How an employee can cost 50% more than their pay
If you pay your employees $10 per hour and bill them out at $15 per hour, you make a profit of $5 per hour, or 50%, right? Wrong! The employee you just hired for $50,000 a year only costs you $50,000, right? Wrong! For several very good reasons, your employees can easily cost 50% more than what you pay them.
Vacation, sick and personal days
Many employees receive 10 days of vacation time and 10 sick days a year. Add 10 days of holiday/personal time a year and your employees are getting paid for, but not working, 30 days a year. Since a work month contains about 20 days a year, your employees are not working 1 ½ months a year. This means you are paying your employees for 12 months of the year but only getting 10 ½ months of work from them.
Without any time off, your employees could be working 2,080 hours a year…until you realize that they are only working 1,840 hours when you factor in the 30 days for holidays, vacation, and sick time. So a person being paid $10 an hour for a full year of 2,080 hours is costing you $20,800 but actually only “producing” $18,400 of work. This means that you are paying them $2,400 for the days they are not showing up to work. In order to cover time off paid to your employees, you need to add 13% to your billing rate. This means that your $10 per hour employee needs to be billed out at $11.30 just to cover vacation, sick, and holiday time.
Payroll taxes
FICA taxes (Social Security) are a necessary part of doing business. To avoid future visits by your friendly IRS agent, you need to pay 7.65% of your employee's wages to the government. This means you need to set aside an additional $0.765 for every $10 you pay your employees. Add this 7.65% for FICA to the 13% you need to cover time off and your employees now cost 20.65% more than their standard pay.
Unemployment and workers’ comp insurance
These two things usually don't cost that much, but it is worth adding one more percent to the pay rate to cover this. Now your employees cost 21.65% more than their regular pay rate.
Medical insurance, retirement, other benefits
It's not unusual to add another 20% to the employee overhead rate if you offer any sort of medical insurance or retirement plan.
Adding all of these expenses to the base employee rate can easily increase your base employee pay by 40%. What impact will this have on your business? Think of the owner billing out his $10 per hour employee at $15 per hour with the assumption that he is generating $5 per hour in profit. When these expenses are added to the base rate, the true employee cost becomes $14 an hour. This leaves only $1 per hour in profit, which is probably not enough to sustain the business.
So how do you make sure your billing rate covers both the employee overhead rate and all of the other expenses you need to cover each month? You now know how to calculate the employee overhead rate, so let's figure out what percent you need to add onto the billing rate to cover your other expenses.
How to calculate a profitable billing rate
Add together all of the expenses you need to pay each month. To keep the numbers simple, let's assume your monthly expenses include $6,000 of owner salary, $3,000 of rent and $1,000 of other expenses. Your employees need to earn enough to cover $10,000 of expenses a month (or $120,000 a year) to stay in business. Assuming you have 10 employees, each employee needs to generate a profit of $12,000 to cover your monthly bills.
You already know that your employees work 1,840 hours a year. It would be great if each of those hours translated into revenue, but let's assume that only 80% of the time your employees are in production mode. This means that each employee has 1,472 hours a year to cover their $12,000 share of the expenses. To make this work, $8.15 needs to be added to each billing hour to cover your annual overhead expenses.
Remember that employer who thought billing out at $15 an hour was generating a $5 per hour profit? The true cost of their employee is $10 for his hourly wage, $4 per hour to cover benefits and $8.15 per hour to cover expenses. This means you need to charge your client $22 per hour just to cover employee and overhead expenses. A billing rate of $30 per hour would be more appropriate, since billing $15 an hour would only cover benefits and no overhead expenses.
Your employees need to generate enough revenue to cover both their benefits and your overhead expenses. Knowing how much these expenses are costing you is the first step. Making sure you spread these expenses across the correct number of working hours is the second step. Add your profit goals to this amount and you have calculated a correct billable rate.
Alison Hinson, owner of Alison Hinson MBA LLC, can be reached at alison@alisonhinsonmba.com.
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