Small business owners — especially those just starting out — too often set billing rates far too low. Owners forget to account in their rates for all the costs of doing business. Instead, their rates look suspiciously like the equivalent hourly wages larger businesses pay their employees.
If you’re like many newer small business owners, your first approach to setting rates is to do the math. You research what the typical salary or hourly wage is for a labor category and apply those rates when you bid contracts.
This seemingly simple and logical approach leaves out most of the actual costs of doing business: benefits, overhead (rent, utilities, etc.), insurance, profit, administrative and management costs, marketing, training and more. These costs double or triple the hourly rate or salary you pay employees and must be factored in when you’re pricing projects. Leaving these costs out of your pricing constitutes a quick path to failure.
This table offers a straightforward way to ensure you incorporate the costs of doing business into the rates you bid. Allocate the overhead amounts in the table by dividing the total amounts by the total annual hours of payroll and add the result to the hourly rate for each employee.
This approach allocates the same dollar amount of overhead to each employee’s hourly rate. Allocating overhead using this straight-line approach is reasonable if all employees are paid roughly the same amount. When there’s variability in hourly rates, more precise calculations involve allocating the overhead in proportion to the hourly rate for each employee. Higher overhead amounts are allocated to higher-paid employees and lower amounts to lower-paid employees.
Consider these two examples of straight-line overhead allocation:
- Services project. You own a graphics design and web development company. You have four employees plus yourself and an administrative assistant. Your bidding two of these four employees on a project. You pay each of the four employees $30 an hour for a total of about $250,000 an year. The combined salary for you and your assistant comes to $150,000. Your overhead costs (using the table), total about $500,000 ($150,000 management and administrative plus other costs from the table). Allocating these costs to the four employees adds about $60 to the $30 hourly rate for a billed total of $90 an hour. Quite a difference.
- Construction project. You own a small construction company specializing in installation and demolition of concrete flatwork. You have 10 employees plus yourself and an office manager. You pay yourself and the office manager a total of $120,000 a year. You pay concrete workers $25 an hour, not counting overtime. If you bid five of these workers on a project at $25 an hour, how are you going to pay your rent, benefits, marketing, administrative assistant and yourself? You need to charge $60 to $75 an hour to make enough to cover your actual costs of doing business.
To summarize, many costs must go into billing rates. Without incorporating all the costs of doing business, you run the risk of going broke even though you have lots of work.
Disclaimer: The examples and table categories are provided for illustrative purposes. Every business is different.