Recover Overhead and Profit in your Labor Rate

I’m going to go back to a basic concept for this blog post – pricing your work, specifically calculating an hourly labor rate, also known as a charge rate.

There are four basic ways to charge for your construction related services. These are:

• Fixed fee or lump sum pricing
• Time & Material pricing
• Cost Plus
• Using an hourly rate

Many contractors use a variation on one or more of these methods. I’m going to look at using an hourly rate and its impact on your business.

There are good and bad sides to using an hourly rate, also known as a charge rate. It’s an easy way to calculate a sales price if you are not good at estimating. Some who use this method claim it is more “fair” to the customer to bill by the hour rather than a lump sum contract. It also gives the guy in the field the ability to price out his work on the spot for small jobs or change work orders.

But there are also downsides. One is the perception by the customer that they will get all non-labor expenses at the contractor’s cost, similar to Cost Plus contracting. This can be a problem if the contractor doesn’t do a good job of defining exactly what is included in the rate per hour and how materials, subs and other costs will be billed to the customer.

Another problem with this method is that it shifts the entire overhead burden of the company onto the labor rate. If you or one of your employees gets sick, or if incoming jobs slow down and you don’t work the required number of hours, you will end up “cash poor” very quickly.

If you charge for your work or service by the hour, it is critical that you use the correct rate. The correct rate will provide enough to pay all job costs, overhead and make an 8% net profit. If you don’t use the correct rate, you will not make a profit and often not be able to cover your overhead. It is just that simple.

The correct rate is based on the needs of your business. One mistake too many make is to charge what they perceive is the “going rate” for the same work. If you don’t take the time to calculate your actual costs, or don’t know how, your company can lose money quickly if what you think is the “going rate” is too low. Your charge rate should be based on your company’s numbers and not be influenced by anything outside your company. This applies especially to your competitors pricing. Since most contractors price jobs incorrectly, if you model your numbers after theirs, what does that make your numbers?

Calculating the correct hourly rate or charge rate can be a nuisance, but the math is simple. Your rate will include your labor cost, along with all the overhead and profit needs of your business added on. The calculation is done by assuming the worker will work a given number of hours per year. That number is then divided into the total company overhead and profit to arrive at the rate per hour that is needed. This method can be used to arrive at one or more different billing rates per hour for different employees.

Let’s do a quick calculation.

Assume you do service work, and have three guys doing fieldwork at $18.00 an hour. We can bill the three guys out at 36 hours per week, 50 weeks per year for a total of 1,800 billable annual hours per employee per year.

Let’s assume that our annual overhead expense is $120,150. We want to make at least $35,600 net profit, which is close to 8% of what we hope our sales will be.

In order to assign all of our overhead and profit to our labor rate, we would divide $155,750 ($120,150 + $35,600) by 5,400 (1,800 X 3 = 5,400) hours and our overhead and profit rate per hour is $28.84.

Add the labor rate of $18.00 to our overhead and profit number of $28.84 and you get a billable rate of $46.84. You would, of course, round that number to a marketable figure.

Now if we wanted a lower rate per hour, transfer some of the overhead and profit to the material cost. Do that by charging our materials at cost plus 30%, 35% or even more.

Be sure to realistically estimate the amount of materials to be used. Deduct the markup on materials from overhead and profit expenses above, and recalculate your hourly rate. I normally recommend a minimum of 35% and preferably higher. Don’t markup anything that you can afford to pay for a second time out of your own pocket. (Our Markup Calculator software makes all this easy.)

The same method could be used if you have sub or specialty contractors or other costs involved with your job. If you bring in an electrician, plumber or HVAC sub, add a similar percentage to the amount they bill for their work.

The main reason that contractors go out of business is not charging enough for the work they do or service they provide. Setting your hourly rate too low by comparing your rate to some mythical “industry standard” is foolishness.

Whatever method of pricing you use, do your own math. Set your target at 8% minimum net profit. Once your numbers are calculated, stick to them like glue. That is the way smart contractors make good money in construction.