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Understanding Labor Pricing By John Zink, Director of Education and Programs When a new contracting company starts up, how does the business owner know what to charge for their work? The simple answer is "Enough to cover all expenses and earn a profit." The tricky part is properly determining what those expenses are. Remember, no amount of optimism can change the simple fact that if you don't charge for all of your expenses, you will go out of business! Let's take a walk through one business owner's process for determining his company's pricing model. Tom, our business owner, is starting up a new company. He is fortunate to be well known and liked in his community and already has a network of customers ready to use his services. He plans to spend his days in the office, running the business and securing additional work for the four technicians he has found to employ for his new company. Tom has also found a receptionist/office manager who will field calls and handle most of the office paperwork. For Tom to determine his cost of doing business, he needs to calculate his expenses for materials, labor, overhead and profit. Materials pricing is available from the supply house, so we will focus completely on the three other areas.
Labor Costs Tom also has to consider his techs' productive time. No technician spends every minute of their day doing work that the company is being paid for. There are also holidays, sick days, vacation days, training days, time driving from one job to the next and a host of other important, but non-billable activities to consider. Tom adds up the time lost to each of these activities and determines that only 65% of each technician's time will be spent doing billable activities. He also realizes that he will need to track how warranty work and call-backs affect this productivity rate over the next year. Tom plans to have each of his techs work 40 hours a week. He combines this information with their salaries and the percentages above to develop a simple worksheet to determine his hourly labor costs. Worksheet #1 Simplified Direct Labor Costs
*A 40-hour work week equals 2080 hours per year. Tom now knows that he needs to charge his customers $38.46 per hour just to pay for his technicians and nothing else. Next he has to account for his salary and all the other company expenses that fall into the overhead category. To do this, Tom will need to create a detailed analysis of all his known and expected expenses for the coming year. As a new business owner, Tom must do some thinking and planning ahead to determine what these costs might be.
Fixed and Variable Overhead Worksheet #2: Simplified Overhead Table
Note: Please keep in mind that the values listed are for example purposes only. You will need to determine your own costs for these line items and any others that you wish to include in your calculations. Tom missed a few items in calculating his overhead, but he has a good start. As other costs become apparent, he will add them to this sheet and make adjustments to his pricing accordingly. Tom now has the information he needs to determine his company's true cost of doing business, otherwise known as the break-even point. He adds his $208,000 in annual labor costs to his $267,900 in annual overhead and then divides that number by his tech's 5,408 billable hours. This calculation tells him that he needs to charge his customers $88 per hour just to break even and pay for the everyday costs of running the company.
Calculating Profit To calculate what to charge for profit per hour, Tom uses this formula: Profit per Hour in Dollars = 20% divided by (1 - 20%) multiplied by $88 This calculation gives him $22 to charge for profit per hour. Tom adds this to his $88 break-even rate for a total of $110 per hour. He could have also just divided his $88 break-even rate by .8 (80%) for a total of $110.
Worksheet #3: Calculating Profit & Hourly Labor Charge
At this point, Tom has to take a moment to collect his courage. He knows of companies in the area charging $40 an hour. After reviewing his numbers again, he knows that if he wants to pay his real costs, pay his technicians and pay himself what he wants to earn, he must settle for nothing less than what the real numbers on his worksheets have told him. Tom soon learns that when his clients are happy with the professional, high quality work and great customer service from his company, they are not concerned with his hourly rate. Tom eventually also finds other ways to manage his hourly charges, including applying profit against material mark-ups and flat rate pricing systems. Understanding overhead and proper pricing is a crucial piece in the puzzle of creating a successful company, especially for new business owners. The simple worksheets above are just a starting point and just one part of a more complete overhead education tool that will be available from the PHCC Educational Foundation later this year. In the meantime, if you would like to practice calculating overhead and pricing based on the example worksheets in this piece, please click the link below. You will be able to plug in different numbers to see how they affect the company. If you want to save the file to your computer, you can move your cursor over the link and click your right mouse button. Select "Save Target As..." and choose where on your computer you would like to save the file to view it later. |
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