How to Calculate Cost Rate the Right Way (and Avoid Undercharging for Services)

BY MARK VAN LEEUWEN, ON AUGUST 5, 2020

Why do so many professional services organizations undercharge their clients? 

Some are simply aiming to offer services for cheaper than the competition. Even scarier: Some are unaware that they’re doing it at all. 

No matter the case, one thing is certain: These companies are using bad cost rate calculations, and they’re killing their profits. 

Without the right employee cost rates, you cannot ask the sales rates your services are worth. Likewise, if you don’t make cost and sales rates transparent to those responsible for projects’ financial success, you’ll struggle to save your margins from cost overrun. 

In this article, we’re going to share:

How bad cost calculation is costing services businesses

How low is too low?

Contrary to what you might assume, selling projects at an unsustainable price is not the type of thing you’ll automatically recognize by gut feeling. And if you’re basing your prices on what your competitors are doing, you’re playing a dangerous game. 

Ultimately, selling your services too cheaply leaves the business coffers empty. It tanks your profit margins and ensures that you won’t generate enough money to invest in your company’s growth. Without growth, there is no continuity.

Those of us in professional services must invest time and money into growing our expertise to stay competitive and keep the company alive. We have an obligation to innovate, to accumulate new industry knowledge and to branch out into newer, better services for our target markets. 

To do this, we need the right resources, which means we must attract field experts to our teams. But that is impossible if you’re using the wrong cost rate formula. You won’t know what price you need to sell your services for in order to make a high enough profit to put them on the payroll. More likely, you’ll unwittingly undervalue your team’s work during the negotiation stage of the next project. 

Rinse, repeat.

Selling projects for the right price

When services businesses price too low, they’re typically only focusing on making up for the individual salaries of project staff. On its face, this seems like a logical strategy. Business expenses aside, projects only cost the company in human hours. 

But this is false logic. 

To their detriment, these organizations are not accounting for their overheads and their much-needed profit margins. Consequently, they’re barely scraping together enough cash to pay their staff’s salaries and benefits. Or rent.

How much does an employee really cost?

When you have people working on a project, they’re not just costing what you pay in their salaries. After all, it takes money to supply an office or a home space to work in. Then there’s the IT, marketing, advertising, sales, management and administrative costs. 

These indirect costs and your staff’s wages aren’t mutually exclusive. Calculate hourly cost rate just by salary, and you’ll miss what you need to earn to make up for your company’s overheads. And without them, there is no business.

Think of this way. Those IT systems, insurance policies and ad campaigns are the costs of staffing your business. So realistically, employee cost rates go well beyond salary and benefits.

Pay attention to your profit margin

To set the right sales rates, you cannot leave out your margin. What does it need to be in order to make a healthy profit? Whatever you’re charging your clients, you need to know what you should be earning per hour in order to achieve the required margin and adjust pricing as necessary.

Most services businesses feel that it’s difficult to achieve the maximum billable hours per year. And if you’re not using your profit margin, that’s true. If you have a target of 80 percent billable hours for your employees to achieve and you’re selling their time for their wage costs plus overheads and divided by 100% billable hours, you’re losing money. If you’re only selling 80%, you need to factor the other 20% into your profit margin to make up for those lost hours and make a profit. 

If you add your profit margin to the overall equation, you’ll get a higher sales rate than what you would normally ask for. In other words, you’ll protect your profitability.

Why your project managers need access to employee cost rate

Your first defense against pricing projects incorrectly is to account for the company overheads and profit margins in cost and sales rates. Your second defense is to have management’s eyes on these financials.

Bad cost rates will likely continue to haunt your projects and profitability unless your account managers, sales managers and senior project managers—those responsible for the sales results—understand what makes projects successful or not.

They need to have a very clear understanding of what happened in the project in order to explain the profit margin.

If it’s lower than expected, one of two things (or a combination) happened:

  • The project team used more hours than estimated at the beginning of the project
  • Your employees executing the project were more expensive than originally calculated

In the middle of the project, did the project manager need to recruit more expensive resources with the right expertise to achieve the desired results? While the project’s sales rate remained the same, cost rates went up, so the profit margin went down. 

An analysis like this helps to prevent a similar scenario from occurring in the future. And it wouldn’t be possible without access to the cost and sales rates.

Shielding salaries: What is the fully loaded cost rate of an employee?

Sharing employee cost rates may seem like it’s not an option if you’re concerned about your staff getting a peek at what is essentially their colleagues’ individual salaries. At the same time, you can’t afford to sacrifice cost rate transparency if you want your project managers to be able to meet projected margins. 

There is a workaround: calculating group cost rates. By doing it this way, you dilute the direct relationship between cost rate and salary. For example, what you charge for all junior designers is identical. All that will be individually distinguishable in terms of pay is the skill level.

You can achieve this with the help of a fully loaded hourly cost rate formula that covers employee salary, payroll taxes, employee benefits and company overheads. With these inputs, you’ll arrive at the true cost of each employee. Then you’ll just take the average cost rate of a group of employees. 

And voila. You have a generic cost rate for a pool of employees based on expertise, experience, services produced for the customer or any classification that makes sense for your business.

The cost rate formula your business needs to price services correctly

Use this formula to learn the cost rate for an individual employee:

employee cost rate formula for services business projects

To determine an employee’s cost as a member of a professional group, just find the average of the quotients for each group member.

How software can help make projects profitable

Let’s back up a bit.

If you recall, I mentioned that some services firms are unaware that they’re selling projects for dangerously low compensation. It’s not so obvious when they aren’t looking at cost rates, sales rates and profit margins together as a unit.

For new users of VOGSY, the old way of thinking—before using VOGSY—was that profitability is a matter of making enough hours. They would set what they believed was a high enough sales rate and hope that with enough invoicing, everything would turn out OK. In reality, that stymied growth and threatened to run their businesses into the ground.

Only after they started using VOGSY, seeing cost rate, sales rate and profit margin side by side every day, did they really start paying attention to the relationship between them. As a result of the transparency of these insights, they were able to start conversations about the real reasons projects weren’t making money. Were too many hours spent on them? Were sales rates actually high enough with respect to the cost rates to make decent margins?

For professional services businesses, software is everything. It provides a window to the inner workings of your business. Solutions that bake in financial insights can guide you in building a healthy, lucrative company.

Drive profitable projects now.

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