Benchmarking is a very valuable activity, and firms are embracing it as a tool to assist them in their financial management. The usefulness is undeniable, and can give a nice view of not only the financial health of the firm, but also answer the question why.
Bottom line profits are great but “how did we make this profit” is just as important as what the profit is.
Profit is made up of revenue (sales), cost of revenue (direct labor, other direct costs and reimbursable costs), overhead and other costs (bonus, taxes, discretionary contributions to retirement plans).
The ratios within this formula are the basis for many of the metrics used in benchmarking. This is great but what happens to the metrics when the accounting processes are not correct? Let’s take a look at a few metrics to see what can happen.
The basis for many performance metrics is direct labor. Direct labor enters the accounting through the timesheet then get costed according to the firm’s labor costing policy. If this policy includes capping certain employees, the direct labor on the financial statements will be low thus the related metric will not be accurate. The effective multiplier will be higher than actual, and the utilization will be lower. Additionally job performance will be better than actual.
The effective multiplier (net revenue/direct labor) and payroll factor (utilization times effective multiplier) are common metrics used in firm management and project manager goals. The potential problem starts with net revenue. This is total revenue less other direct costs and reimbursable costs. A typical scenario occurs when a firm charges clients for use of firm equipment but doesn’t cost this item to the contract.
As an example, the firm bills clients for mileage but doesn’t cost that mileage to the job. Here, the overhead is overstated by the lack of allocation, the reimbursable costs are understated, and the net revenue is overstated. So a firm may believe they have a 3.1 effective multiplier where the real answer is 2.9.
Speaking of overhead, capping labor rates and not charging costs to contracts effects the firms overhead rate, but in opposite directions. Capping labor rates moves direct labor to indirect labor through the payroll variance account in standard cost systems. Not costing equipment/vehicles to jobs also increases overhead.
Not bad if you are a government contractor. Very bad if you are a government contractor. Not only are your performance metrics suspect but your overhead rate is overstated.
Sure you potentially could be paid more, but most government contracts contain cost certifications, which creates a very real liability for the firm who overstates their overhead.
Many CPAs recommend to their clients that the depreciation they record on their financial statements be tax depreciation including the 179 deduction. They consider this appropriate since this is what will be included on their tax return. This is not appropriate. The purpose of a firm’s financial statements is to give management a tool to make appropriate business decisions, not just tax decisions. Asset purchases should be written off over their useful lives thus their costs are included in the financial statements over this time. With the 179 deduction overhead spikes in years of heavy asset acquisition and there is little to no depreciation in years where there is none.
The position of accounts in your accounting can also effect the benchmarking results. Any metric that contains net income from operations is susceptible to this. Many accounting firms believe bonuses and profit sharing contributions are just costs of doing business yet for A/E benchmarking these costs are “below the line” costs. Net income from operations is computed without bonuses, profit sharing contributions or income taxes, these costs are considered discretionary (regardless of what you say about taxes).
The first step firms should take when starting the benchmarking process is examine their accounting policies and procedures to determine if they actually reflect the true costs associated with a contract. The goal is accuracy and consistency, not making any individual client, principal, or project manager look good. The setup of the financial statements should be in accordance with industry standard with appropriate accounting policies. This will result in accurate financial information, consistency in the reporting of costs and give firms competent, reliable financial information.
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About the author: T. Wayne Owens, CPA, is the founder of T. Wayne Owens & Associates, PC, a CPA firm with a singular focus on the design industry, providing accounting services, overhead audits, financial statement audits, tax returns, and more to A/E/C firms. He can be reached at firstname.lastname@example.org.