PcM Quiz Break 6, Q3

practice management
1

Really scratching my head on this one!

The question is as follows:
The principal at a firm is determining billing rates for the upcoming year using the profit plan. The firm’s business plan outlines a projected profit of 22% of net operating revenue (NOR) yearly. They’ve already determined the following information:

  • Projected net operating revenue (NOR): $800,000
  • Projected overhead rate: 1.35
  • Projected consultant costs: $150,000
  • Projected direct labor: $352,000

What should the billing rate be for an employee with a utilization rate of 85% and a direct labor expense of $75,000? Round to the nearest $5.

And the answer:
There are two major steps to solve this problem. First, determine the firm’s net multiplier. Then, determine the hourly rate of the employee. Once you have those two numbers, multiply them together to determine the billing rate. We discuss the relationship of net multiplier to hourly rate in our video Firm Financials: **Profit Plan + Annual Budget **(4:33)

To find the net multiplier, start by figuring out the break-even rate:

  • Break-even rate = overhead rate + 1.0
  • Break-even rate = 1.35 + 1.0 = 2.35

Then, find the profit multiplier:

  • Profit multiplier = profit / direct labor costs
    • Projected profit = 22% x $800,000 = $176,000
  • Profit multiplier = $176,000 / $352,000 = 0.5

Calculate the net multiplier by adding together the break-even rate and the profit multiplier:

  • Net multiplier = 2.35 + 0.5 = 2.85

Remember, all of these multipliers are multiples of direct labor.

Now that you know the firm’s net multiplier, find the employee’s hourly rate. Since hourly rate = total labor / 2,080 hours per year, you need to find the employee’s total labor. You have their utilization rate and direct labor costs, so you can use the utilization rate formula to find the total labor costs:

  • Utilization rate = direct labor / total labor
    • 0.85 = $75,000 / total labor
    • Total labor = $88,235.29
  • Hourly rate = $88,235.29 / 2,080 = $42.42

Finally, multiply the hourly rate by the net multiplier to find the employee’s billing rate:

  • $42.42 x 2.85 = $120.89

The question asks for the billing rate to be rounded to the nearest $5, so $120.89 rounds down to $120.

HOWEVER: why not just calculate the Net Multiplier by dividing the NOR by the DLE? Profit is already included in the NOR. This gives a Net Multiplier of 2.27. If we take the same Hourly Rate of $42.42 and multiply by the Net Multiplier, I get an answer of $96.29, which rounds to $95.

1 Like
2

Welcome to the ARE Community, @adie.mitchell! Thank you for your question.

An important note about this question is that we’re talking about someone who is profit-planning for the following year, using projections. NOR/DL works when looking backwards at a previous year to determine that year’s net multiplier, perhaps to apply that information to future years. However, when planning for an upcoming year, particularly with a specific profit goal in mind (like in this question), you need to start with the overhead rate to figure out the net multiplier as we describe in the explanation.

Put another way, if you use the net multiplier of 2.27, you would actually lose money, because the break even rate is 2.35. This is a great way you could check your work to determine if the answer you are obtaining makes sense from a practical standpoint.

In reality if you were doing these calculations, you’d realize that you need to either increase revenue, decrease expenses, or both, in order to achieve your profit goal.

Hope this helps. Happy studying!

Kiara Galicinao, AIA, NCARB
Black Spectacles

3

OK,
I think this makes sense, and good point about the fact that a net multiplier of 2.27 would make the firm lose money.

It seems that the NOR must be incorrect then. DLE x Net Multiplier should be NOR. But that clearly doesn’t hold true here. $353,000 * 2.85 does not equal $800,000.

4

@adie.mitchell, going back to what was previously noted - the NOR/DL relationship applies when looking backwards at a previous year. Because these numbers are projections, we are using the relationships between overhead rate, breakeven rate, and profit multiplier to determine the net multiplier.

This discrepancy you pointed out indicates that figures might need to be adjusted at a later time, in order to achieve the desired profit.

Kiara