How Design Firms Work
If you were running a donut shop, one “how-to” manual would fit you and almost every other donut shop owner in America. Same for a small print shop or small dress shop.
Alas, in interior design, I could point to radically different business models that have allowed individual designers to create a very nice living for themselves. I could point to one designer who earns over $200,000 a year by working with only one client at a time, and another who earns the same amount yet routinely has 50 or more clients each year. One of these sells merchandise but has no retail front, while the other has a strong retail presence.
But on occasion, when I am working with consulting clients who seem to have an unbalanced business model, I will start by making sure they understand the norm, that is, the way the majority of reasonably profitable, small- to mid-sized interior design firms “work.” For your own interest and comparison with reality, I want to explain that here.
The model I show below is a typical, if small, residential interior design firm. Your job is to compare this to your reality and ask questions about what you’re doing differently, for better or for worse.
Using an actual consulting client of mine, we begin with a four-year history of gross sales:
Latest Year — $661,937
Prior Year — $369,074
Prior Year — 4553,814
Prior Year — $461,0433
Their sales pipeline looked promising and they had recently received some nice PR. So, rather than use an average, I assumed that there was some momentum and word-of-mouth in the market, and thus the company can realistically expect to maintain, or improve upon its most recent year.
Let’s say that $750,000 is a reasonable goal for the next year or two. Many profitable interior design firms fall at about that size. It’s a very nice size, especially if the breakeven point can be determined so that the firm can handle a roller coaster spike of up to $1.2 million without having to increase permanent fixed costs. That's how the money is made!
Having already noted that there are many different models that could generate this level of revenue, one way to look at a residential design firm of this size is as follows:
- The average contribution margin among firms this size is 44%. (Better than my “all-size” magic number of 39%.) The contribution margin is a concept I devised to help interior design firms distinguish between the value of selling hours and the value of selling merchandise. This simply means that 44% of all sales dollars, or $330,000 (based on $750,000 total sales) should be available to cover overhead expenses and contribute to expenses. (This concept is sort of like “gross profit,” but not quite.)
- Typical overhead costs for a firm this size are from 25-40% of total sales, so let’s be conservative and say 35% is what your fixed costs should be, or $262,500.
- The principal should pay himself or herself 7-10% of gross sales, but I’ll use the lower number for a fixed owner’s wage of $52,500. This is already contained in the 35% overhead costs above. (The owner’s wage is contained “above the line,” while their profits and possible distributions are shown “below the line.”)
- This leaves a net profit for this firm of $67,500, also available for the principal to pay to himself or herself, or to distribute as bonuses or reinvest in the business.
- Total net of $67,500 is a 9% net profit, which is not a bad return.
- Total owner’s discretionary income potential is $52,500 (salary) plus $67,500 (profit) or $120,000, which is 16% of gross, a very solid number.
The division of time billing and merchandise sales can vary greatly, but splits around 20/80 or 25/75 are common with the larger number being for gross merchandise sales. Using 20/80 for our hypothetical design firm, this means:
- 20% of the gross sales of $750,000 comes from time billings, or $150,000.
- 80% of the gross sales of $750,000 comes from merchandise sales, or $600,000
- Average gross profit for merchandise sales is 30% (a huge range here, depending on the business strategy) or $180,000. (30% of $600,000) A 30% average gross profit requires a 43% average markup.
- Total contribution margin (design fees plus gross profit on merchandise) is $150,000 + $180,000 = $330,000.
- Contribution margin = Contribution divided by gross sales, or $330,000 / $750,000 = 44%
- Total overhead expenses divided by the contribution margin equals breakeven, or $262,500 / .44 = $596,590.
This firm can break even and pay the principal her full wage on less than $600,000 of sales. However, he or she would only receive their “above the line” wage as there would be no profit.
If this firm were to catch a whale or two and be able to generate $1.1 million in total sales with no increase in overhead, they would enjoy this scenario:
- Contribution margin of $1,100,000 x 44% = $484,000.
- Less fixed costs of $262,500 (Remember, we’re not calculating fixed costs on the new level of revenue, but on the old. The key is that this number remains the same even as you experience spikes in the roller coaster. of sales.)
- Pre-tax profit = $221,500
This principal may have increased their wage along the way, but at a minimum, now has almost $290,000 pre-tax dollars available to pay out to himself or herself.
Just be careful that when the whales leave, you’re not left with additional permanent overhead that will reduce profits when the roller coaster dips again.
Assignment: Can you calculate your break-even point? (Hint: It's just the total of your fixed costs, aka, recurring expenses. Be sure to include a wage for yourself.) To break even, your contribution (most think of this as a gross profit) must exceed that amount. Then ask this critical question: Can you sustain a one-time increase in annual sales of 20-30% without increasing fixed costs? If so, you're on your way to a very profitable future.
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