If you want to calculate the cost of service, you will need information about the resources used while performing that service. These are the most common resources:
- The employees who worked on the service
- The direct expenses of the service
- The indirect expenses (overhead)
- The number of hours engaged by employees on the project
You can see what the calculation for the price of a project would look like here:
According to this table, you can take the following steps to calculate the cost of service.
1. Calculate the Pay Rate for Each Employee
The pay rate represents the average hourly rate you pay an employee. Here is how you can calculate it:
Pay rate is important, s it allows you to allocate the employee’s salary to the specific services they’ve performed. This is the first prerequisite when calculating the price of the service.
All elements are calculated in gross amounts, including all taxes and benefits.
2. Calculate the Overhead Rate
The overhead costs are all costs indirectly related to the project.
For example, the office rent can’t be a project cost. However, you need to have an office to be able to work on the project.
That is why you need to allocate overhead costs to projects.
To do this, you will need the allocation keys. An allocation key is usually a resource directly used in the production of the service. The universal allocation key is time.
Therefore, the costs are divided among the projects in proportion to the time spent on those projects.
In order to conduct the allocation, you need to calculate the overhead rate.
Here is how you can do that:
3. Calculate the Total Hourly Rate
The total hourly rate is calculated by adding the pay rate to the overhead rate.
According to the example above, the total hourly rate would be $50/hour + $13/hour = $63/hour
4. Track the Hours Spent on Providing the Service
Without allocating the primary resource – that is, time – to the service you won’t be able to calculate the service price. That is why it’s important for all employees to track the time they spent on the service.
This doesn’t have to be complicated, as you can use a simple time tracking tool.
5. Calculate the Cost of the Service
The cost of the service is calculated by multiplying the number of hours an employee worked on the service by their total hourly rate. Once you add up the costs of all employees who worked on the service, you will get the total cost of the service.
Calculating the cost of the service can be difficult if you do it manually or in Excel.
The time tracking tool allows you to enter the total hourly rate for all employees.
When the employees record time on a specific service, the system will automatically calculate the costs of the services.
You can get a report with all projects and services including their prices with one click.
Why is the Service Cost Information Important?
Make sure the service is profitable.
If you don’t know the cost of the service, you can’t know whether the service is profitable or not. The revenue is a known variable. Hence, by subtracting the service cost from the billed amount, you will get the profit of the particular service.
Determine a fair price in new inquiries from clients for similar services
When you calculate the cost of service, you can use it as the basis for your pricing policy. Usually, the price is determined by adding costs to an appropriate margin.
Recognize the revenue based on unfinished services
This benefit is important for the accounting aspect. Namely, if you haven’t invoiced a client at the end of the reporting period because the service hasn’t been completed, you won’t account for the invoice, and the revenues for that period will be inaccurate.
You should calculate the revenues depending on the costs incurred while working on the service.