Billable hourly rate is one of the most important categories in managing a service company because it directly impacts the organization’s income and profitability. Hence, our intention for this article is to explain how to maximize and optimize the billable hourly rate to achieve higher profitability.
How to calculate billing hourly rates?
Billable hourly rate is the rate you get by dividing a profit by the number of hours necessary to get that profit (also known as billable hours). So, the actual billable hourly rate is crucial for two important categories – income and billable hours.
Besides the actual billable hourly rate, there is the category of planned (targeted) billable hourly rate. If you want to plan the billable hourly rate accurately, you need to start with a detailed analysis of the actual billable rate. This way you will draw accurate conclusions for profitability increase.
Clear hourly billing rates policies
You need an in-deep analysis to define your billable hours and hourly billing rate strategy. The analysis should cover the following categories:
- Real hourly billing rate historic trends
- Time utilization analysis
- The competition’s billable hourly rate
- Analysis of negotiation and agreements with clients
- Result and cost (pay) rate comparison
- Result and planned hourly billable rates comparison
Historic trends of the real billable hourly rate
This is the initial step, that is, a situational analysis. It concerns diagnosing your company.
The analysis should be comprised of observing the real hourly billing rate on the company level, as well as per all clients, employees, and service lines.
Billable hourly rate on the company level
This step is simple and it doesn’t require a lot of resources and time. You only need to divide the total company revenue by the total spent billable hours. For example, if your company makes $150.000 in a month, and you’ve spent 2500 billable hours in that month, the realistic hourly billable rate is $60. this may not be in accordance with your expectations, considering you have planned to charge your clients an average employee hourly billable rate of $100. In that case, your task is to minimize that gap.
Hourly billing rate on the client level
In and of itself, the fact that your historic hourly billing rate is $60 doesn’t give you a lot of information. You need to allocate that average rate to your clients. That is how you’ll come to valuable insights. For example, the calculations may look like this:
- Client A – $30
- Client B – $55
- Client C – $75
- Client D – $120
Now we see that clients A and B are ’’eating’’ your hourly billing rate. This information is important, as it helps you identify re-negotiation possibilities with those clients. Additionally, it points you toward improving your relationships and focusing on cross-selling with the clients with an hourly billing rate above your expectations.
To make this calculation, you only need to list revenue by clients (for a certain period) and divide it by the number of billable hours spent on each client, based on the client time tracking report.
For example, based on hour tracker report, you’ve spent 100 hours on client A for project B, and the income coming from that client is $3000, which means the real billable hourly rate is $30. you need to make these calculations for each client, and calculate the average hourly rates for all of them.
Realized hourly billing rate per employee
You should conduct the analysis you’ve done on your clients on your employees and projects (service lines). Once you have accurate employee billable rates on paper we’ll come to the big truth – the realistic contribution of each employee to the company’s profit. That is how you can manage the goals and development of your employees better, as well as make changes regarding your human resources policies.
Once we have calculated the actual billable hourly rate per employee, we can easily calculate the profit each employee has made, since we have their cost (pay) rate.
Project time tracking is very important since it allows you to identify expenses per project. On the other hand, you can evaluate the earnings from the accounting records if you aren’t keeping track of them through a time tracking program (LINK).
Time utilization analysis
Time utilization is a key performance indicator (KPI) for professional service companies. It is calculated as the ratio of billable hours within total work hours or total hours. The usual practice is to exclude leaves and vacation time. If you are using time tracking software calculating and tracking time utilization is simple and clear. Otherwise, you will have to calculate time utilization from individual manual timesheets.
Practice has shown that time utilization over 60% is a good indicator, while the ideal would range from 70 to 75%. Time utilization over these values may indicate employees being overwhelmed by work, or that you’re using too little time for education and business development, neither of which are billable activities.
Competition hourly billing rate analysis
The purpose of this analysis is to determine the position of your company compared to your competitors. To conduct it you need the following information:
- Competing company income
- Billable hours
The first category is simple to determine. You can simply download the financial reports from your country’s publicly available register, or set out a symbolic sum to get this information from the companies that own the data.
You will need to conduct a more assumption-based analysis to assess your competitor’s billable hours. Firstly, you will need the number of employees. You can determine that through social media or publically available data. However, to calculate billable hours, you’ll also need to assess the competition’s time utilization. Probable utilization is most likely somewhere between your own company’s time utilization and your industry’s benchmark. These benchmarks are available online for most industries.
Besides, there are also studies of average billable rates by industry and country.
Comparing results with the cost (pay) rate
Since now we know how to calculate the actual hourly billing rate, let’s see how to calculate the cost rate and why their ratio is important.
Cost rate equals the sum of the pay rate and overhead rate. So, it is the hourly billable rate the company pays its employees increased by the hourly rate of the overhead costs – office space lease, amortization, and other operational costs of the company.
The ratio of the billable hourly rate and the cost rate is an indicator of profitability. A company’s actual billable hourly rate being #350 (seemingly a good billable rate, isn’t it?), means nothing. Namely, if that company’s cost rate is $330, the profit is $20, which makes the profit margin 5%, which is very low.
However, a company having a 30% profitability (which is a good indicator for most professional service companies) doesn’t mean they have optimized this ratio. It is necessary to observe the profit by the client and see which profit margins are below and above the average.
If we redefine the business relationships with the clients who have a low margin, the average margin can be improved even more. There are always some clients that will ’’steal’’ your time. It is always good to identify those clients quickly and suggest a different cooperation model (if the clients aren’t strategically important).
How to calculate total cost rate
The total cost rate is calculated by taking all expenses from your profit and loss account for a certain period and dividing them by the total number of work hours in that period. For example, if the accounting data shows the total expenses in the previous quarter being $750.000, and the timesheet reports for that period put the total billable hours of all employees at 10.000. that means your cost rate is $70.
If you are using desktop time tracking app, we suggest you use a version that includes cost tracking per employee cost rate.
What does this information tell us?
The previous calculation means that our real achieved billable rate should be at least $70 to cover all costs. It is a foundation, and we should add our expected margin calculation to it to get our target billable hourly rate. So, if we want 40% profitability, our target billable hourly rate should be $100.
All previous indicators will point you in the direction you should define your billable hourly rate policy toward.
Billable hourly rate settlement
Based on the previous parameters we should define the standard billable hourly rates for your services. You should do it per position and employee. For example:
- Senior – Ann Eathon – $120/hour
- Junior – Joh Milesstone – $100/hour
Additionally, depending on the engagement and the situation, and the state of client negotiations, we suggest making billable hourly rates flexible depending on the case, rather than always insisting on the standard ones.
When we are talking about determining the expected billable rate, we are implying two kinds of potential arrangements:
- Fixed fee arrangements – even though the fee is fixed, we face the challenge of projecting the real billable rate
- Arrangements with variable compensation – the client will pay according to the number of hours invested into the project
There are several ways to determine the billable hourly rate:
Cost plus method
Cost plus method of planning hourly billing rate starts with calculating how much your services cost you by the hour. Then you should add profit margin to the costs. We have explained this earlier in the article. This is the most common starting point for calculating a billing rate.
To accurately calculate a market-based bill rate, you must have current market data. Your best source of information is competitive research: who are your competitors what do they offer, and how much do they charge?
This method is very useful, as it reflects the key paradigm of professional service businesses: charge as much as the service is worth to the client. If you assess that a client has a high ’’pain’’, the billable rate can be higher than the norm. On the other hand, if there is no high ’’pain’’ with a client, you should carefully assess whether the client will pay your standard rate, or if you should offer a discount rate. Still, you should still make sure you’re not jeopardizing project profitability.
So, it is crucial to identify a client’s pain indicators, create awareness that your service can solve their problem, and determine your billable rate accordingly.
Try and find out as much as you can about the scope of the project to understand the value you can provide.
Simply put, this bill rate is very specific to your client and your contribution. As you may have guessed, it is based on the value you provide to the client and the ROI they receive. This can be a very profitable billing method, but it is only appropriate for consultants with a wealth of experience. The client must walk away feeling that they actually got enough value for what you were charging.
Blended billable hourly rate
Clients usually dislike receiving different hourly billing rates for different positions in their offers. This is confusing to them and they feel their budget for the service may be at risk. Hence, in certain situations, you should offer a single blended rate which represents pondered average of your planned rates per position.
Time utilization management
There is a trick regarding time utilization management. Namely, with the rise of time utilization (which is a goal for most companies), if the income doesn’t change, the billable rate will decrease. That is, if we divide the same income by an increased number of billable hours, the billable hourly rate will go down.
That is why the most efficient policy is to increase the billable hours that get additionally invoiced to your clients. That is how you can increase both the hourly billing rate and time utilization.
You should define time utilization for each employee, or, better said, set up a target time utilization for them. You should communicate the goals well, and they should be measurable, clear, and realistic. As time goes on, you should track whether your employees are reaching their target utilization, and define your plan of action so that the deviations aren’t drastic. It is important to make sure the increase in billable hours within total hours isn’t a consequence of increased overtime, since that can cause exhaustion with your employees.
The next steps are redefining your business relationships with existing clients and strategy regarding new clients. This is the most difficult part of billable hourly rate optimization.
Differentiate billable and non-billable hours
There is no exact boundary between billable and non-billable hours since they depend on the company’s specific situation. Still, there is the common practice of counting every activity that relates to working for a client after signing the contract and is accounted for within the scope of engagements counts into billable hours. The practice is that all hours before signing the contract (drafting and sending the offer, for example), as well as all hours not related to servicing the client, are counted as non-billable.
You can learn all ins and outs of billable vs non-billable hours in our dedicated article.
Adequate billable hours management is important since their maximization leads to an increase in income. The client needs to understand that they need to pay for everything you do for them. Hence, it is important to emphasize the specification of your work to your client, and list the activities you’ll be performing for them that you’ll declare as billable.
How to optimize billable hourly rate depending on the client
Accurate workload assessment
Engagements with fixed fees
When it comes to engagements with fixed fees it is necessary to accurately assess the workload. This is best done by observing similar engagements you’ve had in the past. You should identify similar jobs based on reports from your timesheet software. Then you can assess how many hours you’ll need for a project. Additionally, you need to inform yourself of the client’s specific needs, that is, their demands, and how many additional questions they are expected to ask after the project is done. All of these factors should be a part of your planned billable hours calculations.
Alternatively, your offers can contain a price range, for example from $2500 to $2900 depending on the number of invoiced hours.
Engagements with variable fees
You should keep the fact that clients are sensitive to the offers where engagement is agreed upon by the hour without the hours being limited since in that case they are in the position of uncertainty about their expenses. That is why you need to find out whether your new client tended to pay the type of service you offer by the spent work hours or through fixed fees in the past. Either way, we suggest including an assessment of expected work hours in the offer besides the hourly billable rates.
Managing billable rates based on the expected profitability
Even though you have defined the prices per each position or employee (full time equivalent), if you expect your profitability from a project to be jeopardized, you should reconsider your hourly rates (value-based method). Also, if you predict that you can remain profitable even with lower hourly rates, you can offer the client lower billable hourly rates or a higher number of hours.
Whichever model you may choose, you need to assess the profit you expect from the project, keeping in mind how much the said project will cost you.
Define exactly what your work hour that is going to be invoiced represents
It is important to maintain outstanding business relationships with your clients. Hence, you should never invoice anything that may surprise them. You need to define the scope of your projects and the billable items within them, additionally, it is important to define the services you don’t offer. This way you’ll avoid misunderstandings when interpreting your services.
Besides the assessment of your work, you need to set a limit to the number of meetings a client can ask for during the engagement, considering that the time invested in this type of activity represents billable hours for you.
Reducing the deviation between planned and realized rate
Let’s say you’ve given an offer with a fixed price of $10.000. You expect to invest 100 hours, or, in other words, that your target hourly rate is going to be $100. however, once the project is done, the timesheet insights show you’ve invested 130 hours. That means the realized hourly rate is $77. hence, the gap between the planned and realized rate is $23.
Time tracking tools enable you to always have an insight into the scope of this gap for each client so you’d be able to take corrective actions for the following projects.
How to measure the results
Peter Drucker said: You can’t manage what you can’t measure.
So, you need to define a mechanism for measuring your goals considering the optimization of the billable hourly rate. Here is a couple of indicators, most of which you can measure through time-tracking software.
- Time utilization – this indicator is measured by observing the previous period and regarding the plan. If there are deviations you should identify their causes, and make a plan of action to eliminate them
- Actual average billable hourly rate
- Actual billable hourly rate per client
- The deviation of planned and realized billable rates
- Profitability indicators pre clients – Billable hourly rate concerning cost (pay rate)
Data accuracy assurance
In order to have accurate metrics you need to set a control over employees time tracking and prevent any type of time theft.
Also there is suggestion to perform time audit of all time data exported by time tracking tool.
You need many analyses and reports to adequately manage billable hourly rates and billable hours as well as increase your company’s profitability. This can be very exhausting and counterproductive (’’paralysis analysis’’ syndrome). That is why you need a time tracking software solution that can track the following indicators for the most important categories:
- Total hours spent
- Hours structure (billable vs non-billable hours)
- Work task structure
- Time utilization
- Costs and cost rate
Finally, it is important to determine the KPIs you’ll be monitoring, both historically and compared to planned KPIs in due time, and take corrective actions.
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