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Do You Understand Your Costs to Ensure Profitability?
During a recent call with a CEO, we discussed the company’s profitability and what measure they used to drive profit – basically Profit/X. It became apparent that they didn’t have a handle on their costs and what they should be charging to ensure they hit their profit targets. I have addressed this a bit before to ensure that your margins were where you wanted and rejecting low-profit jobs. However, this time the issue is to understand the jobs’ profitability and price new jobs effectively.
The Costs
To determine profitability, we need to know our costs. Thus, we built a table listing every employee, the salary, additional expenses, e.g., health insurance, 401k, etc. (estimated at 35% of wages), and the amount of billable time. As a result, we had a table that looked like the one below.
Calculate Hourly Costs
From this Table, we could determine the hourly cost of an employee. To calculate actual costs per hour, we took the number of billable hours, which for 2021 is 8,760, and subtracted 96 hours, the allowable PTO. However, most employees don’t work their total billable hours for various reasons, so we included a “slack” factor of 10%. For multiple reasons, most projects have “re-work” or errors that cannot be billed and estimated at 10% and included. As a result, the total “Billable Hours” was 7,800 rather than 8,760. These adjustments allowed us to produce the hourly cost for each employee.
Calculate Overall Costs
Taking that data, we then divided the hourly costs into billable and non-billable. We added fixed overhead, which was not related to billable expenses, e.g., CEO’s pay, office rent, etc. Thus, we now had a cost structure for the firm that looked as follows.
| Billable Costs | $1,099,150 |
| Non-billable Costs | 1,194,500 |
| Overhead | 750,000 |
| Total Costs | $3,043,650 |
Calculate Revenue
With the company’s cost structure defined, we could determine how much to markup hourly costs to make a 25% profit. Doing this analysis is easy in Excel; however, ensure you don’t make easy Excel mistakes. , and the result was that marking up hourly costs by 232% would enable the company to meet its profit goal. This analysis is shown below.
| Revenue | $4,056,895 |
| Total Costs | 3,043,650 |
| Profit | $1,013,245 |
| Profit Margin | 25% |
Pricing of new projects
While I am a strong proponent of selling value, not time, if the company wants to know the minimum price to charge to realize its minimum profit, it can use this data. Identifying which employees will work on the project and for how long. For example, they would be able to cost it as follows:
| Employee | Hours | Hourly Billable Rate | Total Billable Charge |
| #3 | 25 | $49.32 | $1,233 |
| #6 | 5 | 44.77 | 224 |
| #10 | 20 | 43.83 | 857 |
| #15 | 15 | 30.50 | 457 |
| #17 | 10 | 48.67 | 487 |
| Total | $3,258 |
With this data, we can now estimate jobs more effectively since we know the employees who will work on the jobs and how many hours they will commit. We have to build some waste into that model, but we have a good idea of how to price jobs.
Performance Table
Also, we can see either weekly, monthly, or quarterly how the company is performing. If we produce a table of the employees and clients and hours worked for a month, we can see the utilization of each employee and profit per client as follows.
This table provides a good insight into the company’s and employees’ performance. As can be seen, Employees #3 and #6 are working more than their billable hours with utilization rates above 100%. While this may be good, one would need to ensure that whatever they were supposed to be doing with their non-billable time was being done. Also, Employee #9 is utilized 71.3% of the time, resulting in lost efficiency. Further analysis is required into why this is the case, but it identifies potential issues. Finally, it would appear that nearly half of the employees are working at less than 95% utilization. Given that the company’s utilization is already adjusted for “Slack” and “Rework,” analysis to understand why utilization is low is required.
We cannot only analyze employee performance, but we can see how we are doing with our various contracts. Clients #1 and #3 are losing money, while Client #4 is profitable. The data doesn’t tell us why, but again that would be work investigating as the company is performing below its goal of 25% profit.
Conclusion
As I stated at the beginning, concerning pricing, I strongly believe in pricing according to value and not hours; however, this analysis and methodology are helpful to understand what an organization’s minimum pricing should be and how it is performing. While several issues are highlighted and require more work, this provides a great way of knowing what to examine to improve performance.
If you would like to do this analysis, call me. I would be happy to help you.
Copyright © 2021, Marc A. Borrelli
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