Productivity and efficiency… These are pretty simple concepts, right? Productivity is typically defined as outputs divided by inputs and efficiency as actual output divided by standard output. But there is a little problem here for the type of work we do as Architects and Engineers (A/Es). What is “input’? What is “output” and how do we define what “standard output” is?
Luckily, most firms have figured this out though. Inputs and outputs are labor hours, right? And the way we manage productivity is through obsessively tracking utilization rates. If we can manage utilization and keep our quality up, then we will surely be able to manage productivity, right? It turns out that if you are working this way, then you are missing a big part of the productivity picture.
So why is this? It is because utilization rates and targets are relatively easy to meet, whether or not you are actually being productive. First, let’s look at the definition of Utilization Rate. Utilization rate measures how billable your employees are and is defined as:
Utilization Rate = Direct Labor / Total Labor
Direct Labor is labor charged to projects. This can be viewed in terms of hours or dollars, though you will get slightly different results depending on which way you view this. Say that your firm has an overall utilization target of 60%. You have managers tracking utilization rates and you are only achieving a 55% utilization rate. The communication goes out to technical staff that they need to be 5% more utilized. So, your technical staff hears that they need to spend more time on their projects. The good news is that clients may get some gold-plated designs or lots of unnecessary additional detail. The bad news is that this doesn’t change the financial results of your company at all. Revenue is the same and overall cost is the same. Has your productivity really gone up?
Another measure that could be used to define productivity for an A/E firm is Direct Labor Multiplier, which is essentially a different way of measuring Gross Profit. Direct Labor Multiplier measure how valuable that billability for your company is and is defined as:
Direct Labor Multiplier = Net Service Revenue / Direct Labor
Say that your firm has an overall Direct Labor Multiplier goal of 3.0. You have your project managers tracking this for each project, and they are falling slightly short of this goal. What is the quickest way for a project manager to get closer to this goal? Reduce the Direct Labor being applied to their jobs. Maybe they will not charge all of their time to the project or encourage the team to lay off their project. This shouldn’t happen in a perfect world, but you don’t want to incent that either way.
There has to be a better way! It turns out the key to measuring the productivity of an A/E firm is a measure called Revenue Factor. Revenue Factor combines these two important productivity measures, Utilization Rates and Direct Labor Multipliers. Revenue Factor is defined as:
Revenue Factor = Net Service Revenue / Total Labor
or… Revenue Factor = (Net Service Revenue / Direct Labor) x (Direct Labor / Total Labor)
so… Revenue Factor = Labor Multiplier x Utilization Rate
Notice from these definitions that if you tried to inflate Utilization Rates (UR) by increasing your Direct Labor, Direct Labor Multipliers (DLM) would decrease. If you tried to inflate DLM by decreasing Direct Labor, UR would decrease. By multiplying these two together with Revenue Factor (RF), you capture the full effect of what is happening to productivity. There is nowhere to hide from Revenue Factor. To illustrate this point, let’s take a look at an example of a couple common-sized profit and loss statements for two successful A/E firm which are not unreasonable based on industry benchmarks. This illustrates both the points of how Revenue Factor works and that there is more than one way to skin a cat based on the strategy of a particular firm. Firm A may be a highly specialized firm with a large portion of time being spent on R&D and thought leadership and Firm B may be a super-efficient firm that concentrates on repeatable efficient design.
| Simplified Profit-Loss | Firm A | Firm B |
| Net Service Revenue (NSR) | 100% | 100% |
| Direct Labor (DL) | – 25% | – 35% |
| Gross Profit | = 75% | = 65% |
| Indirect Labor (IL) | – 25% | – 15% |
| Non-Labor Overhead | – 30% | – 30% |
| Profit (Pre bonus/tax) | 20% | 20% |
| Select Measures | ||
| DLM = NSR / DL | 4.0 | 2.85 |
| UR = DL / (DL + IL) | 50% | 70% |
| RF = NSR / (DL + IL) | 2.0 | 2.0 |
Theory is all great but the proof is in the puddin’, right? I have looked at these measures using statistics for a company utilizing actual results over a period of more than 10 years where many things changed – people, structure, markets, industry conditions, etc. Utilization Rates were about 35% correlated to profit over this period – not really a good indicator of success. Direct Labor Multipliers were a little better at close to 65%. Revenue Factor, however, was over 90% correlated to profitability over that period of time. That is one powerful measure!
To be able to do something with this information, you need to be able to manage with it. They key is to manage all three of these measures together. I will dive into that in a future blog post and introduce some tools (Capacity Utilization, for example) to help with this that you may not have seen before.