How to accurately calculate an employees’ cost rate (aka profitable cost per hour)

As an agency, you’re selling people’s time. And understanding how much this time really costs, honestly and accurately, is important if you’re to make a profit. Fortunately, there are some tips and tricks to getting these calculations right.

The simple calculation would seem to be to take each employee’s salary and divide it by the number of hours they work. Bingo, there’s their hourly rate. But obviously that’s not really going to work. You need to get an honest and accurate picture of what it costs your agency to deliver a piece of work, or a service.

Clients aren’t just paying for one person’s time on a job. They’re paying for the full cost of servicing.

Employees cost a business more than just a salary. There are individual extras, like pensions, and overheads like computers, office equipment, software. Plus, there are other costs to your business, such as non-chargeable resources, rent and utilities.

For effective pricing, you need to calculate each employee’s true cost rate. This means understanding the cost of their time to your business. And getting it right means you can make a profit on each job or service and each client.

I’d recommend you start with four calculations:

1. Total salary cost for each employee

Take each employee’s gross salary (total before taxes and deductions), including any additional benefits such as car allowance or bonus payments. Add the employers’ National Insurance contributions (NIC) and pension contributions. This gives you their total salary cost.

2. Annual cost of your business overheads

Take your total business overhead costs, excluding chargeable staff salaries, NIC and pension contributions but including your non-chargeable staff salaries and associated costs. This will give you the total overhead you need to recover. If you have departments with significantly different overheads, you could calculate the overhead per department to give a more accurate reflection. Otherwise, I’d recommend keeping it simple.

3. Overhead charge for each chargeable resource

Now you’ve got your overhead costs, you need to apportion this across your chargeable resources. Divide the total overhead figure by the number of chargeable resources* to see how much extra each employee needs to recover on top of their salary to cover the business overheads. You can also divide by the total number of employee to give you the total employee cost to the business.

*For an accurate picture, you need to use the full-time equivalent (FTE) here, to account for part-time resources being able to recover less. To do this, calculate a full-time worker’s annual hours, assuming 7.5 hours per day x 5 days per week x 52 weeks = 1,950. Next calculate their actual hours, for example 7.5 hours x 3 days per week x 52 weeks = 1,170. Then divide part-time hours / full time hours to get the FTE. In this example FTE is 0.6. Therefore, if you have 9 full-time people and one part time, you’d have 9.6 people as opposed to 10.

4. Total charge-out cost for each chargeable employee

Add this apportioned overhead recovery figure to your total salary cost per employee. This gives you the final figure the employee needs to recover each year. Then you can divide this by the total number of workable days and hours to get the charge-out cost per day or hour for each chargeable employee.

To calculate the number of annual workable hours, first calculate the number of workable days in a year.

For example, 5 workable days per week x 52 weeks in a year – 20 days’ annual leave – 9 bank holidays = 231 work days per year.

From here you can calculate the number of workable hours each year = 231 workable days x 7.5 workable hours in a day = 1732.50 workable hours per year. You may also allow want to allow for non-recoverable time such as 1-2 sickness days and any company days.

It’s a good idea to review at the end of each year, as your overheads costs may change through the year. But I’d only recommend recalculating if changes are significant.

Using these figures for accurate costing

Once you have the cost rate by employee, you can calculate average cost rates by level, such as junior, intermediate, senior, director. Or by role, such as account manager or art director, for example. You can then use this in your estimating process to gauge profit before quoting a job.

You can either use a system like Synergist, as shown above, which does this for you, or set up a spreadsheet as below:

While it’s a nice idea, as you probably know projects don’t always go to plan, so you should be tracking time spent vs time estimated. Using individual cost rates you can accurately track costs and profit during a job to make sure you maintain good profit margins.

Plus, you can discover the actual cost of delivering each job, phase or task within a project and see how you could be more profitable next time. For example, did you use an expensive resource, which reduced the estimated profit? Did the junior take more time than estimated? Using these insights, you can also create templates to drive more accurate internal estimates and delivery processes.

It’s worth putting in some time to calculate your figures upfront, as they can really help you avoid profit pitfalls and make sure you’re charging accurately for each specific job.