You are diligently tracking time. You understand that you must consider the actual time you can allot to dedicated client work, and you are calculating the expenses that will always exist to run the business, whether you have a ton of clients or not. Good job! Now, let's make it all make sense by figuring in the profit margin you will need to consider to make offering your services truly worthwhile.
Obtaining this magic number lies in calculating the billable rate, and it can start to get a bit complex. Like utilization analysis, we will walk through each piece of the puzzle to make sure you are accurately taking each step to arrive at your magic number. While there may be a few fluctuations due to things like market rate for similar services and personnel, the basics required to accurately estimate your best billable rate will always be there.
How to Get Billable Rate
The billable rate is the rate you charge each client to provide your service. How do you get it, and how do you pick one that actually makes you money?
The calculation for your billable rate is:Cost per billable hour + overhead per billable hour x (profit margin)
Seems simple enough, right? But let’s make sure you understand how to accurately get these numbers, so that the billable rate remains an accurate calculation.
“Per Billable Hour” - What Is The Hour?
You'll notice that each of the items in the calculation are “per billable hour”. Remember our billable hours are our inventory, meaning the number of hours we actually have to offer to client work. This is how we make money as a digital agency. We don’t have 40 hours per full time person, it’s likely 30 for the classic full time employee. We need to look at the true hourly rate, so leave the 40 hrs/week calculation alone. We only want to consider the actual time we have to dedicate to meeting our client’s needs. For a refresher, go back to our rundown of Professional Services Accounting here.
In the example below, you see in the highlighted green areas our calculation of the hours available for each production and overhead staff. Since all of our production staff are full time, you can see the consistency in the “available hours” column, then the changes in the “target billable hours” column, as the utilization rates come into play. For the general and administrative staff, their expected utilization is 0, because they are not directly client facing.
To be a successful service based business owner and manager, you need to be laser focused on how each hour is spent and ensure each is used to max efficiency. Your time keeping efforts are the basis of this.
What is The “Cost” in Cost/Billable Hour?
The cost we consider in cost per billable hour is your full scale payroll expense against the utilization rate of each employee. We discussed this in detail in describing Utilization Analysis, where we walk you through assessing the capacity and output of each employee based on their time spent on the client work versus general and administrative work. This calculation of cost takes into account all of the employees and their utilization rates (their payroll cost divided by the hours they work).
In the example below, you will see a summary of the annual and monthly payroll expense (base salary, commissions, insurance, 401k, etc.), the available and target hours (as highlighted above in green), with the cost per billable hour to the right. You can see the difference in cost per billable hour for the same staff class with same payroll, but different utilizations in yellow. In the orange line item, you can see how the cost increases by staff level (Sr. Developer), as salary increases, and typically utilization expectations decrease.You can see the underutilized employee in orange costs more, while the over utilized employee in yellow costs less per hour.
Remember, your two biggest outflows of money are production cost (the payroll expense associated with doing client work) and overhead (the general and administrative expenses, plus the typical cost of running a business).
Overhead Per Billable Hour
To get this number, look at your overhead expenses. Overhead costs are those that need to be spent in order to keep the business running, with or without a ton of clients. This includes your human resources staff, marketing and sales, overhead expenses like rent and utilities, subscriptions, administrative staff, expenses, etc. Now you will need to turn that into an hourly rate.
Looking at them from a monthly perspective, there will be variations. The variations will come from things as simple as the days (and associated hours) of each month changing slightly, to things like the amount of people on the job and their availability or utilization.
In the example below, you will see a summary of the overhead expenses highlighted in yellow that show the salaries of our G&A employees, as well as basic overhead expenses. The calculation of those overhead costs in a per hour calculation are highlighted in yellow in the bottom row.
As you look at the other expenses outlined, you will see the totals from our production labor (direct client work) up top, and the total expected billable hours in the second to last row. See how each month varies slightly? This affects the overhead per billable hour cost in relation to those changes.
As your revenue and your team grows, your overhead per billable hour should decrease due to cost efficiencies For example, your human resources employee(s) still supports the company’s HR needs whether it spans 20 or 40 people. Or, from a general expense perspective, you will still need to pay rent whether you are filled with 10 people or 20. You can see this in the example above, as the hourly capacity goes up, and the overhead per hour dips down from $50.28 in January, to $44.11 in April.
Before Moving on to The Profit Margin, Let’s Remember...
Not only does the importance of accurate time tracking come into play in your cost per billable hour, but timely and up to date bookkeeping as well. You need to have both accurate reports of time and expenses each month in order to make an accurate calculation of your production and overhead costs and the time associated with it.
The Margin Piece
Now that you have figured out your major expenses in the production cost and overhead, it is time to figure out how much it will take per hour with various profit margin levels. We typically factor in 20% as a good point to pay the business owner(s) and keep the business moving forward in a healthy fashion.
In the example below, you can see the variations in what your billable rate should be based on the profit margin in the columns to the right. You can see the swing that is created by our two employees outlined in red, this (again) is related to their cost per billable hour, and influenced by their utilization rate being less or more than our target percentage. The average overhead per billable hour rate is outlined in green. This is what we are adding to the cost per billable hour, to get the numbers in the “plus overhead per billable hour” column. The bold numbers in the “blended” row provide the average, or target rates across all of the entries.
Looking at the various employee costs, you will get a sense of how much variation there is across all of them. Again, this will be a function of their utilization and labor costs. Seeing the rates based on each profit percentage, will help you see how much you can charge and how profitable you can be. As a decrease in overhead cost comes into play as you take on more client work, you will see a bump in your profitability as well.
Outlining the various margins and drilling them down to your end rate, will give you an idea of how much you should be charging. In the example above, $130.95 seems to be the rate to charge to cover your production labor and overhead, while factoring in a 20% profit margin. In an industry where $150/hour is the norm, this may give you the opportunity to bring in a 30% profit, and potentially more, once you’ve leveled out the variations in the two employees outlined in red. Conversely, you may need to stay within a tighter budget to bid a project competitively. In this case, you can see that your focus needs to be on maximizing your staff’s utilization, to stay profitable.
The Bottom Line
In the examples outlined above, it is easy to see how one or two employees off their targets can greatly skew your optimum rates, but you will not be able to address those challenges until you have accurately identified the time usage and your overhead costs. This is a result of timely bookkeeping and accurate time tracking. Once you have mapped out your available hours properly, and matched them to both your overhead and production costs, can you figure out your billable rate. It may be a complex calculation, but it is literally the lifeblood of your business success.
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If this sounds like a great plan, but is a bit too complex for the creative type you are, we get it. We love this stuff, so why not let us manage this for you, so you can focus on doing the work you love.
If you are an accounting pro seeking a change of pace and prefer to lend your talents to a growing company that appreciates work/life balance and keeping accounting fun, look no further. Join the team where people are greater than numbers. Take a look at our current openings, or send us your resume and an introduction. We hire when we find the right fit, not just to fill a desk.