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  • Financial Management

    Effectively tracking and managing financial performance involves looking at different levels of detail and understanding clearly how all of the pieces are interrelated. Design firms prepare a variety of reports at different intervals-primarily weekly and monthly. Together, these different perspectives combine to give a holistic view of the business.

    Weekly reports

    In a busy studio, it's important to look at individual project reports at least once a week. Within each project, compare the original budget to the actual expenses that have been incurred. This allows you to see how quickly the budget is being used (the “burn rate”) and whether or not the project will produce its anticipated profit. Most project management software is already set up to produce a report that compares estimates to actuals and recaps project billings to date.

    It's also important to look at an overall cash flow projection every week. Maintaining positive cash flow is always a challenge for small businesses. The process of preparing a projection helps you to anticipate what will be coming in and what needs to go out. The projection itself will be based on two reports from your financial system: an updated accounts receivable aging and an updated accounts payable aging. An accounts receivable aging report is a list of unpaid invoices, usually sorted by client. On the left, each invoice is listed in order of date issued. On the right, there are three columns to identify how long you've been waiting for payment. You can set these preferences in your financial software, usually “current” (less than 30 days), “30 to 60” and “60 or more.” Unless a client has informed you to the contrary, your expectation is that the oldest invoices will be paid first. Your accounts payable can be aged in the same way. Typically you will pay the oldest vendor invoices first, although priorities sometimes shift. You will also have a few additional obligations that may not go through the accounts payable system at all, such as rent or loan payments.

    The structure of your cash flow projection is this: for each period, you show the beginning balance, expected cash in, planned cash out, and the ending balance that will result. This allows you to predict the net change. The goal is to avoid periods of negative cash flow, which would force you to drain your reserves or borrow. This cash flow projection needs to be updated weekly so that it can be used as a guide for disbursements. Most design firms try to write the majority of their checks in one weekly batch because it's more efficient than preparing them in dribs and drabs. Some payments must be made on specific dates (such as payroll and rent) but with others there is often more scheduling leeway (such as the timing of payments to vendors). Look at the weekly cash flow projection to see what flexible payments you can afford.

    Monthly reports

    At the end of the month, when you have sent out the last of your client invoices, follow up by preparing and sending a statement of account to each active client to recap open items. (Usually this client statement is in the form of an aging report.)

    For yourself, it's important to prepare complete monthly financial statements including a P&L and a balance sheet. These should be prepared as soon as possible after the month has ended. If someone else prepares the financial statements, it's vital for you as a businessperson to spend time reading and analyzing the information. Get comfortable with the formats. Know where all of the numbers come from and how they have been calculated. In this way, you'll to be able to use the statements as the basis for sound business decisions.

    The P&L (also called an income statement) is an operational view of your business over a span of time, such as a month, a quarter or a year. Within that specific time period, it shows how income compared to expenses and whether or not a net profit was produced.

    The balance sheet, in contrast, does not represent a span of time. It shows the strength of the company at one particular moment. It is an itemized statement of assets and liabilities in order to show the net worth of the business at that one moment. It's called a balance sheet because it is based on the “accounting equation,” a mathematical expression that describes the relationship of the items included. The formula is this: assets = (liabilities + owner's equity). Looked at in another way, the total assets of the business minus its total liabilities will equal owners' equity, which can also be called the net worth or book value of the company.

    It's preferable for your in-house financial statements to be accrual-based. In accrual-based accounting, all income is counted when it is earned and all expenses are counted when they are incurred, regardless of when the actual cash is received or paid. This means that on your financial statements, you will be recognizing project activity in the month where the work itself took place. Your invoices to clients are recorded as sales and then tracked as open accounts receivable. Your purchases from vendors are recorded as expenses and then tracked as open accounts payable. This is in contrast to cash-basis accounting, where income and expenses are not counted until the actual cash changes hands. Cash payments tend to happen long after the fact, which can distort your view of monthly activity and indicate ups and downs that are quite misleading. For this reason, accrual-based financial statements present a more accurate picture.

    Also in an accrual-based accounting system, adjusting entries are made when the books are closed at the end of each month in order to update your accounts for items such as depreciation that have not been recorded as part of your normal daily transactions. (More about depreciation below.)

    The P&L and balance sheet are inter-related. At the end of each year, the final net profit (or loss) shown on the P&L is moved into the retained earnings account on the balance sheet. This allows the P&L to start again at zero for the following year.

    For your reference, here are typical formats for a design firm's balance sheet and P&L. Sample percentages are shown to indicate the relative size of each category. Dollar amounts will of course vary based on the size of each firm.

    Balance sheet format for design

    Current assets

    Cash
    16%
    Accounts receivable
    45%
    Allowance for doubtful accounts
    0%
    Work in process
    10%
    Other 
    4% 
    Sub-total current assets
    75%

    Long-term assets

    Furniture/fixtures/equipment
    20%
    Computers
    20%
    Autos
    1%
    Leasehold improvements
    7%
    Other
    4%
    Less: accumulated depreciation
    -28%
    Other 
    5% 
    Sub-total long-term assets
    25%

     

    Total assets
    100%

    Current liabilities

    Accounts payable
    11%
    Credit lines/short-term loans
    9%
    Accruals
    10%
    Client deposits
    9%
    Other 
    7% 
    Sub-total current liabilities
    46%

    Long-term liabilities

    Leases/long-term loans/other
    11%


    Owners equity

    Stock
    5%
    Retained earnings 
    38% 
    Sub-total owners equity
    43%

     

    Total liabilities and equity
    100%

    To help you become familiar with the format of the balance sheet, here are some simple explanations of the key categories and terms (your CPA will of course be able to provide you with much more detailed information):

    Assets

    Assets include anything of value owned by the firm. They are listed on the balance sheet in the order of their liquidity, which means how close they are to cash.

    Current assets

    These include cash and other items such as short-term investments that are expected to convert to cash within the next twelve months. How much cash should you have on hand? The general rule of thumb for a design firm is to accumulate an amount equal to three months of payroll and overhead. If something bad happens to your firm, such as the loss of several top clients, this cash reserve would give you some breathing room for making adjustments and recovering.

    Accounts receivable

    This is the total of all outstanding invoices that have been sent to, but not yet paid by, clients. For most design firms, it is the largest current asset.

    Allowance for doubtful accounts

    Occasionally you might find yourself in a billing dispute with a client. As a result, you may not receive full payment on some invoice or other that you have submitted. When finalizing the balance sheet at the end of each month, the conservative approach is to prepare an adjusting entry to factor back the accounts receivable total by a few percentage points in order to allow for potential bad debts. The amount of the allowance will depend on your own history, but it is usually small. If you have been careful in selecting credit-worthy clients, getting signatures on detailed proposals and providing excellent customer service, you should have few disputes.

    Work in process

    The amount of work that you have put into active projects but not yet invoiced to clients is a valuable asset. In larger firms especially, a great deal of care is taken at the end of each month to calculate the value of the work in process that will be shown on the financial statements. There are two options for preparing this adjusting entry-one is to value the work at your net cost, and the other is to value the work at gross billing rates. Using the first method, unbilled project expenses that have already been posted to the cost of sales section of the P&L can be temporarily moved to the balance sheet and set up (at cost) as a type of inventory. In the second method, the unbilled project costs can be left on the P&L and an entry made to accrue the unbilled revenue (at contract billing rates) that relates to them.

    Long-term assets

    These include such items such as computers, equipment, office furniture and vehicles. When you purchase an item that costs more than $100 and has a useful life of at least three years, you will capitalize it (book it as an asset on the balance sheet) rather than expense it (post it directly to the P&L). The goal of this is to avoid distorting current profitability with the full impact of a large purchase. Also, a major purchase is usually financed, which allows you to match the long-term asset with a long-term liability (the loan payable), rather than depleting current cash.

    Depreciation

    Assets such as equipment and furniture will not last forever. Based on the useful life of each item (depending on the type of asset, this can be as short as three years or as long as twenty), an appropriate percentage of the purchase price will be expensed each year in an adjusting entry. There are various ways to calculate depreciation, but the simplest method is “straight line” which means that an equal portion will be expensed each year. By the time the item is worn out, its book value as an asset will have been reduced to zero. Long-term assets also include real estate. Business buildings can be depreciated but land cannot. Many design firms do not own the buildings where they are located. If you are leasing a space and you make improvements to it (such as upgrading the wiring or remodeling) you can depreciate the cost of those leasehold improvements. The depreciation period will normally be the number of years remaining on the lease. (Your CPA will be able to answer any specific questions that you may have about depreciation.)

    Liabilities

    Liabilities are debts or other obligations that your business must pay. They are categorized as either current or long-term.

    Current liabilities

    This includes anything that must be paid within the next twelve months. Client deposits are included here because it's possible that some or all of the amount deposited would have to be returned if a project were cancelled. Bank lines of credit are also included here because they are intended for short-term use only.

    Long-term liabilities

    These are debts or other obligations that will be paid beyond the next twelve months. If you have taken out a business loan that will be repaid over a number of years, it will appear on your balance sheet in two separate pieces-the current portion and the long-term portion.

    Owner's equity

    This section of the balance sheet includes the original investment made by the founder(s) of the firm plus any profits that have accumulated over the life of the business. If the assets of the company were to be liquidated, it represents the portion of the proceeds that would come to the owner(s) after all debts had been paid. In a sense, it is the portion of the overall business that is currently owned free and clear.

    Retained earnings

    These are accumulated net profits that have been kept within the business. On financial statements, they are usually split into the subcategories of “current year” and “prior years.” These retained earnings are held for future needs or for future distribution to the owner(s) of the firm.

    Profit & loss statement format for design

    Income

    Labor billings
    71%
    Billings for outside services & materials 
    29% 
    Total income
    100%

    Cost of sales

    Direct labor costs
    25%
    Independent contractors
    5%
    Cost of outside services & materials 
    26% 
    Total cost of sales
    56%
    Gross margin
    44%

    Overhead

    Indirect labor costs
    11%
    Other operating expenses 
    22% 
    Total overhead
    33%

    Net profit before incentives
    11%

    Incentives
    6%
    Net profit before taxes
    5%

    Again, here are some explanations of key terms and concepts:

    Income

    This section includes all revenue of any type. For creative firms, most revenue comes from sales to clients, which should be split into two major categories:

    Labor billings

    These are fees charged to clients for professional services provided by your staff.

    Billings for outside services and materials

    These include all third party items that you have billed to your clients, usually at marked-up amounts.

    Cost of sales

    In order to produce billable work, you incur various costs directly related to active client projects.

    Direct labor costs

    Direct labor is the time that you and your team have spent working on active client projects. You should track those hours and use them to break out the billable portion of your payroll. Under normal circumstances, billable labor will represent roughly two-thirds of your total payroll. The remaining, non-billable portion of your payroll will be posted to the overhead section of the P&L.

    Independent contractor costs

    Some creative firms rely heavily on freelancers. Others do not. When freelancers are involved, design firms track the expense separately, but typically do not break it out as a separate line item when invoicing the client. If it is folded into the billings for professional services, this usually means that the work is being billed to the client at rates that would have been charged for staff labor. This is a different approach than simply marking up the freelance expense by a small percentage, as you would do with other outside costs.

    Cost of outside services and materials

    These are amounts that the design firm has paid to third parties, usually for project supplies, materials or outside services such as printing. They are recorded here at the amount that was on the vendor's invoice to the design firm. These project costs plus the markups added by the design firm will equal the total billings to clients for outside services and materials (discussed in the income section above).

    Gross margin

    This is a standard calculation that is used for businesses in nearly every industry except for advertising (more about that below). Your sales to clients minus the direct costs of those sales (primarily labor and materials) equals the gross margin. After projects have covered their own costs, the gross margin is the additional amount that they have made available to the firm to be used for other purposes.

    Overhead

    This section of the P&L includes all general operating expenses that are not directly related to any particular client project.

    Indirect labor costs

    In each period, this is the portion of your payroll expense that was not directly matched to hours spent on active client projects. It includes marketing time, sick and vacation time, paid holidays, staff meetings, and secretarial or administrative activities. Typically this works out to roughly one-third of the payroll.

    Other operating expenses

    These include such things as rent, utilities, telephone, insurance, employer taxes and benefits, as well as the cost of your own marketing materials.

    Net profit before incentives

    When design firms are profitable, it's common for bonuses or incentive payments to be distributed to the various team members. Most often these are discretionary rather than guaranteed, and they might be determined on a monthly, quarterly or annual basis. They may include such things as matching payments to a 401(k) plan, some type of general profit sharing, or perhaps individual bonuses to those personally responsible for successful projects or accounts.

    Net profit before taxes

    After any bonuses or incentives have been posted as expenses, this is the remaining profit that will be reported for business tax purposes.

    Percentages

    It's useful to look at each line item on the P&L as a percentage of total business income. Most financial software does this automatically. In design firms, it's also common to analyze each category of expense as a percentage of labor billings only. For the most part, graphic design firms concentrate on selling their own services, so it's typical for labor billings to be the major source of income. Material billings tend to be much smaller because many design firms do not want to take on the potential legal liabilities of brokering large amounts of printing or other third-party services. If something goes wrong with a third-party service such as printing, it's much safer for the designer if the client made the purchase directly.

    So far, our discussion has focused specifically on graphic design firms. However, a few creative organizations are hybrids. They take on traditional graphic design assignments and, at the same time, create and manage advertising campaigns. This creates a challenge in the area of financial reporting. For comparison purposes, let's look at the standard P&L format that is used by advertising agencies.

    Profit and loss statement format for advertising

    Income

    Labor billings
    16%
    Resale of media
    55%
    Resale of outside services & materials 
    29% 
    Total income
    100%

    Pass-throughs

    Cost of media placement
    46%
    Cost of outside services & materials
    24%
    Other project expenses 
    2% 
    Total pass-throughs
    72%
    Agency gross income (AGI)
    28%

    Operating expenses

     
    of total
    of AGI
    All labor costs (direct & indirect)
    15%
    53%
    Other operating expenses 
    8% 
    28% 
    Total operating expenses
    23%
    81%
    Net profit before incentives & tax
    5%
    19%

    As you can see from the above sample, advertising agencies use a P&L format that is quite different from the one used by graphic design firms. A standard gross margin is not being calculated. This is because a very large portion of advertising agency billings have traditionally been for the resale of media and third party services, rather than for staff labor. Large outside purchases such as media placement are often referred to as “above the line” costs or “pass-throughs.” This category also includes printing costs on any projects where the agency acts in the role of a print broker. The client is billed a list price-a marked-up amount that is higher than what the agency paid to the third party. When the costs of these large pass-throughs are subtracted from total billings, the amount remaining reflects the agency commission that was earned and the amount of any fee billings. Total billings minus all pass-throughs equals the “agency gross income” (AGI). The AGI must be large enough to cover all “below the line” costs (including all payroll and overhead expenses) and still leave a net profit. For this reason, each “below the line” line item on an advertising agency's P&L can be analyzed in two different ways: as a percentage of the firm's total billings, and as a percentage of AGI. If your firm does not do advertising, you should not use the AGI format.

    Additional financial issues for design firms

    In addition to fundamental business challenges such as developing effective pricing and cost controls, maintaining adequate cash and managing debt, there are two additional issues that are important specifically for design firms: maintaining balanced staffing and maintaining a healthy ratio of billable to non-billable hours.

    Balanced staffing

    As a design-centered organization, your business will consist of project teams supported by appropriate infrastructure. Overall headcount must be tied to workload as closely as possible. This means hiring very cautiously, particularly when it comes to support positions. As an example, let's say that your firm has a total staff of ten people. At least seven out of those ten employees must have the potential of being highly billable. That includes creative direction, design, production and project coordination. No more than three out of the ten employees should be in support positions that do not have the potential of being highly billable, such as marketing and sales, finance, network administration/IT, reception or secretarial. However, don't make the mistake of providing too little support. Your office will not run smoothly at all if no one is answering the phone and no one is balancing the books. The right level of support frees up the design staff to concentrate on client assignments.

    Next, you must make sure that your new business development activities keep your office at or near your billable capacity. Initial hiring decisions will determine the billable potential of the firm but, once the staff is in place, you can only achieve that potential if new business development brings in a constant stream of appropriate new assignments. Strong billings will be the outcome of a healthy workload and good time management.

    Billable and non-billable hours for the individual

    What is the highest billable potential for an individual staff position? To calculate this, start with the total of regularly scheduled hours, then subtract all applicable vacation time, sick time, paid holidays, staff meetings, administrative time and marketing activities. The hours remaining will be the maximum amount of regularly scheduled time that person has available to devote to client projects.

    For example, the target for a staff design or production position might look something like this:

    Full time schedule 52 wks x 40 hrs
    2,080
    100%
    Less:      
    Vacation 3 wks x 40 hrs
    120
    5%
    Sick 8 days x 8 hrs
    64
    3%
    Holidays 10 days x 8 hrs
    80
    4%
    Staff meetings & admin  50 wks x 4 hrs 
    200 
    10% 
    Highest potential billable target  
    1,616
    78%

    Many design firms state the billable target for each staff position in the initial hiring letter or employment agreement. Others negotiate targets at the beginning of each year. As a point of comparison, some law firms and accounting offices determine compensation on a scale, depending on how many billable hours the individual agrees to produce. This works well for a law partner who brings in his or her own accounts and bills on a time-and-materials basis, but it is less appropriate for design teams billing clients on a fixed-fee basis.

    Billable and non-billable hours for the firm

    The actual billable percentage achieved by the entire firm will be a combination of all the individuals involved. This statistic is also called utilization or productivity. If you have the right staff mix to begin with, and then maintain a good workload of client assignments, total utilization for a graphic design firm should be in the range of 60% to 65%. Below this range, the firm will not be producing enough billable hours to sustain itself over the long haul. A low billable percentage usually indicates that there are too many non-billable people on the payroll and/or the billable staff members have not been given enough client work to do. At the other extreme, a long-term billable percentage above 65% can indicate that the workload is too heavy. This brings the risk of burnout for the team members producing the majority of the billable client hours.

    Utilization

    Creative direction
    80%
    Design
    80%
    Production
    80%
    Project coordination
    80%
    Marketing
    30%
    Admin, finance, tech 
    10% 
    Overall
    60%

    In analyzing the time spent on client projects, keep in mind that there is a big difference between “billable” and “collectible.” Even though someone reports extra project time, it might not result in any additional money coming in from clients. If an individual team member is falling short of his or her personal target, it might be tempting to pad a timesheet or two with additional “billable” hours. On a fixed-fee project, those hours would just sink the budget without changing any invoice totals. In a time-and-materials relationship, they would lead to very serious problems. Honest and accurate time reporting is an absolute requirement.

    A note about marketing staff: the example given above shows a target of 30%, but the real billable target for a marketing position will depend on how that role is structured in your particular firm. If the role is defined primarily as an external sales rep, then the billable percentage will be low. However, if your new business development person also spends time participating in active client projects as an account manager or a project manager, then the billable percentage will be higher. You will have to decide what mix of responsibilities is best in your own particular situation.

    In each pay period, track the actual billable percentage for the full team and use it to split your total payroll dollars into the two categories discussed above: direct labor (project time that is included in the cost of sales) and indirect labor (non-project time that is included in overhead).

    Benchmarks

    Over time, you'll develop a sense of what the normal levels of activity seem to be within your own firm, but you need to use external references as well. Each month, compare your firm's performance to a basic set of industry norms. Key financial indicators fall into four categories: solvency, efficiency, profitability and labor. Some of these are expressed as percentages while others are expressed as multipliers or ratios. Each ratio is the result of dividing one balance sheet or P&L item by another, so it is focused on a specific financial relationship. In each instance, the normal range varies quite a bit from industry to industry. For your reference, here are explanations of key indicators in the four main categories, along with standard benchmarks for graphic design firms.

    Solvency

    Solvency is your company's long-term ability to meet all of its financial obligations. This is analyzed by comparing liabilities to assets. There are several different variations of this debt to assets comparison. You can look at just the current amounts, just the long-term amounts, or the combined totals. When analyzing solvency, assets other than cash can be taken into consideration because it may be possible to liquidate them to serve as an additional cushion against losses. It's advisable for design firms to be very cautious about taking on debt. Although debt is not necessarily “bad,” it does require timely payments of interest and principal. The higher the level of debt that you take on, the more important it is for your company to produce consistent profits and steady cash flow. This can be difficult if work comes to you primarily on a project-by-project basis and you have few, if any, longer-term client contracts.

    Current ratio

    Formula: current assets/current liabilities

    Typical range: 1.6 to 2.2

    Explanation: This is a measure of short-run solvency, that is to say the immediate ability of the firm to pay off short-term debts as they come due (as well as to cover any unforeseen cash needs in an unpredictable business environment). If you are thinking of borrowing money or applying for credit from major suppliers, those potential creditors will use this ratio as an indicator of how likely it is that you will be able to make required payments in a timely fashion. The 1.6 number stated above is not unusual for design firms, but it is actually too low for comfort. It is much better to have a current ratio of 2.1 or higher, indicating that for every dollar of debt coming due within the next twelve months, your firm has two dollars of cash (or assets that will convert to cash in that period) available to meet the obligation.

    Quick ratio

    Formula: (cash + accounts receivable)/total current liabilities

    Typical range: 1.4 to 1.7

    Explanation: This is sometimes called the “acid test” ratio because it's a more rigorous test of short-run solvency. It considers only cash, marketable securities (cash equivalents) and accounts receivable, because they are your most liquid assets. A quick ratio below the indicated range would not be considered healthy because it would imply that you are dependent on less liquid assets to cover short-term debt.

    Total liabilities/equity

    Formula: (current liabilities + long-term liabilities)/equity

    Typical range: 1.1 or less

    Explanation: Another way to look at solvency is to compare a company's liabilities to its equity. This comparison is sometimes called debt to worth, or the debt to equity ratio. It is a standard measure used by banks to determine the health of your firm. A debt to equity ratio lower than two to one is considered to be reasonable and safe for most businesses, but the preferred limit for design firms is one to one. A high debt to equity ratio is a signal to creditors that a firm might be a credit risk because it is too dependent on debt to finance operations. A firm in this situation is described as highly leveraged, meaning that the amount of debt is quite high in relation to the owners' equity.

    Efficiency

    In general terms, efficiency is the ratio of the output of any system to the input. For design firms, this means how tightly you run your business. It includes such useful measurements as how quickly you collect money from clients, how heavily you rely on vendors and how effectively you use your business assets.

    Collection period in days

    Formula: accounts receivable/(annual sales/365 days)

    Typical range: 58 to 68

    Explanation: This is the average length of time it takes to convert your sales into cash. There is a direct relationship between accounts receivable and cash flow. A longer average collection period means that more of your money is tied up in accounts receivable and less cash is available for various other uses, such as paying bills. As you can see from the typical range listed here, many designers have difficulty enforcing the “net 30” terms printed on their invoices to clients.

    Assets to annual sales

    Formula: assets/annual sales

    Typical range: 32% to 44%

    Explanation: This is a general measure of your firm's ability to generate sales in relation to your total business assets. As you can guess, the best situation is to produce a high level of sales with only a modest investment in assets.

    Accounts payable to annual sales

    Formula: accounts payable/annual sales

    Typical range: 2.4 to 4.2

    Explanation: This measures the relative speed with which your company pays suppliers. If your numbers are higher than the typical range listed here, it is an indication that you are using vendors' assets (the cash that you owe to them) to fund your own operations.

    Profitability

    This is a very important category of financial comparison with other firms in your industry. There are three measures here that you will want to examine closely.

    Gross margin

    Formula: (annual sales-annual cost of sales)/annual sales

    Typical range: 42% to 53%

    Explanation: As explained in the P&L definitions above, the gross margin is the amount of money that, after they have covered their own direct labor and material costs, projects have made available to the firm for other purposes. If the gross margin is below the range indicated here, you should look at cutting project costs and/or increasing your prices (and maybe even reconsidering the mix of services that you are offering).

    Pre-incentive margin

    Formula: net profit before incentives/annual sales

    Typical range: 8% to 11%

    Explanation: Targets in some creative firms may range as high as 20%, but most graphic design firms are happy if they achieve an actual net profit of 10% for the year. Out of this profit, you will have to decide how much money, if any, can be awarded to team members as discretionary bonuses, profit sharing payments or 401(k) matching contributions.

    Pre-tax margin

    Formula: net profit before taxes/annual sales

    Typical range: 2% to 6%

    Explanation: After discretionary incentives and bonuses have been recorded, this is the amount of profit that would be reported for business tax purposes.

    Return on assets

    Formula: net profit before taxes/total assets

    Typical range: 6% to 14%

    Explanation: This compares the pre-tax earnings to total business assets. The higher the number, the greater the return on assets. However, the desire to produce greater profits using fewer assets has to be balanced against other important considerations such as risk, sustainability and necessary reinvestment in the business.

    Labor

    In a design firm, labor is the most important resource. It is the largest single expense and it generates the majority of income. To be successful, you need to monitor the following labor indicators very closely.

    Effective multiplier

    Formula: labor billings/direct labor costs

    Typical range: 2.8 to 4.0

    Explanation: This is sometimes called the net effective multiplier or the direct labor multiplier. It is an important comparison of your project labor expense to the related client fees that are being generated. As a multiplier, it indicates that each $1.00 of direct labor expense typically generates about $3.50 in fee billings. Needless to say, a multiplier of 4.5 or 5.0 would be even better.

    Total income per employee

    Formula: total annual sales/average number of employees during year

    Typical range: $150K to $200K

    Explanation: This can vary greatly, based on how you choose to do business. If you broker a lot of third party services or have large pass-throughs like media placement, this number can be much higher than the range indicated here.

    Labor billings per employee

    Formula: annual labor billings only/average number of employees during the year

    Typical range: $100K to $125K

    Explanation: For most graphic design firms, this is a more reliable indicator of labor efficiency than total income per employee because it is not distorted by large billings for materials, printing or other outside services.

    Chargeability

    Formula: direct labor costs/total base salaries

    Typical range: 59% to 69%

    Explanation: As explained in the P&L definitions above, this is your direct labor utilization rate. In each pay period, this identifies the portion of total staff labor that related to active client projects. Over the long haul, most graphic design firms seek to maintain a chargeability rate of around 65%.

    Breakeven multiplier

    Formula: (direct labor costs + operating expenses)/direct labor costs

    Typical range: 2.5 to 3.0

    Explanation: This includes indirect labor and all other general and administrative costs (payroll taxes, benefits, utilities, rent, etc.) but not incentives or business taxes. As a multiplier, this means that for every $1.00 of direct payroll spent on projects, the typical design firm incurs an additional $2.75 of indirect operating expenses.

    Overhead multiplier

    Formula: (operating expenses + other expenses + interest expense) /direct labor costs

    Typical range: 1.6 to 2.3

    Explanation: Here, overhead expenses are calculated more broadly to include such things as the interest paid on loans, but it still does not include incentives or business taxes. The overhead multiplier tends to decrease when the firm is busy. Lower is better. In good times, workloads increase and project schedules are tighter, which causes more of the payroll to be recorded as direct labor and less to be absorbed as overhead.

    Some suggestions for staying on track

    There are many things that you can do to maintain good financial health. For starters, make sure that you calculate a reliable budget for every project and build a reasonable profit into your client pricing. Then, strive to complete each project on budget. Even when you are busy with active projects, keep an eye on your backlog (some firms call it the “pipeline.”), which is the amount of client work that you have committed to do in the coming months. An increase or decrease in that backlog is a strong indicator of future sales and, by extension, an indicator of future profits or losses. Stay on top of this by maintaining a detailed projection of your firm's expected workload and billings. It should include current projects that are winding down, newly signed contracts that are ramping up, and potential projects that you are just now pitching. The value of the latter must of course be factored back to reflect your probability of landing them. The goal of the projection is to see how much of your firm's capacity is booked in each of the coming periods so that you can fine-tune your sales efforts and make any necessary adjustments to headcount.

    It's also wise to set some specific goals for the firm at the start of each business year. Goals should be aggressive enough that you and your team have to stretch to reach them, but never so wildly optimistic or unrealistic that they cannot be achieved.

    Consider setting targets for each type of work that you do:

    • Total revenue by project category (this indicates how you want your portfolio to grow)
    • Gross margin by project type (some types of work may be more profitable than others-over time, a successful businessperson will seek to expand the services that are profitable and rethink the ones that are not)

    Also consider setting targets that are client-related:

    • Total revenue by client category (the best way to insulate yourself against industry cycles is to seek out clients who are engaged in different types of businesses)
    • No single client should represent more than 25% of your annual billings (it's much safer to have several mid-sized accounts than to become dependent on a single large one)
    • On a regular basis, compare client billings to client profits (the most active accounts are not necessarily the most profitable-you may need to periodically adjust pricing or levels of service so that each individual account produces an acceptable margin)

    Staying on track involves setting internal goals that are attainable and verifiable, capturing and measuring your actual activity completely and consistently, and benchmarking your firm's performance against that of your professional peers. Being successful also requires that you constantly look for and adjust to trends in your clients' industries and in the general economy.

    About the Author: 

    Shel Perkins is a graphic designer, management consultant and educator with more than twenty years of experience in managing the operations of leading design firms in the U.S. and the U.K. He has served on the national boards of AIGA and the Association of Professional Design Firms. He has been honored as an AIGA Fellow "in recognition of significant personal and professional contributions to raising the standards of excellence within the design community." The third edition of his best-selling book, Talent Is Not Enough: Business Secrets For Designers, is available from New Riders. 

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