How to Calculate Labour Costs — (Part 4) The Quick and Dirty Method

In the last article in this series, we discussed the ten costs that make up our business model. We also introduced the two definitions of hours that we use to define rates.

If I cross-reference costs and types of workers, I get a table that looks like this:

Cost

Employee

Contract

Salaried Hourly Freelance Company
  1. Actual labour
Paid Paid Incl. Incl.
  1. Non-productive labor
Paid Incl. Incl.
  1. Statutory Holidays labour
Paid Incl. Incl.
  1. Days off labor
No Incl. Incl.
  1. Vacation labour
extra Incl. Incl.
  1. Benefits
Incl. Incl.
  1. Employment taxes
Incl. Incl.
  1. Worker overheads
Incl. Incl.
  1. Company overheads
Incl. Incl.
  1. Company profits
Incl. Incl.

For a salaried employee, one pay amount covers all types of time including unpaid leave (days off). With an hourly employee, because each hour is paid separately we know how much we are paying for productive and non-productive time, statutory time and vacation time. However, days off (unpaid leave) is not included or paid for. For contractors — freelance or company — one amount is paid to include all costs.

We ended our discussion by explaining that there are four rates we are interested in:

  1. Pay Rate (or pay per hour)
  2. Labour rate or full labour cost per billable hour
  3. On site cost
  4. Chargeout rate

Each of these rates will apply to different groups as you can see by checking the above.

However, to calculate these rates we are interested in two different definitions of hour.

For most service industries, the base is going to be the salaried employee. Market value for employees tends to be stated in terms of yearly salary. This is especially true in IT where most employees are, in fact, salaried. In the following, wherever I use an example it will be based on a salary of $95,000 per year.

Pay Rate per Hour

The first rate we are interested in is Pay Rate. This is the amount that we will pay an hourly employee. The key here is that at the year, if the employee does not work any overtime, they will earn the same amount as a salaried employee. It’s also the same calculation that should be used to calculate the overtime pay rate if overtime is being paid.

Working hours is easily calculated. There are 5 days in a week and 52 days in a year. That gives 260 days in a year. Of those 10 days are unpaid leave. Notice that they aren’t vacation days. Many people think that is what they are subtracting. They are wrong. There are therefore 250 paid working days in a year. Now subtract any vacation time over 2 weeks which is not paid in vacation pay. I know it sounds complex but it really isn’t. For example, let’s say the individual has an arrangement to take 5 weeks of vacation but only four of that is paid. So they will receive 12% vacation pay (rather than 6%) but they need to make the same amount in 245 days. For our purposes however, we’re going to presume that any vacation time is paid. That means if the person works 8 hours per day they will work 260 x 8 = 2080 hours. If they work 7.5 hours per day they will work 260 x 7.5 = 1950 hours.

So our salaried employee is actually earning:

Pay per hour = Salary / Working Hours
= Salary / 2080
= $95,000 / 2080
= $45.67 per hour

After we round out to make the calculation easier we end up with the following rule of thumb:

Hourly Employee rate per hour = Salaried Employee rate per hour = Yearly Salary / 2000.

Notice that we need to pay both employees the same benefits and both employees will cost us the same employment taxes. In fact, the only difference between the two is in the name we give them.

Labour Rate or Full Labour Cost per Billable Hour

The second rate is effectively our real cost for the employee. The pay rate was the amount the employee would receive from us. But as you learned earlier, there are more costs involved than just the employee’s pay. There are benefits and employment taxes. You can’t escape them and you can’t avoid them. At least you can’t and be both honest and safe. As we’ll discuss later, both government and the courts will work to ensure that you don’t avoid them.

The second portion of the labor rate is that the base typically changes. While it is possible to calculate the labour rate based on work hours (actual hours or pay hours), typically basing the labour rate on productive hours makes more sense. In that way, you actually have the cost per billable hour which can be used to calculate project costs.

This calculation requires two estimations. The first is that the number of non-productive hours be estimated. Between vacation, statutory holidays, training, meetings and other non-productive time, very few people are able to work more than 1500 hours in a year. The second estimation is the cost of benefits and employment taxes. This generally works out to about 1.5 times the basic salary cost. While there is some variation from company to company, the number of hours and the benefits tend to be inversely proportional. And for our purposes, they almost always come out to the same amount.

As a result using our example, we get the following calculation:

Labour rate = Total Cost per billable hour
= (Salary + benefits + employment taxes) / productive hours
= (Salary * 1.5) / 1500
= ($95,000 * 1.5) / 1500
= $95.00 per hour

Thus a typical hourly employee earning $45.67 per hour is actually costing us about $95.00 per billable hour.

Therefore we can use the following rule of thumb:

Cost per billable hour = Cost per productive hour = Salary / 1000

Some people believe that this is saying divide by 1000 hours. That is wrong. This is not a division by 1000 hours. The 1000 is a result of a multiplication and a division and is meaningless by itself.

On-site Cost and Chargeout Rate

The remaining two rates are unfortunately much more subject to variation from company to company.

The first is on-site cost. Simply put it is the cost of having a person available — with the proper equipment — to work. So for example, for an HVAC technician it would include the vehicle and supplies. For an Information Systems programmer it would include a desk, a computer, a phone and a sliver of office space.

One of the issues project managers sometimes face is that the difference between the cost per billable hour and the on-site cost is born by the client not the contractor. This is quite common in the case of IT where computers and desks are frequently supplied by the client.

The importance of the chargeout rate is that it is the price of last resort. Price is a matter of value in the eyes of the client and really isn’t related to the cost of the product being delivered. However, if the price drops below the chargeout rate then it is not economically feasible for the company to continue providing that service. Effectively they would be better off becoming an employee.

While the actual chargeout rate is highly variable the service industry tends to follow a consistent 100% markup. So we can use a rule of thumb of:

Fair (Minimum) Price = (Salary / 1000) * 2

Of course, this is highly variable from company to company and industry to industry.

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