TOTAL MONTHLY EXPENSE
First total your yearly business expenses. This is EVERYTHING except design consultants. This includes business consultants, wages, payroll expenses, everything that you spend money on because you have a business.
Now divide by 12 to get your average monthly total expenses.
TOTAL PRODUCTION EXPENSE
Next you will calculate how much you spend on the labor to produce the work that you are able to bill for. You will do this for each individual in your firm (or just yourself if a freelancer). Gather these pieces of information:
- Hourly Pay Rate they are paid. Or take annual salary and divide by 2080 hours, the normal work year.
- Time Off, which is the total hours per year of vacation, holidays and personal/sick days.
- Percent Billable is the percentage of hours per work day, not counting time-off days, that you normally bill for or bill to a project. 8 hours per work day is 100%. Subtract the administrative time and business development time. The percent that you arrive at is rarely 100%. This may take some researching of past time cards or invoices to see what is average. Using a high percent that rarely is achieved will give you a useless result.
2080 annual hours - annual Time Off hours x Percent Billable x Hourly Pay Rate / 12 = individual's Production Expense per month.
The total of all the individuals equals the Total Production Expense.
The next step is to find your OVERHEAD FACTOR. You find the Overhead Factor by dividing the Total Monthly Expense by the TOTAL PRODUCTION EXPENSE. This number represents your OVERHEAD FACTOR. This number is usually more than 2.0 and less than 5.0. If you are far outside this range, check your calculations. It is more desirable to be low than high. Low means your mark up is low. A high mark up means you may have trouble being competitive because your business is inherently inefficient.
However, we aren't finished just yet - you need to find the BILLING OVERHEAD FACTOR. The Overhead Factor tells you how much you have to charge to break even by multiplying this factor times the individual’s HOURLY Pay Rate. What is missing is profit! There are a lot of ways to look at profit. You can use an arbitrary percent. You can pick an amount and determine what percent that is of your TOTAL MONTHLY EXPENSE. You have to decide this for yourself. The profit is usually in the range of 10% to 25%; but you might have reasons to go outside the range. It's your call. In any event you write the percent profit that you have chosen as a decimal, add 1.0 and multiply times your Overhead Factor to get your BILLING OVERHEAD FACTOR. For example, if your Overhead Factor is 3.1 and your desired profit is 20%, then you calculate 3.1 x 1.2 = 3.72 to get your Billing Overhead Factor.
Multiply your Billing Overhead Factor times each person’s Hourly Pay Rate to get their Billing Rate. I suggest that you make a simple spreadsheet like the example below, save it, and review/update it once or twice a year.
This can be an eye opening exercise. I learned this technique from Paige Highfill, an architect, who was teaching other architects how computers can be used in architecture before CAD came along. [Cave men were still a common sight.] When I tried out the calculation, I was shocked to find that we were losing $15 per hour on every hour we billed out! That explained a lot.
There is an alternative way of doing the analysis if you are a freelancer. A lot of the research required is similar. Go to http://freelanceswitch.com/rates/ where you will find an online form that will generate the hourly rate answer for you.