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The Journey To Understand Cost Per Billable Hour

If you are a service based business owner up nights wondering if you're charging enough to cover your workforce, you're not alone. It’s your biggest expense after all, and crucial to your growth as you take on more projects. The worry doesn’t stop there. There’s also the delicate balance between keeping employees productive, but not overworked. So how do you truly know the answers to these questions without losing sleep? You analyze your utilization and get to know your “cost per billable hour”.

Utilization Analysis IG Pic

Let’s dive into this concept a little deeper to better understand how analyzing your utilization can give you the data to capture your billable rate. It boils down to a few key areas of understanding; labor cost, expected billable time, and utilization rate. All of these items are displayed readily for our clients in the Digital Agency Workbook - a detailed spreadsheet analyzing the company’s key expenses and revenue stats. Once you know these items, you can calculate out that magic rate.

Labor Cost

As mentioned above, this is your biggest spend as a service based business, but essential to follow through on your client commitments. This boils down to answering two major questions:

  1. what is your payroll expense?
  2. what are the expected billable hours spent working each year/month/week?

When calculating your labor cost, it is “full scale” payroll, meaning all the nuts and bolts on top of paying an employee. This includes not only salary, but insurance, benefits, payroll tax, 401k, etc. Since this will be your biggest expense as a company, the goal is to make it as efficient as possible. This means drilling down the details to know it inside and out per hour - from yearly, to monthly, to weekly. You will calculate the cost of labor against the time they are available to work to get each person’s “cost per billable hour”.

Time Tracking Is Of Utmost Importance

What is something you can never get back, once you’ve used it? Time. This is a major player in how best to start analyzing where you are spending those precious billable hours. This doesn't have to be complicated, but it has to be done in order to get an accurate sense of what each billable hour is worth.  Just for fun - write down how much time you spend on certain tasks for projects, then compare this to a day (or month) of actually tracking your time. I bet there will be a major disconnect between the two. This means the financial disconnect will be inline with the time usage disconnect. If you are not tracking time, you are not setting your service business up for success. If you are underestimating time spent on quoted projects, you are in for some inefficient and costly business lessons. Get an accurate picture of how much time is spent per employee and per job, so you can track and understand who is getting overworked and who can step up their use of time.

How can you make the time you pay for work better for you? You will need to set benchmarks surrounding your time spent on client tasks, then you will need to average it over time to get a sense of the typical time spent surrounding a certain task, to best calculate your hourly rate.

Nowadays, there are a ton of easy to use time tracking tools at your disposal. We use Harvest, which (like all of our other go-to systems) pairs nicely with other systems, like Quickbooks. If you are managing projects and using a system for that, chances are, they have a time tracking feature built in. Use it. These systems will help you quickly get a sense of where your time is going and how accurately your billing covers it. Depending on what you find, you may end up drastically changing your rates.

Utilization Rate

The utilization rate factors in the amount of time the employee spends directly on client work. Assuming you are considering a full time employee, for each 40 hour week, let’s say 30 hours will be directly billable to a client.

Within those other ten hours, you can assume that is time spent on vacation, sick days, and general/admin tasks like employee training, etc. Calculating this out into a percentage, you come up with a 75% utilization rate: 30 hours /40 hours = .75 .

For employees not spending the classic 40 hour per week on the clock, you will calculate this based on the hours worked directly on the client as well.

An employee who works 20 hours per week, having a target utilization rate of .75%, will need to be spending 15 hours per week on direct client work: 15 hours /20 hours = .75 .

For these examples above, your target utilization rate is 75%. By understanding this percentage, you can assess how many of their hours need to be spent on client billable work to stay inline with the goals of your company. Conversely, you can see how far off you are from efficiency each employee is, and adjust accordingly.

Putting It All Together

Once you understand what you are tracking, and how to best analyze it, you can start to understand what each billable hour needs to cover. We do this by calculating labor cost and dividing that by billable hours. Here is the breakdown:

Monthly Available Hours

Assuming you have an employee available for 40 hours per week, 52 weeks per year, they will have a monthly amount of available hours totalling 173. We come to this number by saying this person has (40 hr/week available) x (52 weeks/year) and divide that by 12 months.

Administrative Employees and Higher Level Employees

Keep in mind the employee’s role when it comes to mapping this out. A director level employee will have less billable hours dedicated to a project. A lower level employee will have a higher concentration of billable hours focused on client work. You will need to adjust your calculations accordingly to add their billable time into the equation. Maybe the director will have about 50 hours per month (approximately 12.5hrs/week) on the project, so use the most accurate number to get the best calculation. Also, you will not include employees solely dedicated to general and administrative tasks in this number either. They are going to be in your overhead/billable hour category and added on separately.

Target Billable Hours

To get the Target Billable Hours, you will need to multiply those available hours (173) by the target utilization rate (75%), to get your magic number. In this case, it is 130 hours per month.

For an employee working 20 hours a week, their magic hourly number per month to stay in line with a 75% target utilization rate, will be 65 per month.

Cost Per Billable Hour

To see what each employee will cost per hour, you simply take their total labor cost and divide that by the target billable hours. In the case of an employee costing $5,235.19 per month, with 130 billable hours per month, they will have a cost per billable hour of $40.27. If you use the normal hourly rate calculation and divide by the available 40 hour work week, it will produce a lower hourly number, but it won't be accurate. The overall goal is to factor in the time not spent on directly billed work to ensure your billable rates cover the outflows of the business.

Let’s play with some examples to see what happens.

Note the differences in calculations:

Correct calculation - an employee working 40 hours/mo, with 30 of those billable:

($5,235.19/ mo) / (130 target billable hours/mo) = $40.27

Incorrect calculation - same employee, but assuming all 40 hours/week are directly billable (which is typically not sustainable):

($5,235.19/mo) / (173 hours/mo) = $30.26

Only billing 20 hours per week: what happens when that same employee bills only 20 hours per week, versus the 30? It changes the dynamic of their expected utilization and cost:

($5,235.19/mo) / (86.66 hours/mo) = $60.40

A part time employee billing 20 hours per week: when that same employee is actually a part time employee, you can see how the percentage of expected utilization keeps the cost/billable hours in line with that number as a full time employee at the same rate:

($2,617.60/mo) / (86.66 hours/mo) = $40.26 - the same as the first calculation.

Assuming all of the data in the chart represents your actual employee dynamic, you can see how having too much indirect time skews the overall target company utilization, with the less efficient employees.

 

Viola! Now you know exactly what it costs you per hour for each employee to dedicate time to a project. Pretty cool, huh? This gets you started on the basic understanding of what each employee costs per billable hour. Once you calculate your overhead costs, you will have your overhead per billable hour, and can also add on profit margins, to round out a full scale review of where your pricing needs to be. Stay tuned for the next overview, where we will dive into more detail on those aspects that play into an in-depth analysis.

The biggest takeaway here is that your biggest spend (labor) needs to be properly analyzed in order to accurately project how much you should be charging a client to cover your costs. Without accurate time management and analysis of the full payroll expense, you won’t be able to understand where your rates currently are. By ensuring accurate time keeping and by implementing a proper analysis, you will have a better basis for continually reviewing and assessing your labor costs moving forward.

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We love this stuff, but we are also accountants who dig numbers.  As a creative person reading these stats, you may already be on spreadsheet math brain overload.  That's OK, because you can outsource this accounting piece to us and get the overview.  No calculation checks, necessary.  Tell us about your business and we'll be happy to hop on a call to see how assessing your labor and utilization rates can help your agency.

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