Author: Heinrich van der Vyver
As seen in Entrepreneur Magazine
We’ve all been there. Maybe you’re there right now. You charge out your work at a certain hourly rate, but you’re suspicious that you’re either a) being ripped off or b) hitting above your weight. It’s more than likely that the only way you judge if your pricing model is accurate is against what you think your competitors are charging. When a prospective client walks in with a quote from across the street to see if you can do the same – for less – you carefully examine that quote for clues as to what you should be charging.
More than that, there is often a real fear near the end of the month that you might not cover your running costs. You hope and pray for a big job to come in soon so that you can charge a big deposit and at least pay salaries.
I’m here to bring you good news today; there is a better way.
Determining Your Hourly Rate
Knowing what your true hourly rate should be in order to cover your overheads and expenses will give you a clear path to business control, growth and potential profit.
So how do we do it? Initially it takes a bit of work, but after it is calculated it is relatively low maintenance and will ensure you run your business smarter.
Start With Your Cost Centres
Aside from making up the basic framework and substance of a business, and being the basis for creating a profit, cost centres are what we use to determine hourly rate.
A cost centre is used to break the business into measurable portions in order to determine if that portion is profitable. A cost centre could be your design team, your delivery fleet, or your expensive machine that fills one third of your factory floor. The reason we break up a business into cost centres is to better identify and isolate variables to determine how efficient they are. This is less overwhelming than trying to improve efficiency as a blanket rule across the entire business.
If you have an ERP or BOS system in your business that handles your business admin and quoting, then make sure you understand how to set up your overhead and production cost centres in that system. We like QuickEasy BOS for this as it has a handy cost centre Wizard that allows business owners to have full control and clarity into this step. Alternatively, if you do not yet have ERP software, this will be a more manual process for you.
Every business has two types of cost centres:
A business has direct and indirect costs, and these require two different types of cost centres.
Production cost centres
These are the direct costs. These contain expenses such as equipment or computer costs, monthly maintenance and production salaries – costs directly associated with the production of a product or service that you sell.
- Machine costs: The total replacement value of a machine or computer or equipment, broken down to a per-month value.
- Maintenance costs: Does your equipment need monthly maintenance? This must be included in your calculation – perhaps this is your IT maintenance contract or your vehicle’s service fees. Provision must also be made for breakdowns and repair.
- Labour costs: Only salaries directly associated with production are to be added here. The machine operator and his assistant, the driver, the designer using his Mac book – their weekly or monthly salaries will be included in this cost centre’s cost.
Overhead cost centres
These are the indirect costs. These contain expenses that are not necessarily directly recovered from the sale of your product or service, but are necessary to support the business. These are expenses such as electricity, rent and admin salaries. Essentially the ‘expenses’ from the Income Statement, less the production salaries.
There are typically many production cost centres in a business, and only one overhead cost centre.
Overhead costing models
When considering how to cover overhead costs, there are two models that can be implemented.
The first approach splits the overhead costs across the business’s cost centres, and includes them in the hourly rate. This ensures that every estimate and quote covers a portion of your Overhead expenses. Each production cost centre accounts for a percentage of the overhead expenses – the larger the production cost centre, the greater portion of the monthly overheads is allocated to it.
Alternatively, overheads can be excluded in the hourly rate and added as an adjustment or markup in your quote.
Determining the hourly rate depends on the productivity within a cost centre. Knowing how many productive hours are available for work to go through that cost centre will help you determine what each hour should cost.
- Weeks per year: With 52 weeks in a year, not every week is productive for your staff members. There are two weeks of public holidays every year, and three weeks of annual leave. That leaves 47 productive weeks in a year.
- Hours per week: With 40 hours typically available per week, in reality most people are only productive 80% of the time. That leaves 32 productive hours per week.
To calculate the productive hours per month (which you will use to calculate hourly rate) take weeks per year, multiplied by hours per week, divided by 12. Or:
Hours per month = (weeks per year x hours per week) / 12
Note: Be attentive when it comes to your productivity calculation; not all cost centres are as productive as the next. If after a while you notice a cost centre only sees 20 hours of work a week for example, then the calculation will reflect a higher hourly rate. Initially you may have to do some thumbsucking to start the ball rolling; feel free to use these values (above) for your baseline productive hours as a start. Alternatively, your ERP or BOS system should show you monthly cost centre recovery so that you can adjust productivity accordingly. Once again, we like QuickEasy BOS for that.
Calculating Hourly Rate
We’re almost there – you’re about to find out what you should charge per hour for each of your cost centres.
To determine your hourly rate, total your monthly costs (equipment, maintenance, labour) and divide this by the productive hours of the cost centre, or:
Hourly rate = monthly cost / hours per month
Apply this to each of your cost centres. There you have it! Rinse and repeat. Now that you know what hourly rate is required, you can recover the costs of operating each cost centre. Once you have implemented this don’t just leave it there – salaries increase, equipment is replaced, electricity goes up – so be sure to review your cost centres from time to time to make sure your expenses are up to date and reflecting accurate costs.
After that, it is up to the business owner to determine if the cost centre should charge a flat hourly rate, or what markup or adjustments should be made to the calculated hourly rate in order to make a reasonable profit.
The guesswork is removed, anxiety is replaced with clarity and the business owner can make price-decisions based on fact.