Misconceptions About Utilization Rate for AE Firms

November 4 2021 | by Brad Wilson, CMA, CDA, MBA

Utilization rate describes how much potential output is being used, whether it’s a person, business, or machine. In its simplest form, if a device can produce ten units in a particular period and completes 8 of them, it has an 80% utilization rate.

The math for deriving utilization rate is easy, but the real-world application to people isn’t as straightforward. This blog will cover the top misconceptions about utilization rate as it applies within architecture and engineering firms.

People Aren’t Widgets

One of the most common mistakes regarding utilization rate is treating a person’s productivity like a machine. A machine can put out the same number of widgets for hours, but people don’t consistently produce from one hour to the next, especially in a professional services environment.

Energy level, type of work, interruption frequency, and other factors influence how much a person can accomplish. The vast amount of variability in output highlights why firms should be cautious about how they use the utilization number in operational and financial forecasts.

Each Hour Worked Is Not Equally Valuable

Different team members are paid at different rates. The value of one hour of Employee A’s work and one hour of Employee B’s work isn’t equal. Since a firm’s profit is the difference between an hour billed to the client and an hour paid to the employee who performed the work, problems occur when averages are used to compute a capacity utilization rate for the firm. Utilization rate calculation must be based on cost from the general ledger instead of hours from a timesheet.

Another common challenge is that employees who cost the most are typically the least billable. Owners and principals dedicate a lot of time to non-billable activities like business development, but they tend to earn the most. As a result, the utilization rate based on hours is generally much higher than if based on cost. These discrepancies create flawed numbers, which derive optimal billing rates and ideal utilization rates far from reality.

Overtime for Salaried Employees Is Problematic

Since many AE employees are salaried, uncompensated hours over 40 can be complex. For example, if an exempt employee works 45 billable hours, their utilization rate based on hours is 112%. However, the benefit to the firm is even more significant because the compensation for the five surplus hours is zero. If you calculate utilization based on hours, you miss that entire piece.

Similar problems arise for hourly employees who work overtime and get paid time-and-a-half. How does utilization rate based on hours capture premium time? The answer is it doesn’t. An hour over 40 at time-and-a-half is much less valuable to the firm than the 39th hour.

Utilization Rate and Goals

A good rule of thumb is that every AE firm should have an overall utilization rate goal. It may also make sense to set goals at the department/studio level. Avoid setting individual utilization goals since employees don’t control the amount of work they’re given in any week or month. Additionally, employees who see their work queue dwindling tend to stretch the remaining work, increasing their utilization rate but driving the project over budget.

Transparency and communication about firm utilization goals is strongly recommended. Employees should know how their work contributes to setting and reaching goals. However, they must keep the client’s interests in mind when determining what percentage of any given hour is truly billable.

The Move to Lump Sum Fee Contracts

Another issue affecting the use of utilization rate is the growing movement to lump sum fee contracts. For multiple years now, over 50% of AE firm projects have used this fee structure, and in this scenario, lower utilization equals higher profit. Plus, clients are happier when projects are completed faster. Bottom line: Lump sum projects undercut the idea that you make more money when you bill more hours.

The Trouble with Timers

Some firms use work timers to help track utilization by auto-populating timesheets. The problem with timers is that they only measure the beginning and end of a work session, with no measure of productivity level. It’s an approach based on the fallacy that all hours are equally productive.

Non-Billable Time Is Necessary

When considering the utilization rate, successful firms will tell you that a certain amount of non-billable time is necessary for success. Not only are vacation and sick time critical for physical and emotional well-being, so is time for training to improve skills and advance their career. Withholding time to increase a person’s utilization rate hurts both the employee and the firm in the long run. Ideally, an employee’s “available time” should be the total work hours in a year (2,080) minus the sum of whatever leave they are allowed, plus planned education hours.

Utilization Rate and Firm-Wide Budgeting

Without a doubt, the highest and best use of utilization rate is for budgeting. You must know your firm’s capacity to generate fees. Each person’s cost multiplied by a market-specific direct labor multiplier gives you your billing rate. That rate multiplied by the number of available hours equals the firm’s possible revenue. And that revenue times your targeted utilization rate gives the actual revenue you can expect in a year.

The composite utilization rate across all staff members is an important metric because it indicates whether to hire or how aggressively you need to fill your pipeline. You can make more informed decisions by comparing the number to your annual backlog.

Next Steps

Utilization is one of several important metrics that AE firms should be measuring. Join us for our upcoming webinar, where we’ll discuss the top financial metrics, how they are calculated, and how to apply them for business improvement.

 


Brad Wilson, CMA, CDA | Stambaugh Ness

Brad Wilson, CMA, CDA, MBA | Director, AE Consulting

Brad’s 30+ year career spent working with architecture and engineering (AE) firms includes his most recent role as Partner with TWO CPAs & Consultants, Inc., as well as being a Consultant with PSMJ Resources for 17 years. Additionally, after serving as an outsourced CFO and controller for numerous firms, Brad has deep firsthand knowledge of how to develop and execute successful finance and accounting practices in the AE industry.

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