Understanding profit: how to manage costs in your architecture firm

As we enter a period of lower workload and possible recession, we’re also faced with increased costs due to inflationary pressures, as well as the cost-of-living crisis.  

The knee-jerk reaction to this is to try and win more work, whether that’s through more activity, bids, or competition. However, this isn’t the optimal response— we should, instead, be focusing on profitability.  

What is profit?

Simply put, profit is the excess of billing over costs.  

That’s the straightforward part—but there are still some nuances.  

While profit does equal the excess of billing over costs on paper, in the real-world, profit is the excess of money received over costs.  

For example: if the client refuses to pay the final invoice or deducts some spurious (or not so spurious) amount for from it, then that needs to be considered in profit.  

The management of clients, debtors, and credit control is essential to ensure you mitigate against non-payment of invoices.  

Equally important is being able to mitigate against the possible reasons for non-payment, such as a thorough QA process or full retention of all project emails and correspondence. These claims are often settled on the lack of evidential proof rather than right or wrong.  

The challenge to recognize with outstanding invoices is that initially and for small sums, it’s the client’s problem to deal with. When they’re larger and older, it becomes a problem of the firm to deal with.

But invoicing and ensuring payment of those invoices is one side of the equation. The other side is costs.  

Managing costs

It’s all too easy when faced with a lack of fee billing to chase any project and agree any fee. Fee billing, while increasing income, only temporarily increases cash.  

The only way to truly increase cash that can be retained and kept as reserves is through profit. If you can’t make a profit on a project, you must analyze why you’re undertaking the project and consider how, if it’s going to make a loss, you are going to fund that loss.

The fee for the project will be known in advance—however, it’s the management of the costs that will determine profitability. Project costs relate to the cost rates of individuals, or grades of staff, and the hours that those individuals work on projects.  

Provided your cost rates fully recover your actual costs, something which must be reconciled on a regular basis, project profitability will equate to practice profitability. (Unfortunately, project losses also equate to practice profitability.)

As a general rule, 80% of project losses occur when you sign the fee agreement. Either there isn't enough fee or too much service is being provided. The easiest way to reduce some of this risk is to have a full project resource plan before you agree any fee.  

It’s also essential to understand your expected projected costs at all times. It’s only with this information that you’ll be able to understand and manage expected project profitability.  

While losses will inevitably occur, none of these should be surprises; they should be known and actively mitigated. This will require a consistently updated resource forecast (monthly or weekly).  

With a regular cadence of forecasting, you’ll achieve your expected project profitability and provide essential business-wide resource requirements.

Project costs and bid costs

There are two elements to the overall cost of a project: the cost of winning the project and the cost of delivering the project. While these do need to be separated, they’re both costs of the project.  

Some AEC firms prefer to ignore the cost of winning a project as an actual project cost and treat it instead as an overhead cost on a separate “bid” project. Other firms prefer to treat it as a project cost but allocated it as a stage of the project.  

Either as a separate project or as a stage within a project, the same cost will be shown as a firm wide cost. However, treating this winning cost as a stage within a project will provide useful detail both in terms of budgeting at a project level and analyzing bid costs at a more granular level.  

With more bidding activity, bid costs do need to be carefully monitored and controlled. Whichever method of allocating these costs is chosen, it’s imperative to set a budget for bid costs and to monitor that budget to ensure you don’t start your project looking at a loss.  

Key Takeaways

• Focus on profitability, not just activity
• Understand your profit, and the factors that effect it. For example; project vs bid costs
• Mitigate non-payments with efficient management of clients
• Understand the importance of cost management and why it is essential to long-term profitability
• Have the ability to project profitability and costs through accurate forecasting
• Learn the risks associated with fee-agreements and how to mitigate them