Manage the Gap

Dear Dave
How much overhead is too much? What should a firm’s overhead be?
OC TX

Dear OC
Each firm’s circumstances, and therefore overhead rate, is different. What’s right for one firm is not necessarily right or appropriate for the next, based on a wide range of factors including overall size, strategy, geography of where a firm is located and so forth. By itself, comparing overhead rates from one firm to the next does not tell you all that much.

A far better indication of the "rightness or wrongness" of overhead for any particular firm is to measure the margin, or gap, by which the firm’s Effective Multiplier (Net Fee Revenue divided by Direct Labor) is greater than the firm’s Overhead Multiplier (Indirect Expenses plus Direct Labor divided by Direct Labor). The financial key is to manage your practice is such a way as to maintain the widest possible margin (or gap) between the two ratios. A firm’s overhead rate is never too "high" if the Effective Multiplier is also high resulting in a healthy gap.

The gap can be improved by either reducing your overhead expenses, or increasing your effective multiplier, or some combination of both. Reducing the overheard multiplier requires cutting non-project related indirect expenses which comprise the numerator in the firm’s overhead calculation. Increasing the effective multiplier can be achieved in a number of ways which may include, among others, selecting better clients in the first place, charging higher hourly fees, tighter project management controls, or becoming more efficient in completing project design and documentation, especially on projects with lump sum and or otherwise fixed fee type contracts.

According to the 2003 Wind2 A/E Financial Survey, the industry median Effective Multiplier was found to be 2.86 and the Overhead Multiplier was 2.52, resulting in an average gap or margin between the two key ratios of .34 (2.86 – 2.52). The wider the gap, the more profitable the firm. In my consulting practice, I routinely come across firms with gaps of 1 or higher. Interestingly, the firms I see with the largest gaps generally have higher than average overhead rates. Seems the old cliché may indeed be true that you do "sometimes need to spend more to make more".

So, don’t become overly fixated with your firm’s overhead rate—keep your eye on the gap. It’s all about the size of the gap.