In a previous blog post, I outlined some measures to help architecture and engineering (A/E) firms manage productivity. The key measure presented in that post was Revenue Factor. Revenue Factor is a combination of Utilization Rate and Direct Labor Multiplier. I have defined these below for reference.
Utilization Rate = Direct Labor / Total Labor
Direct Labor Multiplier = Net Service Revenue / Direct Labor
Revenue Factor = Utilization Rate x Direct Labor Multiplier
Now these measures are only useful if you do something with them. If you want to manage your productivity and profitability, then Revenue Factor is one of the key measures you need to manage. In order to manage Revenue Factor, you need to manage two things – utilization and gross profit (which Direct Labor Multiplier essentially measures). In this post, I will describe a tool, Capacity Utilization, that I believe is a better way to manage utilization than more traditional utilization measures.
Utilization is traditionally measured using the measure of Utilization Rate shown above. This can be on dollars or hours, but hours are typically used when it comes to individual employees. Many firms utilize this measure to determine how billable employees are and as a measure of productivity. However, using Utilization Rate alone has some limitations. It fails to capture true productivity as discussed in the article referenced above, fails to capture the effects of overtime, and only provides a weak link to the budget.
Luckily, we can borrow a concept from the worlds of manufacturing and economics, Capacity Utilization, that will address a couple of these shortcomings. Capacity Utilization is defined, in simple terms, as the ratio of output to potential output. Potential output for our purposes here will be defined as the potential output over the long term. People can dial up their output over short periods of time, but we are interested in managing and budgeting our businesses for the long run. So, it follows that Capacity Utilization, as it relates to billability for the A/E firm, can be defined as:
Capacity Utilization = Direct Hours / Target Direct Hours
Target Direct Hours = Target Utilization Rate x Standard Hours
Capacity Utilization provides a measure that describes the percent of long term “full capacity” that an individual, a department or other group, or a firm is operating at. When an individual or a firm is charging direct hours to projects equal to their budgeted (or target) direct hours, they can be said to be working at 100% capacity. Target Direct Hours are determined by taking Standard Hours (typically 2080 for a year based on a 40 hour workweek) and multiplying them by a target utilization rate for each employee.
Target Direct Hours and Target Utilization Rates can be set by taking Standard Hours and subtracting out indirect time (holidays, paid time off, time spent on proposals, administrative time, etc.) based on what you have set in the budget. If you do this for each employee (or practically you would do this grouped by labor category) and sum them up for the whole firm, you will find the capacity of the firm in terms of direct labor. This should allow you to provide a direct link between your budget and target utilization. The following example shows what this may look like for a billable technical architect or engineer for a one year period.
| Total Standard Hours | 2080 hours |
| – Holiday 8 days) | – 64 hours |
| – Paid Time Off | – 140 hours |
| – Training | – 40 hours |
| – Proposal Time | – 80 hours |
| – Administrative Time | – 80 hours |
| = Target Direct Hours remaining | = 1676 hours |
| Target Utilization = Target Direct Hours / 2080 hours = 80% | |
The following example illustrates how Capacity Utilization capture the effects of overtime better than the traditional measure of Utilization Rate. If a manager is only reviewing a utilization report with Utilization Rates, she will miss the fact that Engineer 2 may have more work than Engineer 1 and is “burning hot” by working above capacity. After all, they are both 80% utilized, right? When viewed with Capacity Utilization, the manager can see that Engineer 2 is working at 125% of capacity. While this may be OK for short periods of time, this can really cause issues if allowed to continue for too long. Remember that whether you are above or below what you have budgeted, you are still missing the targets you have set for your business – bigger is not necessarily always better.
| Engineer 1 | Engineer 2 | |
| Direct Hours (D) | 32 | 40 |
| Indirect Hours | 8 | 10 |
| Total Hours (T) | 40 | 50 |
| Target Direct Hours (TD) | 32 | 32 |
| Utilization Rate = D/T | 80% | 80% |
| Capacity Utilization = D/TD | 100% | 125% |
As mentioned previously, Capacity Utilization is helpful to manage at an individual, department, or firm level. Department managers can use this measure to quickly identify opportunities for redistribution of work or identify who is at risk of potential burn out. Operations managers can use this to identify departments that may need additional staff or additional work. Firm managers can quickly determine how closely billable hours are tracking the budget since target rates and hours serve to set the budget. Put this all together, and you have a great tool to help you more effectively manage utilization at your firm.