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Factoring in all the variables, and ways to learn financial management. July 24, 2002

Question
We have a seven-person shop utilizing around 5000 square feet. We are trying to come up with a fixed cost per hour to charge our clients. We know our fixed cost. Our employees are all paid at different rates. Do we average employee's wages with our fixed cost or what?

Forum Responses
You need to forecast how much work you expect to do over the next fiscal year, i.e., you are going to work about 260 days for the year, giving you a capacity of 14,560 billable hours (260x7x8). Unless they are queuing four deep and ten wide for your time, you are not going to bill all that. Set a target at what you think you can do, like 60%, or 8,736 hours. Add up your payroll for the year. Let's say the total direct (gross) payroll (including your direct time!) is \$400,000 per year for .5 of your time and seven of your people. If you're going to give raises, collect for them now and add 5% or whatever. Your direct labor charge is now \$400k/8,736 or \$45.78 per hour.

Overhead is something no one wants to pay for, but it's necessary. My advice: find out what overhead rates your competition has, peg it at that or a point lower, and drive your costs into that range. Example: space, machinery, office, labor, sundry items come to another 400K per year. This is 100% of your direct labor charge. When you bid a job, figure the effort in direct labor hours, multiply by 45.78 and then double it. To make a profit, add your target profit margins to that.

I think that a 52 minute production hour is more realistic, because of taking coffee breaks, getting tools, getting stuff, asking questions, using rest room, cleaning paint gun, etc. The 52-minute hour has worked for me in the past.

From contributor R:
To figure out the labor rate, you need to know your actual labor costs, which include:
- Workmen's comp insurance - usually a percentage of payroll multiplied by an experience modification rate.
- Company's contribution to Medicaid/Medicare, 7.65%.
- Company's contribution to unemployment insurance, determined by unemployment office.

- Benefits you may offer, such as health. (Monthly costs divided by hours worked per month will equal hour cost per employee.) Seven employees working 40 hours per week x 4 weeks =1120 working hours. If your monthly health insurance cost is \$3,500.00, divide the 3,500 by 1,120. The cost per hour per employee is \$3.12.

Also, you must add in any benefits like company contributions to pension plan, etc. If you really want to get specific, add in vacation time and holidays if offered. An employee that has two weeks vacation and is paid 400/week costs you \$800.00 per year of non-billable time. It would come out to about \$0.40 per hour based on working 40 hours a week for 50 weeks (you gave him or her the other two weeks off). If you offer paid holidays, this is also a cost of labor. If you offer five paid holidays per year, a \$10.00 an hour employee would cost an additional \$0.20 per hour. This also goes for paid personal time or paid sick time, if offered.

An employee making \$10.00 per hour:
Cost of med/social security \$0.77 (7.65)%
Cost of workmen's comp \$0.65 (used 6.5 percent; use your rate)
Cost of health insurance \$3.34 (used monthly cost of 550.00)
Cost of vacation time \$0.40 (two weeks vacation)
Cost of holiday time \$0.20 (five paid holidays)
Cost of personal and sick time \$0.20 (five sick and personal days)
Cost of pension plan \$1.00 (\$1.00 per hour)
Total direct cost for an employee is \$16.56 per hour, based on the above. If you don't offer all of this, omit what you need to.

Now add your overhead costs. This can be done in many ways. I try to break it down so I know what my daily budgeted overhead costs are. If I plan on buying new equipment, I factor this into the equation. This includes everything else but billable material and subcontractors, all vehicles, cost of equipment loans, professional fees, repairs, utilities, office help, your salary if it is not billable, etc.

Let's say it is \$150,000.00 per year. Divide by total working hours per year. (13,440 - these hours are based on seven men working 40 hours a week for 48 weeks. We gave two weeks vacation, one week for holidays and one week for sick personal time.) The overhead cost per hour for each man is \$11.16. The actual cost to run the shop and pay its employees is \$27.72/man hour worked (assuming all employees make a base rate of \$10.00 per hour).

At this rate, you have covered your costs, paid your employees and paid yourself if you figured your salary into overhead costs. The problem is, it does not take into account un-billable time, unforeseen costs which may arise, and a fair profit for the company.

Most companies shoot for a minimum of 10% profit. We will also add on 10 percent for unforeseen circumstances. So we add an additional \$5.55 per man-hour. Our total billable rate is \$33.27 x 13,440 hours billed = \$447,148.80. The direct cost of labor plus direct labor costs is \$222,566.40 (which is based on actual hours worked).
Total costs are \$222,566.40 + 50,000.00 = \$372,566.40
Profit is \$74,582.40 if everything goes as planned.

This number does not include materials. Adding 10-20 percent on top of material costs is a common practice. Also, adding 10-20 percent on top of subcontractor costs is common.
Your final hourly rate will also be determined by past expense history and how efficient your shop is, especially on jobs with a set cost. Once you start to track your costs, you can easily adjust costs on future work as needed to make a fair profit. Using extra material and/or additional labor, which is not billable, would also bring profits down.

There are many ways to determine costs on a job. Some people guess and hope they make money, some people use formulas, such as three times material costs. I bet most successful small business owners have one thing in common - they know their costs and track profitability on jobs by doing job cost analysis. Time will also affect the above rates.

By tracking profitability per job, you can determine if you are charging enough to make ends meet. This also allows you to make decisions on raising costs or cutting expenses if necessary, rather than in 6-12 months when tax returns are done or there is no money in the bank and it may be too late.

I would have one or two rates based on the higher pay scale in your shop, such as a craftsman's rate and a laborer's rate. It is difficult to explain to clients why you have 5 different rates for people doing the same job, unless it is a specialty like finishing, etc. Using the higher rate allows flexibility for raises and covers time spent training help and unforeseen costs.

You could also take an average of all the rates, including all direct labor costs, and base your hourly rate on this. This works fine if everyone works the same hours. Averages get out of whack if your more expensive guys are working more hours than the others. Cutting back help and ending up with only the more expensive guys can also throw the average out.

I agree with the above post. We also take into account the time and costs of our training program and use 50 minute hours. We have two general shop rates based on wage/skill level and bill the higher cost machines (CNCs, bander, panelsaw, molder) at their cost plus operator.

Where did you guys learn all of this information?

From contributor R:
There are many different ways to obtain information on job costing, budgeting, and financial management and running a business.

1. Most community colleges offer what I call short courses. They are not college accredited courses and anyone can take them for a fee. They are not always taught by professors, but sometimes taught by professionals who have experience in the area being taught. The course usually runs 1 or 2 days a week for 5-6 weeks. They basically give you what you need to know and eliminate the BS. Most everything is in laymen's terms. Some that I have taken include small business management, financial management for business, accounting for small business and personnel management. Some high schools may also offer these educational programs.

2. "Score" Services Core of retired executives is an organization that has chapters around the country. They also have a web site. The organization is composed of retired executives who volunteer their services to small business. They also run workshops and encourage business development. They will also work with businesses on a one-on-one basis.

3. Local Chambers of Commerce sometimes sponsor seminars on small business management. When you become a member, they will send you information.

4. Trade shows and trade organizations often have one or two-day seminars emphasizing management and running small businesses.

5. Most accountants can provide job costing information and budgeting information. They use the information you provide them, such as insurance costs, labor costs, etc., and put it into budget form. Once you have it set up, you need to keep up on it to make it a useful tool. Update it as necessary and keep track of costs and sales. Meet your accountant a minimum of once a month so she or he can maintain profit and loss statements and give you an overview of your company. For example, if your sales are below budget for the month of February but your costs remained the same, you know going into March that you either have to increase sales to cover February's losses or cut costs or a combination of both to stay within your budget. By tracking it a minimum of once a month, you get a financial picture of your company and you can adjust accordingly. The first company I worked with did a P&L statement once a week along with a job costing statement. Business consultants are another source of help.

6. Then there is the school of hard knocks. Learn as you go and ask a lot of questions. Sort through the answers and discard the ones that are not useful. What might work for one company may not work for another. Talk to other professionals and get their advice. Many communities have networking groups from various industries that meet and discuss problems and business concerns and use each other to bounce ideas around. They may not be from the same industry, but they have similar problems and concerns. Joining one of these groups can provide a wealth of information. Learn from your mistakes.

7. Let your employees know estimated times to complete work. Track the hours and see how close the estimate is to the budget. If you know the employee worked diligently on the project, but it took them 20 percent longer to complete it, you know next time you need to include more time in the estimate. Giving employees budgeted hours sets a goal for them and makes them more conscious of their work. You can also use incentives - by bringing jobs under budget (and maintaining quality), the employees are given something in return (cash is always appreciated).

Tracking hours puts the burden on the employee. Have a time sheet or job sheet that the employee or shop foreman fills out with the employee's name and time spent on each job. (The last thing you need to be doing is chasing employees down for times.) Tie it to payroll and let them know they are paid off the sheet. You can still keep a time clock to verify start and stop times, but utilize the sheet for payroll. Also, time sheets allow you to quickly bill any job that is time and material, without having to go back and ask each individual how much time they spent on a particular job. It is also a document that can be referred to six months later, if need be.

8. Watch costs. For example, if you are working on a 10 percent profit margin and you spend \$100.00 dollars foolishly, it will take \$1000.00 of sales to make that profit back. If you save \$100.00 intelligently, you decreased the need for a \$1000.00 worth of sales.

Divide your Total Indirect Costs (overhead, rent, insurance, benefits, utilities, receptionist, everything besides your labor cost on a project, and the supplies for that project) by your Total Direct Labor Cost in dollars (all labor costs associated with specific projects). You may use your prior year totals or estimate the current year's totals. You'll come up with a "multiplier". Add 1 to this "multiplier", multiply your hourly wage by this number, and you will cover your Overhead.

Total Indirect Cost (\$)
Total Direct Labor Cost (\$)

Example: My Labor Cost for the year = \$25,000

All my other costs (including my receptionist) = \$35,000

\$35,000
-------------- = 1.40
\$25,000

1 + 1.4 = 2.4

Profit Percentage: 10%

2.4 + .10 = 2.5