of money during the period. When a cash flow statement is projected into the future, it’s called a cash flow projection. Businesses use this projection to make decisions on future hiring, investments, and other financial decisions.
A cash flow projection covers three types of cash activities: operating activities, investing activities, and financing activities.
- Operating activities include income from sales minus labor expenses and other costs of doing business.
- Investing activities include the purchase and sale of fixed assets, like a building or equipment.
- Financing activities include stock offerings and long-term debt. Not every business has activities in all three categories, so just use the ones that apply.
We’ve got a sample cash flow projection in Google Sheets that you can download and use to develop your own report. Use your anticipated revenue and expenses to analyze whether your cash inflows will be enough to cover the outflows.
The importance of cash
“Cash is king,” as they say — and nowhere is it more important than when it comes to running your business. Architectural firms, like any professional services company, need to keep their eye on their expected cash flow to ensure that they can pay their employees and other expenses. When customers are slow to pay, this can put a strain on a business’s cash flow. Using tools like a mechanics lien to secure payment can help ease the burden.