I was recently asked about how a small business could go about determining its hourly rate. This individual was a contractor and wanted to cover their salary, their overhead and have enough room within their hourly rate to secure a profit. It’s a rather simple and straightforward process. However, it's essential that your hourly rate accounts for profit; it's not uncommon for entrepreneurs to forget this essential step. To clarify, I’ve included some simple steps to determining the hourly rates for a small business.
Most new small businesses make mistakes when charging their hourly rates. Over time, they begin to realize that their hourly rate doesn’t cover enough of their expenses and doesn’t provide nearly enough profit to finance future growth.
To avoid this from happening, it’s essential that small business owners properly determine their hourly rate at the outset. Changes can be made going forward, but the basic calculation should stay the same.
As the company grows, that hourly rate tends to grow as well due to rises in costs, inflation and other miscellaneous expenses. As such, new businesses must be willing to periodically review their hourly rates to remain competitive.
For this particular example, I’ll show the steps using direct and indirect expenses, and then provide another example where a small business might want to use overhead within their hourly rate calculation.
To read more about determining a company’s overhead rate and percentage, please read: Calculating Overhead Rate & Percentage for Small Businesses
Calculation to Determine Hourly Rate
(Hourly Salary + Direct Expenses/Hour + Indirect Expenses/Hour) / Profit % = Hourly Rate
We’ll use the example of a small contractor working on their hourly charges. First, the individual needs to account for their hourly salary. Second, they need to define their direct expenses, which are those expenses that are directly attributed to the job itself. Third, they must define their indirect expenses. Fourth, they must add their hourly salary, their direct expenses and indirect expenses together and then divide that total by their desired profit percentage. The new total will therefore be their hourly rate. However, in order to get that hourly rate, they must sum up their work week in hours – since their jobs will be quoted in hours.
Step 1: Determine Hourly Salary
Regardless of whether you are that consultant about to embark on your new business venture, or the contractor trying to get your foot in the door, you must include an hourly salary within your hourly rate. This should be the same salary you would be paid if you were an employee at any company. This might require some research on your part, but it shouldn’t be that difficult. Don’t be afraid to give yourself a raise! After all, it’s your business now.
Step 2: Determine Direct Expenses
Your direct expenses would be those expenditures that contribute directly to the job itself. For instance, if you were that contractor that hired an employee, then your direct expenses would be that employee’s salary and any of the parts, materials and items that go directly to completing the job.
Step 3: Determine Indirect Expenses
Indirect expenses are those expenses that don’t directly contribute to a particular job, but are nonetheless essential to operating a business. Indirect expenses would be gas, insurance, taxes, maintenance on vehicles, upkeep on equipment and any support expenses that are essential to the company’s daily operations.
Step 4: Determine Profit
This is perhaps the biggest mistake new businesses make when determining their hourly rate. It’s not enough just to pay yourself an hourly salary and cover expenses. You’re in business to make a profit! As such, you must include a profit within your price. Profit is the mechanism by which you’ll be able to finance your company’s future growth. Most companies use gross profit on sell price, but in the case of determining your hourly rate, you can use gross profit on hourly rates. This is done by taking your hourly rate and dividing it by your desired gross profit percentage.
Example
Let’s assume that a painting contractor wants to determine his or her hourly rate for a specific job. They've been asked to quote on painting three rooms. This contractor estimates that it will take 16 hours or two days to complete the entire job.
1. Determine Hourly Salary: As a former employee for another contractor, the painter made an hourly salary of $20.00.
2. Determine Direct Expenses: For this particular job, the contractor is asked to paint three rooms. Each room requires two cans of paint ($25.00/can), one can of primer ($20.00/can), a single roller ($10.00/roller), two plastic drop sheets ($5.00/sheet), and one roll of “painter’s tape” ($5.00/roll). Their total direct expense per room is $95.00, $285.00 for all three rooms, or $17.81 per hour ($285 / 16 hours).
3. Determine Indirect Expenses: The contractor also knows that his or her indirect expenses average $400 per week. This contractor works approximately 40 hours a week. As such, their indirect expenses are $10.00 per hour.
4. Determine Profit: He or she wants to make 15% profit on this particular job
- Salary/Hour: $20.00
- Direct Expenses/Hour: $17.81
- Indirect Expenses/Hour: $10.00
- Determine Profit: 15%
Calculation to Determine Hourly Rate: (Hourly Salary + Direct Expenses/Hour + Indirect Expenses/Hour) / Profit % = Hourly Rate
($20.00 +$17.81 + $10) / .85 = ($47.81) / .85 = $56.25 Hourly Rate
In this case, the painter should charge $900.00 to paint three rooms ($56.25/hour x 16 hours).
Using Overhead When Determining the Hourly Rate
The above example is ideally suited to those contractors and small business owners who are just starting out and don’t have the luxury of historical data on their company’s overhead. For some, it just seems easier to clarify direct and indirect expenses within their hourly rate. However, as the small business grows, they’ll have to become more mindful of their overhead and its impact on the rates they charge for jobs.
Companies include overhead within their price in order to cover those expenses that don’t directly go towards a given product or service, but who are an essential part of the company’s operations. The simplest way to determine the overhead rate and percentage is to divide the company’s indirect expenses by its direct expenses. This amount is then multiplied by 100 to get the overhead percentage.
- Overhead Rate = Indirect / Direct Expenses
- Overhead Percentage = Overhead Rate x 100
Continuing on the example above, the overhead rate per hour would be $10.00 / $17.81 = .56 or 56%. The contractor could then take their direct expenses of $17.81/hour and multiple it by .56 to determine their overhead. This would be $17.81 X .56 or $9.97.
The calculation would then become: (Hourly Salary + Direct Expenses/Hour + Overhead/Hour) / Profit % = Hourly Rate
($20.00 + 17.81 + $9.97) / .85 = ($47.78) / .85 = $56.21 Hourly Rate
Now, a number of you might be wondering why I wouldn’t just use one, all-encompassing formula that includes defining overhead, instead of separating direct versus indirect expenses.
The only reason I’ve done this is to make it easier to understand the differences between direct and indirect expenses. Determining hourly rates for a small contractor business means that customers should only be asked to cover 100% of those direct expenses attributed to their particular job or purchase, and a portion of the company’s indirect expenses.
In our example, the customer pays for all direct expenses attributed to the job ($285.00) but only $160 of the weekly $400 indirect expenses of the contractor. In this case, other customers will help cover the contractor’s indirect expenditures so that no single customer will be asked to bear that burden. This allows the contractor, or small business owner, to spread out their overhead or indirect expenses over multiple projects – which makes their hourly rates more reasonable.
Finally, if the small business owner knew their overhead rate was always between .50 & .60 month to month, they could then determine their overhead costs per hour by taking their direct expenses and multiplying it by this .50 or .60. Some are able to do this calculation in their head.
To read about determining your break even point, please read: Sample Break Even Excel Sheet for Small Businesses
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