Creative Project Compensation

May 11, 2009 · by Scott Simpson

Helping clients understand the value your firm brings to a project is the first step in calibrating the compensation your firm earns. If there’s a value proposition, then there’s a metric to quantify it. All you have to do is get creative.

Helping clients understand the value your firm brings to a project is the first step in calibrating the compensation your firm earns. If there’s a value proposition, then there’s a metric to quantify it. All you have to do is get creative.

The current recession is having a big impact on design firms across the country. Construction financing is scarce, even for established clients. Many projects are being delayed or cancelled outright. More firms are chasing fewer opportunities and offering lower fees, so it’s increasingly difficult to get new work. Because personnel costs traditionally represent about half a firm’s total operating expenses, staff reductions are inevitable.

Reports of layoffs in the 15 percent to 20 percent range are not uncommon, especially among firms that concentrate in the corporate/commercial, housing, and hotel/hospitality sectors. Some firms operating in these sectors have reported even higher levels of staff cuts. And since the financial turmoil on Wall Street has played havoc with endowments, even traditionally recession-resistant markets such as health care and higher education have been affected. All this will have a profound effect on the architecture, engineering, and construction industry.

While every organization suffers from business cycles to some degree, architecture firms are particularly sensitive since there is no way to build up a long-term inventory of work, and profitability is directly related to how many staff are billable at a given time. There are few fixed assets: Most of the “working capital” is in the form of people who are mobile in every sense of the word.

Like lawyers, architects essentially sell time, but the perceived value of this time is not sufficient to build up large cash reserves to sustain a practice through the lean times.

Factor in the escalating cost of technology, and it’s easy to see that the business of architecture is based on a high-cost, high-risk, low-reward model. It’s not exactly a winning formula.

Demonstrating Value

If there’s any good news to be found in all of this, it is that the current difficulties will force architects to reconsider their basic value proposition. Why do designers get hired? What do they do that’s worth the money? How should they be paid for their services? These are fundamental questions that surprisingly few practitioners take the time to ponder in meaningful detail.

The traditional assumption has been that the drawings are the product and that the essential value of the architect was to produce plans and specifications to be used by contractors to build buildings. The profession has gradually migrated to the notion that the drawings are instruments of service, meaning that the construction documents are merely a means to an end, not the essential product itself. A good analogy is the lawyer’s brief: It’s not the ink and paper that the client is paying for but the value of the ideas expressed. While hourly rates for lawyers can easily range between $400 and $700 (and even higher for top-tier firms), these kinds of billable rates are unheard-of in the design world. Yet architects are frequently responsible for projects that represent tens and even hundreds of millions of dollars of risk for their clients. Why are the compensation models for lawyers and architects so different?

In law, it’s relatively easy to make a business case for the cost of the services provided. Tax lawyers can save their clients many times the amount of their fees. Patent lawyers can establish rights that potentially generate hundreds of millions of dollars in profits. Litigators can protect their clients from costly judgments or even incarceration. By contrast, the primary value proposition of architects is good design, which is devilishly difficult to define even among the most talented and experienced professionals.

Like any business owner, architects need a practical and sustainable long-term business model. They must clearly articulate to their clients and to the public at large what they are worth and how they should be paid. In order to run viable firms, they need to attract the best and the brightest talent. Obviously, cost-based compensation is not the answer; instead, architects must sell value — value that can be measured in meaningful ways.

A conventional design fee for a commercial building is typically in the range of 5 percent of construction cost — the same percentage fee that is paid to a real estate agent who will lease the space. The architect will work for several years and contend with a great deal of complexity, uncertainty, and risk; the real estate agent will be paid about the same or even more for far less effort. Why? Because the client can easily assess the cost of the commission against the revenue stream coming from the leased space. There’s a clearly understood cost/benefit ratio.

Now more than ever, the design profession needs to develop metrics for the value it creates. Currently, the A/E/C industry is the nation’s second largest segment of the economy (after health care), representing about 7 percent of the gross domestic product, or roughly $1 trillion annually. However, of this trillion dollars, only about 3 percent, or $30 billion, is paid to architects in fees, usually in the form of percentage-based or fixed-fee contracts. However, there are many other ways of measuring value:

•    Permitting. For most complex projects, the permitting process will consume months or even years. Each delay affects the client in terms of increased cost due to inflation or delaying the revenue stream from the completed building. A good architect who knows how to manage the approvals process can save a client big money.

•    Space utilization. This is an underappreciated design metric. Because things such as structure, mechanical shafts, and toilets are required, only a portion of the total built space is available for directly productive purposes. For example, in a research laboratory, an efficiency ratio of 60 percent is considered fairly standard. But with good design, it’s possible to push that to 70 percent or even higher. Better utilization means that more people can be accommodated in the same space (increasing productivity per square foot) or that the overall building can be smaller (reducing capital cost). Either way, the client wins.

•    Energy consumption. Highly efficient mechanical, electrical, plumbing and lighting systems are becoming increasingly common, but architects and engineers need to take this to the next level by analyzing and demonstrating how much money clients will save each month through reduced energy bills. A building that costs less to operate has tangible value to both client and tenant. People will pay more for smart design because it pays for itself.

•    Maintenance. Some clients build only for the short term, intending to syndicate or sell the project in five to seven years. However, many owners (schools, hospitals, institutions) are in it for the long term. Close analysis will show that the use of durable materials both inside and out can cut the cost of ownership dramatically. A typical maintenance budget is about $8 per square foot per year. For a 100,000-square-foot structure, savings of just 10 percent will translate into $1.6 million over 20 years — more than double the architect’s original fee.

•    Cost control. Clients, architects, and contractors alike assume that each project will experience some level of increased cost due to unanticipated conditions and change orders. Part of the cause is poorly coordinated documents, requiring costly changes in the field. By using building information modeling technology, architects can greatly reduce or even eliminate coordination errors, resulting in direct savings to the client (and to themselves). BIM technology has many other uses as well, including energy modeling, daylight modeling, materials tracking, and construction logistics, all of which can generate savings to the client.

•    Speed. The gestation period of a building is notoriously slow, usually two to three years. If an architect can shave just 10 percent off a 36-month schedule, the owner can put the building into service that much sooner, receiving the benefit of accelerated rent. Using the same hypothetical 100,000-square-foot structure at $25 per square foot per year, that’s an additional $825,000 in the owner’s pocket. How much additional fee would it be worth to pull this off?

These few examples make the point: There are plenty of ways to define value in design, and not all of them have to do with form, massing, or aesthetics. Helping clients understand how to measure this value is the first step in calibrating compensation. It’s also important to realize that the value delivered by good design accrues over the life of the building, long after the original fee has been paid. On a cost-per-year basis, top quality design is actually a tremendous bargain.

Other Alternatives

Consider compensation models from other industries. It’s already been noted that fees for lawyers are primarily time-based. In medicine, by contrast, most services are performed on a fixed cost-per-service basis, with rates set by third-party payers (the insurance companies). Doctors actually have surprisingly little to say about what they get paid. This applies even to highly sophisticated procedures such as cardiac surgery and organ transplants. Under this system, there’s a financial incentive to minimize expensive tests and release patients from the hospital as soon as possible (as long as patient safety is not compromised). The analogy to design would be charging a fixed fee for a specific unit of service, such as reviewing a shop drawing.

In retail, customers pay only for what’s actually purchased, not what’s produced, stocked, or advertised. The shelves can be full of expensive inventory, but revenue is generated only at the point of sale. The cost of carrying inventory eats into potential profit with each passing day that merchandise remains unsold. If it takes weeks or months to unload inventory, losses are inevitable regardless of original product cost, which is why end-of-year clearance sales are so common. The analogy in design would be charging only for the work actually put in place, not for what’s drawn on paper.

Unlike retailers, realtors don’t own any inventory at all; they sell or lease what belongs to someone else. Their value is in linking the buyer with the seller and facilitating the paperwork with the bank. For this, they receive a commission based on sales price, and they carry very little risk. At the same time, they get paid only for performance. No sale, no commission, so the revenue stream can be very unpredictable, especially as market conditions change. Suppose architects discounted their fees up front but then took a “success fee” when the building was fully occupied? This might serve to align both the design and business objectives.

Somewhat like retail, success in the film industry is based on ticket sales. Regardless of the quality of the film, if it attracts a large audience, it is considered a winner. Profits are made not only by selling the seats but also at the concession stand, so there are several integrated revenue streams. This is also true in professional sports, where ticket sales are only part of the story. The franchise also makes money from concessions, advertising, broadcast rights, and merchandise sales (whether or not the team wins). If people will pay to enter a ballpark, theater, or museum, would they be willing to pay an admissions fee for using other kinds of buildings? Parking lots are an obvious example in which the value-for-cost is clear. However, churches must rely on voluntary contributions from those who attend; there is no quid pro quo. People are not likely to pay to get into stores or restaurants — they are accustomed to paying on the way out. This begs an interesting question: Is there a logical way to link attendance to design value? Could architects’ fees be based, in part, on how many people use a building over time?

And what about financial services? People expect free checking and savings accounts but willingly pay hefty fees through loans and credit cards. In a reversal of the typical retail transaction, banking customers bring their own inventory in the form of a deposit, and in return the bank offers to keep it safe and then return it with interest over time. Essentially, banks must “give away” money in order to make it. Though this sounds counterintuitive, it works. The current financial crisis notwithstanding, just compare the average profit margins for banks with those of design firms.

And let’s not forget software, which is perhaps the best example of a value-added business. The actual cost of the software (the disc) is mere pennies, but the charge to the consumer can be hundreds or thousands of dollars per copy. Everybody understands and accepts this at the outset. The customer pays willingly because the utility of the software far exceeds both its production cost and purchase price. The user is paying for the intellectual capital. For a true value-added business such as software, there are many parallels to design. This is even reflected in the common lexicon, such as “software designer” and “systems architect.”

Aspects of all of these business models have an implication for design. Should architects charge strictly by the hour (like lawyers), sell product (like retailers), take a percentage of what they save their clients (like bill collectors), or base fees on the value-added (like software engineers)? Can architects charge today for benefits that will accrue over many years or should they be like authors and take royalties? Could they be like real estate agents, getting a commission each time one of their buildings is sold?

Perhaps there is a hybrid approach, combining aspects of all of these methods, that makes the most sense. Not all design effort is the same, so we shouldn’t assume there’s a one-size-fits-all approach. Buildings differ greatly by site, program, size, schedule, budget, and jurisdiction. Very often, design doesn’t result in a building at all. Each phase of the process (SD/DD/CD/CA) has its own inherent challenges and underlying value.The key is to make it clear to the client at the outset how the architect’s skills can create real value and then structure a deal that rewards actual performance. This can include fixed fees, percentage fees, deferred fees, or success fees such as incentives for cost control or bonuses for timely delivery.

If there’s a value proposition, then there is a metric to go with it. Since architects are in the business of creativity, there’s no reason that their business practices can’t be just as creative as their other skills. When it comes to creative compensation, think of it as a design problem.

 

Scott Simpson is a Senior Fellow of the Design Futures Council and a Richard Upjohn Fellow of the American Institute of Architects. He co-authored, with James P. Cramer, How Firms Succeed and The Next Architect.

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