Remember Vince Lombardi, former head coach of the Green Bay Packers, for whom the Super Bowl trophy is named? He won many championships over the years, but he started every training camp the same way: teaching foundational principles. It didn’t matter if you were a 10-year All Star or in your rookie season. Everyone went through the basics because coach Lombardi understood that a mastery of the fundamentals won ballgames.
It’s no different in contracting. Unless the team fully understands the fundamentals of proper labor pricing, it’s tough to make a profit. The foundational principle of proper labor pricing is that rates need to be calculated from a cash-flow, not accounting, standpoint.
Equipment Replacement Dollars
When a vehicle or piece of equipment is purchased, Uncle Sam typically allows the owner to write off the cost over five years, or 20 percent a year. This becomes a cost of doing business in the form of an overhead cost called depreciation. Equipment replacement, however, looks at the same piece of equipment from a different viewpoint. Equipment replacement asks how many more years the equipment will last and what will it cost to replace, then builds the future cost into today’s pricing. When it’s time to replace equipment, the owner then has the cash to pay for it.
For example: A vehicle purchased three years ago for $25,000 is estimated to last four more years, and the cost of replacement will be a net $28,000 after trade in. That means the equipment replace cost would be $7,000 per year ($28,000 / 4 years = $7,000 a year).
Typically, equipment replacement costs will be at least twice the accounting depreciation figure (since it is dealing with past costs, not future costs), and equipment replacement costs will typically be the company’s second-highest cost of doing business.
Direct and Indirect Labor
Indirect labor covers overhead people — normally office staff and/or owners — who do not work in the field.
Direct labor covers technicians working in the field whose time is normally billed directly to the customer. Direct labor has significant amounts of nonbillable time. Nonbillable time is composed of shop time at the beginning and end of the day. It also includes travel time between jobs; vacation; sick days and holidays; callbacks; warranty work; and company meetings. A typical service technician making multiple calls a day will have nonbillable time in the range of 50 percent. Install crews will be in the 15 to 20 percent range.
Think about that for a moment: If you have a service tech making $18/hour, or perhaps $20/hour when you include company matching taxes, that tech is costing the company $20,000 a year (1,000 nonbillable hours per year times $20/hour = $20,000/year) in nonbillable time. That $20,000 needs to become part of the company’s overhead cost just like rent, utilities and insurance.
Fixed and Variable Overhead
Fixed and variable overhead are the basic costs of doing business including gas, insurance and office supplies. Be sure to also include the following, often overlooked overhead costs.
Money that is not, and will not, be collected
Many companies have past debt that needs to be paid off: taxes, money owed to a supplier, a line of credit or personal loans. Decide how many years you want to take to pay off the debt, and build the repayment cost into the overhead.
Full amount of the loan payment is another huge difference in cash flow and accounting. If you have a $500-a-month loan payment, $100 of it is interest and the other $400 is principle, the only thing that shows up in the accounting P/L statement is the $100 interest. However, from a cash-flow perspective, the company wrote a check for $500, which flowed out of the company. If a company has a lot of loans, this can be a major reason your accountant says you are making money — which you will have to pay taxes on — while there is no money in your checkbook!
Material and Equipment Costs
When the company purchases materials or equipment to resell to the customer, they will often mark up the item to generate a net profit. The markup on the items sold can, and will, absorb some of the fixed and variable overhead of running the business.
Amazingly, many company owners do not pay themselves a regular salary; they simply take money out when needed. But if you don’t build rent, utilities or insurance into your customers’ pricing, it won’t get covered. Likewise, if you don’t build your salary into your cost of doing business, it won’t get covered either. Put a family budget together to determine what salary you need to earn, and build it into your cost of doing business as indirect labor.
Calculating Your Rate
To set simple, profitable hourly rates, first calculate the company’s total annual equipment replacement costs by listing all vehicles and equipment over $1,000 in value. This will become one of your fixed overhead costs a bit later. Next, calculate all indirect labor costs and include your costs of matching taxes — Social Security, federal unemployment tax and your unique state unemployment rate.
When it comes to direct labor in the field, determine the cost of nonbillable time, which will become an overhead cost. Next, determine the actual number of billable hours to the customer (total hours the company pays for less nonbillable hours. Calculate the weighted, average hourly rate of all direct labor personnel, then total the real cost of doing business — including fixed and variable overhead, direct and indirect labor, cost of nonbillable time, full amount of loan payments, equipment replacement costs and matching taxes. From here:
Project how much gross profit will be generated through the sale of materials and equipment over the coming year.
Calculate the overhead rate per hour. Take the total cost of doing business and subtract the projected gross profit, then divide the remaining number by the billable hours.
For example, let’s say your overhead rate is $48.78/hour:
Determine the breakeven hourly rate. This is the rate you would need to cover all the company’s costs of doing business but would not generate a net profit. The breakeven rate is the combination of the overhead rate per hour ($48.78/hour in our example) and the average hourly rate of the direct labor people. If the average rate were perhaps $16.53, the breakeven rate would be $65.31.
Add profit to the equation to determine the final rate. To generate a 10 percent net profit, divide the breakeven rate by 0.9. If the company wants 15 percent net profit, the hourly rate would then need to be:
= $65.31 / 0.85