In a previous blog, Is Your Labor Billing Rate Killing You? Part 1 of 3, we identified various issues on how to accurately calculate your labor billing rate.
At Tom Vignali CPA, Inc., we often advise our clients on how to effectively calculate out the actual labor rate in determining the actual labor billing rate. Additionally, there are other critical items that need to be considered when finalizing the billing rate. A company can charge an accurate labor billing rate, but that would ignore other fees that should be included in the billing rate. It might also ignore some other issues that affect the revenues collected. So, using data from the previous blog, we will address some of these other issues here, specifically:
Utilization Rate
Contribution to G&A (General & Administrative Expenses)
Profit Margin
So, in the previous blog Is Your Labor Billing Rate Killing You? Part 1 of 3, we identified the calculations that could be used to address ALL of the expenses for a $20.00 per hour pay rate on an annual basis, including payroll taxes, administrative, benefits, vacation, travel and sick time. The assumption was that you were paying the employee for 2,080 hours (52 weeks X 40 hours per week) on an annual basis at an annual cost of $47,008 per year, but after all of the adjustments were made, the company was only capable for billing for 1,205 hours, resulting in a labor cost of $39.01 per hour. This assumes that the company is able to bill for 100 percent of that employee’s available billable time, or, is at a 100 percent utilization rate. So, lets address that.
Labor costs increase as utilization rates decrease
This rate is based upon how much of the available billable time is actually billed for, not how many hours the company is paying the employee for. After all, revenues are generated from billing, and if you can only bill for 1,205 hours, that is the source of your revenues. So, if we use the above calculations for labor costs generated from an initial pay rate of $20.00 per hour with an annual cost of $47,008 per year with 1,205 hours available to be billed for, we can make the following calculations of actual labor costs based upon the utilization rate: ($47,008 / available billable hours = labor costs).
Billable Hours Utilization Rate Labor Costs
1,205 100% $39.01 per hour
1,084.5 90% $43.34 per hour
964 80% $48.76 per hour
843 70% $55.76 per hour
Now, it must be noted that all of the calculations identified in the previous blog Is Your Labor Billing Rate Killing You? Part 1 of 3 must be calculated out according to how much and what the company is paying for. In some instances, companies only pay for work performed, and in this instance, the utilization rate will always be 100%, but the actual labor costs will still be higher than what the pay rate is.
In either case, the above illustration of the utilization rate should indicate how the actual labor rate increases as the utilization rate decreases. Of significant note from the above illustration, based upon the calculations provided, a rate of pay of $20.00 per hour could actually result in a labor cost of $55.76 per hour based upon the available billable hours and the actual utilization rate. It must be (and often is) shocking when a company thinks that their labor costs are $20.00 per hour and the calculations reveal that they are $55.76 per hour! The amount of hours you pay an employee for, and the amount of hours you bill a customer for that employee’s services, are usually different. The amount you pay the employee versus the amount you charge for that employee are usually different. Pay rates, labor costs and labor rates ARE NOT the same thing! In the above example, at 100 percent utilization rate, we could calculate the following:
Pay rate: $20.00 per hour
Labor Costs: $39.01 per hour
Labor Rates: $39.01 per hour + contribution to G&A + profit margin
(Final amount to be determined).
Don’t overlook contributions to G&A (General & Administrative Expenses)
So, there are a variety of considerations here. If your company generates revenues solely from the sales of service, then 100 percent of the G&A expenses must come from the sales of services. If there is a mix between services and product sales, then the company must make a calculation as to what the contribution to G&A should be from product sales and what it should be from service sales. Sometimes this can be calculated out as a respective percentage of revenue volume for each, whereas sometimes the percentage calculation should be based on other issues.
In either case, if you sell a service, the company should be covering the cost of that service and making a contribution the G&A expenses of the company. We won’t get into product sales or G&A contributions here, but they are variables that impact the service/labor-related contributions to G&A.
Of significant note, though, is that the contribution to G&A expenses, when part of a billing rate for labor/services, often far exceeds that of the labor costs. In other words, when calculating out a billing rate based upon services only, the revenues dedicated towards G&A expenses usually far exceed those dedicated towards labor costs!
So, to make this very simplistic, using all of the previously stated financial data, assuming that the company only has one employee that they are paying $20.00 per hour and that they are billing out 100 percent of that employee’s billable time (1,205 hours), with a labor cost of $39.01 per hour, with an annual G&A expense for the company of $175,000.00, the following calculations would exist:
G&A: $175,000.00 / 1,205 billable hours = $145.22 per hour G&A contribution
Labor Rate: $39.01
G&A Contribution: 145.22
Revised hourly rate: 184.23
Now, this figure is purely astounding, and many service companies would claim that there is NO WAY that they could generate $145.22 per hour from their fees as a contribution to G&A. But then, no company is using/charging for just one employee to generate their total G&A expenses.
So, if the company had 10 service employees, all at the same rate of pay, at the same utilization rate, the calculation would be:
G&A: $175,000.00 / 1,205 billable hours = $145.22 per hour / 10 employees = $14.52 G&A contribution
Labor Rate: $39.01
G&A Contribution: 14.52
Revised hourly rate: 53.53
Now, this looks much more realistic! But there are other issues to be addressed.
Let’s just remember, we’re still dealing with all of the same basic assumptions and have added an annual G&A expense of $175,000.00, have increased to 10 the number of employees paid at $20.00 per hour and haven’t included any product sales. Calculations for a blended contribution to G&A and Profit Margins from the Labor Billing Rate and Product Sales are something we can discuss on an individual basis at a later time. It is critical that these calculations be developed specifically for each individual business.
Zeroing in on your profit margin
So, now for the final issue. Every company should calculate for a profit margin. So, let’s be modest and project for a 15 percent profit margin mark-up on fees charged. Let’s use the above labor rate charge of $39.01, the G&A contribution charge of $14.52, and mark that up by 15 percent. The calculation would be:
Labor Rate: $39.01
G&A Contribution: 14.52
Sub Total: 53.53
+ 15% Profit Margin: 8.03
Total Hourly Charge: 61.56
Interesting to note: in the previous blog Is Your Labor Billing Rate Killing You? Part 1 of 3, we had discussed mark-up calculations based upon labor rates and pay scales. Based upon the above calculations, if a company had used the base pay of $20.00 per hour and marked it up by 3 (triple key), it still would have been inadequate to cover the expenses and profits required in the hourly charges calculated. The difference of $1.53 amounts to approximately $19,000 in lost billing revenues.
But, let’s see how this would look in a basic Income statement based upon the 10 employee/100 percent utilization rate scenario:
Revenues: 741,798.00 100% (10 X 1,205 X $61.56)
Direct Labor Expense: 470,080.00 63% (10 X $47,008.00)
Gross Profit Margin: 271,718.00 37%
G&A Expense: 175,000.00 24%
Net Income: 96,718.00 13%
Notice that the Net Income is less than what the Profit Margin mark-up was. Also, if the $96,718.00 Net Income sounds really great, just remember:
$96,718.00 / $61.56 (hourly rate) = 1,571 hours / 10 employees = 157 hours / 48.2 weeks worked = 3.26 hours per week.
In other words, if the hours billed for all employees are reduced by just 3.26 hours per week, the Net Income would be eliminated.
This is Part 2 of 3 in this series on this topic. Look for Part 3 in a subsequent posting, where you will find our
final conclusions and recommendations.
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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