At Tom Vignali CPA, Inc., we have numerous clients who charge their customers an hourly rate for the services provided by their employees. In some instances, our clients think they are charging too much, and in other instances our clients think they are not charging enough. In all instances, we always require that our clients work with us to make some basic calculations and projections to determine what the rates charged should be. In some regards, it is a complicated process. In other regards, the financial calculations are pretty basic. In reality, all of the numbers and financial figures are available, and by making the correct calculations, we can assure our clients that they are charging enough to cover their expenses, but not charging too much to price themselves out of the marketplace.
In order to proceed with these calculations, let’s set some ground rules, assumptions, parameters and standards. We will use some standard parameters to make these calculations easier. Adjustments can be made to these parameters as issues change for your specific situation.
Consideration 1: Your Rate of Pay Is Not Your Actual Labor Cost
Let’s assume that you pay an employee $20.00 per hour. This is not your actual labor cost as there are other benefits and expenses that are related to this rate of pay. There are employer payroll taxes, worker’s compensation insurance and other benefits related to this rate. Let’s assume that employer taxes and worker’s compensation expenses add an additional 13 percent to the rate of pay. Let’s assume that there are no other benefits related to this rate of pay.
So, the calculation would be:
Rate of pay: $20.00
ER costs 13% $2.60
Total labor cost $22.60
Consideration 2: Calculating Your Annualized Rate of Pay
Let’s assume that you employ this employee for the full year, 52 weeks at 40 hours per week. That would mean that you are paying this employee for 2080 hours of work.
So, the calculation would be:
52 weeks X 40 hours X 22.60 = $47,008 per year.
Consideration 3: Determining Your Available Billable Hours
Let’s assume that you offer this employee one week of paid vacation, one week of sick time, and nine paid holidays.
Since you are paying this employee for 2,080 hours, we need to subtract these non-billable hours from the equation:
So, the calculation would be:
Hours paid for: 2,080
– Vacation hours – 40
– Sick hours – 40
– Holiday 9X8=72 – 72
Available Hours: 1,928 (48.2 weeks)
In this instance, with the effective reductions in available billable hours versus actual paid hours, the effective cost per hour can be calculated as $47,008 / 1,928 = $24.38 per hour. But, this would assume that the employee is being billed out for 100 percent of their available time, which is unrealistic. So, let’s make some additional adjustments.
Let’s assume that for each week worked, the employee spends five hours for administrative work and 10 hours for travel time to and from appointments. This means that they spend one hour per day for administrative work and two hours per day for travel. Remember, they are only actually working for 48.2 weeks per year.
So, the calculations would be:
5 hours admin work X 48.2 weeks 241 hours
10 hours travel X 48.2 weeks 482 hours
Additional adjustment: 723 hours
When we combine these adjustments to the previous available billing hours, the result is:
Available Hours: 1,928 (48.2 weeks)
Additional adjustment: – 723 hours
Available hours 1,205
So, to re-calculate the actual cost for this employee being paid $20.00 per hour relevant to the amount of hours you are able to charge for their services:
Annual cost: $47,008 / 1,205 available hours = $39.01 per hour.
So, just to cover the cost of this employee, the actual labor cost is $39.01 per hour, despite the fact that the pay rate is only $20.00 per hour. Remember, this assumes that you are billing out 100 percent of their available billable time. As the utilization rate of their available billable time reduces, the actual labor costs increase. For example, if you reduce billable hours from 1,205 to 950, the calculation will be:
Annual cost: $47,008 / 950 available hours = $49.48 per hour.
Consideration 4: Setting Your Billing Rate
There are a variety of issues to be addressed in setting the billing rate. The first is that the billing rate should at least cover the direct labor expense. The above calculations clearly identify how a pay rate does not accurately reflect the actual labor expense.
Secondly, one would assume that there are profits to be made from selling the services of labor. The above calculations do not provide for any profits.
Thirdly, one would assume that by selling labor services, there would be some contribution to the G&A (General and Administrative) expenses of the business to cover their operational expenses.
So, the above calculations ONLY calculate what the actual labor costs are for an employee being paid $20.00 per hour. To calculate how one must “mark up” these services to generate revenues to cover G&A expenses and a reasonable profit, additional calculations need to be made.
Some calculations use “key mark ups,” i.e., double key, triple key and quadruple key mark-ups of the labor rate. These calculations are based upon the actual labor rates, but are done in coordination with utilization rates.
Some calculations are based upon the actual fixed G&A expenses and desired profit margins.
In either case, the desired impact is that one should calculate ALL of these figures to determine the best method of calculation to assure that the billable rate generates enough revenue to cover the actual labor expenses, covers the actual G&A expenses and generates a reasonable profit.
Consideration 5: Calculating Your Actual Labor Cost
All of the above listed numbers, figures and calculations can be adjusted. Each business has specific needs and circumstance. It is critical to calculate all of them. G&A expenses can be adjusted. Labor costs can be adjusted. Benefits can be adjusted. Utilization rates can be adjusted. But, one thing is certain. If you pay an employee $20.00 per hour, that is not the accurate cost figure to use to markup labor services for a billable rate until you perform all of the other calculations. As we have identified in this example, a labor pay rate of $20.00 per hour could very easily be converted to an actual labor cost of $39.01 or $49.08 per hour. How you calculate the actual labor cost figure is critical!
So, if you find that your labor billing rate is killing you, it might be that you have not used accurate labor rates in your calculations. The descriptions provided should illustrate how you might be under-calculating what you should be charging.
In subsequent blogs, we will provide additional guidance on how to use accurate labor rate calculations to adjust your billing rate, how to increase the utilization rate, how to ensure an accurate G&A contribution from the billing rate, and how to maintain an adequate profit margin.
This is Part 1 of 3 in this series on this topic. Look for Parts 2 and 3 in subsequent postings.
As always, if you need immediate assistance regarding these issues, don’t hesitate to contact us at Tom Vignali CPA, Inc.
Contact Us:
Thomas W. Vignali CPA Inc.
118 Point Judith Road
Narragansett, RI 02882
T: (401) 415-0798
tom@tomvignalicpa.com
www.tomvignalicpa.com
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