Customer Billing Rates Last Step: Determine Billable Hours/Utilization

Billable hours and staff utilization targets are the core key performance indicators (KPIs) of professional services organizations. Legal and accounting firms are renowned for setting annual billable hour and utilization rates for all staff that work on projects/jobs/cases/engagements and evaluating them against these targets and also tying part of their compensation to these targets.

It surprises me how few small to medium size architectural, engineering, and consulting firms do not set annual staff utilization/billable goal targets or for that matter figure out how many billable hours they need to achieve at a targeted billing rate to meet their profit goals. It is extremely difficult to monitor the financial performance of the firm without setting these targets.

The general rule of thumb is that there are 260 days, with weekends backed out, which a person can work in a year. This translates into 2,080 hours (260*8) that a person has available to bill projects. Most people will not and are not expected to work/bill these amounts of hours. There are holidays, vacation days, personal days, continuing education requirements and sick days that need to be taken into account. If billable staff has sales and marketing responsibilities this time also needs to be taken into account in determining the billable hour goal.

So you need to deduct these non-billable days from the total 2,080 to come up with a billable hours target by staff or staff type or in total. Generally billable hour targets come in somewhere around 1,800 hours for a staff person.

Take your Staff Cost +Profit/Billable Hours target and you get your customer billing rate. So if we take our fictional staff person in Step 3 and divided $275,000/1,800 we get a billable rate of $152.78. As mentioned in my First Things First post, this is your standard billing rate. You are trying to achieve this standard rate per project and if your project billing rates are different then you need to know where you stand against this rate throughout the year.

Billing Rates Step 2: Compute Overhead Costs & Overhead Rate

In Step 1 we came up with the direct costs related to our billable staff. So at least we will recoup these costs – assuming we get this amount from our customers. Obviously this is not enough to make us money since we need to cover all our other operating cost such as non billable staff, rent, lights, professional education, business development etc. These are known as our “Overhead Costs” of doing business. The easiest way to compute overhead is to deduct total direct costs from total expenses. Take the resultant overhead cost number and divide it by the total direct costs of the firm. This results in your “Overhead Rate”. To go through a simple example, suppose our total budgeted expenses (last year’s actuals if you don’t budget) are $1,000,000 and $400,000 is direct costs. This leaves us $600,000 overhead costs and dividing $600,000/$400,000 gives us an overhead rate of 1.5 or 150%. To put it another way for every $1 of direct costs you also incur an additional $1.50! So if your direct cost for a staff person is $100,000 you better collect $250,000 ($100,000 + ($100,000*1.5)) during the year before adding on your profit….otherwise you will lose money unless you cut your overhead to match collections.

You can get a lot more sophisticated in computing overhead costs (e.g. establishing overhead cost pools) but unless you are a larger organization with multiple departments it is not necessary. Also a rule of thumb in the professional services industry is that total direct costs plus overhead is generally 2 times actual salary but it is worth computing it for your organization in case it is significantly different.

Federal and some state cost based contracts set very specific rules with regard to what can be included as overhead costs.  Become familiar with these rules before you bid on those type of projects because they can substantially impact the running of your business.

Billing Rates Step 1: Determining Direct Costs

The first step in developing standard billing rates is to compute the direct cost for each staff person that can bill a project. Direct costs are expenses that can be identified solely to that staff person and not to anyone or anything else. Generally they are payroll costs such as salaries & wages, employer tax contributions (Medicare, SSI, unemployment insurance, etc.), employer benefit contributions (health insurance, 401K, disability insurance, etc.). If you also budget/track some non-payroll expenses by staff person such as continuing education, computers, cell phones then you add these expenses. This results in the total direct costs per billable employee. Total these costs and divide by the number of billable employees and you come up with your firm wide average direct costs. Group these employees by the types of billing rates you need (see my previous post on this) and come up with an average direct cost by group (totaling the group and dividing that by the total number of staff for the group).

This exercise should be fairly straight forward if you properly set up your chart of accounts and payroll system and your accounting system is like Envision Accounting and reports direct costs by staff, staff type, organization etc.

I also recommend that you use current year budget amounts instead of prior year actuals since salaries, employee taxes, etc. usually change in a forth coming year.

First Things First: What Customer Billing Rates to Develop?

Develop billing rates based on how you bid projects. So if you bid time & material (T&M) projects by staff person, meaning by their name, then you need individual billing rates by staff person. If for T&M projects you bid by a staff type, meaning environmental engineer, landscape architect, programmer, project manager, etc., then you need billing rates by these classifications. Fixed Price, deliverable or work plan bids can use the billing rates for individuals or staff types multiplied times the hours you estimate to do the work, but if this is the preponderance of your work, you should develop a composite staff wide billing rate.

These billing rates are your standard billing rates. This means they are not project specific but rather based on your costs and expected staff utilization; these rates are what you need to charge to meet your desired profit goal. If you don’t have a desired profit goal then you should go work for someone else, it doesn’t mean you will meet the goal but you need to have a profit objective. Also if you have a significant other it allows you to answer “How much do you think you will make this year?”

Once it comes to bidding a specific project you may increase or decrease your standard billing rates based on the competitive environment. Consequently, every project has a project billing rate which may be the same or different than your standard billing rate. Fixed price, deliverable or work plan projects do also since project billing rate=bid/estimated hours. If your project billing rate is different than your standard billing rate then you know that project is going to impact your desired profit either up or down depending on the amount of the variance.  This is know as your billing rate variance.

What do you do if you have negative billing rate variance? Another project needs a positive variance to cover it…otherwise you need to increase utilization, decrease cost or both.

Do I Really Need Customer Billing Rates?

Before we get started on how to develop architectural, consulting, and engineering firm billing rates, let’s address this question.

I think from a marketing perspective you do need rates since existing or potential customers are likely to ask what they are and answering: “We don’t have rates” would not be very cool. So from a practical standpoint you need quotable rates. You could purchase one of several industry financial surveys and base your rates off of it so that they sound reasonable and unless you are billing for time & materials the customer may have no idea if you are using your official rates or not.

The above approach is probably acceptable if you can answer the following questions:

1. What are my projected cash expenses for this year?
2. What are my expected cash collections this year from my booked projects?
3. How much more work do I need to sell and collect this year to cover the difference between 1 and 2 plus a decent profit for me?

If you are highly confident that you can pull off 3 then you may not need to go through a formal rate development process since your saying “Hey I can sell, bill, & collect the dollar amount of work to cover my cash expenses and my required profit.” I say go for it!

If you cannot confidently answer these three questions then you need to go through a more thought out billing rate development process so you can monitor where you stand against your desired profit.