It took me a full summer to figure it out, a summer of discovering that there was more to doing lawns than just pushing a lawnmower around in circles. Back in the days when you really had to push (pre-motorized), having a roster of four to six regular paying customers in the neighborhood made a significant life-style difference during the long school vacation. Doing lawns provided spending money earned in the evenings and on weekends after banking the paycheck from my summer day job in cost accounting at Raytheon. Gas money. Pizza money. Date money. Fenway money. Very tame in retrospect, but what did I know, then?
Part of what I learned in the real world during those last two summers in high school was that cost accounting in a manufacturing plant was different than cost accounting for my services on the lawns of Fairview Avenue. My value (or, at least my rate – they of course had no appreciation of my real value ) as a member of Raytheon’s summer costing team was $1.43/hour ($9.25/hour today), so I figured that $2.00 for an hour and a half mowing the lawn across the street at the home of elderly Mr. and Mrs. Lovejoy, and $5.00 flat rate for my estimated three hours up the street at wealthy Mr. Lerner’s, who always wanted extensive (hand) clipping along his walkways, was fair.
The Lovejoys were happy to pay me the two bucks, even when I managed to cut my time to an hour. Not so Mr. Lerner. His weekly work list always expanded to fit my three hours allotted, except when he went on vacation – ahh, two hours flat! That was the first summer.
By the second summer, I had learned about supply and demand. As the only kid on the home block big enough to do battle reliably with the neighboring turf, my value to the Lovejoys and the Lerners was significantly higher than what I had been charging. And with plenty of time to think behind the lawnmower, I had also figured out some things about full costing: all the effort and expense of acquiring, cleaning, lubricating, and sharpening my tools, plus the time spent going back and forth when Mr. Lerner moved a mile away to a more upscale neighborhood with a much bigger lawn, was worth an overhead charge. It was Brad’s New Deal that second summer, as my revised rate card enabled the expanded social calendar of a newly-minted high school graduate.
Fast forward a few decades. Cost accounting continues to be a critical analytical tool in manufacturing, but it remains underutilized in service environments, especially among smaller companies. Rare is the software developer, or the consulting firm, or the architectural and engineering company, or even the accountant who can identify with confidence his/her most profitable projects. Yet the key analytical process, as I described in response to a question by the lead project manager for my contract software developer client last week, hasn’t changed much in all those years since I was figuring it out while mowing alone:
- For employees directly involved in the work product, calculate the average hourly loaded pay rate for each job type, which is the total of
- The total direct weekly (or biweekly) payroll divided by the number of hours worked
- The total payroll tax (FICA, SUTA, FUTA) for the same period divided by the number of hours worked
- The hourly premium for Worker’s Compensation, a percentage of payroll which varies depending on the job-related risk assessment (usually less than .5% of wages for knowledge workers)
- Employer-paid benefits package (e.g. health insurance), expressed as cost per hour, including paid time off (PTO)
- Determine the Utilization Rate for each direct employee, calculated by dividing
- The employee’s number of billable hours for the week (or month) by
- The employee’s total paid hours (excluding PTO) for the same period
- Figure the Effective Hourly Rate by dividing
- The average loaded pay rate for each job type calculated in 1. above by
- The utilization rate in 2. above.
- Calculate the Contribution of each client project by multiplying
- The Effective Hourly Rate by
- The number of billed hours for each job type and
- Adding the results for all of the job types to derive total direct cost, then
- Subtracting that – and the total subcontractors’ and unreimbursed direct costs – from the total billed revenue for the project.
The “Contribution,” which is more fully labeled the Contribution to Overhead and is also called the Gross Profit, is the dollar amount available to cover overhead (Selling, General, and Administrative) expenses plus taxes and profit. Expressed as a percentage ($ Contribution divided by $ Revenue), the result is known as the Gross Margin, which for service companies is a key measurement of economic viability. Although there is variability by industry or profession, a company-wide gross margin of 60-70% typically characterizes a healthy service company.
“Great,” you say. “Now how do I know if I’m making a real profit on any of my projects?”
There are two more steps in the process:
- Determine the Overhead (“Burden”) Rate for each direct hour by
- Estimating the total direct hours to be billed for the year (or quarter, or month) and dividing that into
- The budgeted total S, G, & A overhead, plus the targeted profit and the estimated income taxes for the same period.
- Calculate the Total Profitability of the project by
- Adding the Burden Rate (#5) to the Effective Hourly Rate (#3) for each job type, then
- Multiplying that by the number of hours contributed in each job category, and
- Comparing the result to the invoiced revenue.
If Project Revenue (what you invoiced) is greater than the calculated Total Profitability, you’re ready for the graduate course in costing. If not, it’s back to the basics, behind the lawnmower.
As the ‘Gator scrambles through the Bayou seeking higher ground, project costs threaten to inundate him, if the oil slick doesn’t catch up to him first:
“Statewide, Florida tourism is a $60 billion business that employs a million people. That’s not all in beach communities, but depending on how far the oil travels, [Florida State University Professor of Tourism Mark] Bonn says a large percentage of that business could be affected. What could be the biggest cost for BP is cleanup, [which] BP chief executive Tony Hayward told several newspapers…would only reach $3 billion. Hayward’s statement runs counter to most analysts’ estimates that cleanup could cost tens of billions of dollars.
“Mr. David Kotok (Chief Investment Officer, Cumberland Advisors): ‘If the slick and the damage continue to enlarge and get into the loop current, then the potential can grow towards a hundred billion. There are no limits. We have no idea.’
“Separate from the cleanup, there are the liabilities BP and other companies involved with the rig might pay, not just to the rig workers or some of their families, but for the millions of people who are directly or indirectly affected by the spill. Most notably, this includes workers in the tourism and fishing industries. Some estimate the Gulf Coast region’s tourism industry at $20 billion a year. Fishing revenues are harder to quantify.
“Louisiana’s seafood industry alone generates well over $2 billion annually. Sport fishing in those states is also an industry in the billions. Finally, BP will likely face a number of fines. If the Justice Department investigation reveals criminal wrongdoing, Cumberland’s Kotok says BP’s fines could get as high as $200 million per day of this spill.”
– Yuki Noguchi, reporting for National Public Radio, June 7, 2010
Draining the Swamp
Service company pricing
Basic formula: Price to client = 3x full direct payroll cost of the project
Basic derivative: One-third for direct cost, one-third for overhead, one-third for owners’ compensation, profit and taxes
Basic definition: Payroll cost includes total direct hourly fees for the project, plus payroll taxes and allocated benefits
Winning formula: Being able to charge (and collect!) a fee equal to 4x to 5x direct payroll mark-up