What are cost rates?
Cost rates are simply the individual costs of an employee or contractor to you as a business.
Why do we need cost rates?
In a professional services firm, you’re trying to sell a service.
You employ staff to deliver this service. But they only have so many hours available in any working week, so you’re actually selling man-hours to your client.
Now it may be that you don’t bill clients by the hour, and instead those hours are covered as part of an overall fee.
But the fact is, you still need to know how much those man-hours are costing your business.
Why? Firstly; you need to know the accurate cost of performing the work that you’re doing, so that you can work out the true profit of your projects.
Secondly, I always recommend that my clients do 2 things when they’re calculating fees.
- Work out what the fee is likely to be as a percentage of the construction cost
- Build-out the fee using a resource-based, bottom-up method - cost both and apply the mark-up to work out what the likely fee is going to be.
This is so that you can check if different fee approaches match-up.
Cost rates are a simple concept, but they're fairly difficult to calculate.
The aim is to make the profits on your projects in any one-year, equal the profits in the business for that same year.
This a very simple check that any business can do today. Here’s how:
- Add up all of the income from your projects for the year and all the costs that have been reported on projects for that same year
- Work out what that profit comes to, and check if that equals the profit of the business.
So if your business costs £1 million a year to run, then I'd expect the cost of your time, added up across all of your projects to also equal £1 million for the year.
Obviously it’s never going to be exact, but it should roughly equal the profits of your business (give or take 10%) .
If the figures don't add up at all, then your cost rates are wrong.
The impact of incorrect cost rates
- If you don’t get your cost rates right, your fees will be incorrect
Inaccurate cost rates also mean that the profits on your projects are incorrect.
So why is this an issue for architects & AEC firms?
Whenever I visit an architectural practice or engineering firm, one of the first things I do is look at their cost rates.
Over 90% of the firms I visit have incorrect cost rates.
Which is an astonishing figure when you think about it.
Most of these firms employ fewer than 50 staff, so they don’t tend to have professional accountants working alongside them who know how to calculate cost rates properly.
So a lot of these firms come up with their own cost rates over time; either via a finger in the air estimation, or by using the old RIBA method of 30% salary, 30% overhead & 30% profit – which is never accurate.
How to calculate your cost rates correctly
Before I get into this, I strongly recommend you download the cost rate calculation example document, which really helps illustrate the process:
Step 1: Set productivity targets
You‘ll need to start by making a list of individuals at your firm, with each of their salary rates.
After that, you apply a percentage to each individual, which can be called a productivity % or utilisation %.
A productivity/utilisation percentage is the amount of time an individual has available to them during a single year to actually spend on delivering billable projects.
Take a Part II Architect for example; you would expect around 80 – 82% of their time to be to spent on billable projects throughout the year.
The other 20% or so accounts for things like annual leave, sickness, training, internal meetings etc. – everything your typical project worker does that isn’t billable, project-related work.
Once you’ve worked out the productivity % for each individual, you then need to multiply that by their salary.
This calculation gives you the total amount of their salary that is recoverable on projects.
The remainder is left in the overhead.
Using the example above, you can see that Director 1 earns £70,000 per year and spends 50% of their time on billable projects.
So £35,000 of their salary is recoverable and the remaining £35,000 is left in the overhead.
You can then sum the balance that sits in the overhead for all staff, which will give you an overall figure.
This figure - the non-billable time spent by fee earners - is the biggest overhead figure in any professional services firm.
Step 2: Work out your overhead %
Once you've worked out that big overhead figure of non-billable time spent by your fee earners, you then need to add it to the rest of your overheads, which will include things like:
- Software licenses
- Payroll burdens such as pensions & National Insurance.
Once you’ve added that up, you have your total overhead figure.
The total overhead figure is the amount that you’re trying to recover via time spent delivering fee-paying projects.
You need to divide your total overhead figure by the total salary recoverable on project delivery, which gives you an overhead percentage.
So using the example in the table above, the overhead % calculation would be:
It's vital that you do this calculation yourself because your overhead % can be anything, from 50% to 300%. It’s all relative to the scale of your firm.
Once you’ve calculated your overhead %, you can work out what your cost rates are.
Step 3: Calculate your cost rates
From here on in, its fairly simple.
You've got your list of individual salaries & you know how many hours people are working in a year (usually 37.5 x 52 or 40 x 52).
The next step is to calculate your hourly salary cost per individual.
To do this, you divide the salary cost of each individual by the number of hours they're paid to work in a single year.
The resulting figure is the hourly salary cost for that individual.
You then need an overhead figure for that individual, so you multiply the hourly salary cost by the overhead percentage you worked out earlier.
Using the example above, Director 1 is paid £70,000 per year, so their hourly cost is £35.90.
We worked out earlier that Director 1's architecture firm has an an overhead percentage of 110%.
So to work out Director 1's cost rate, multiply his hourly cost x the overhead percentage 110% , which gives you another £39 to charge. Add the two together & you get £75 per hour.
So that individual who costs you just shy of £36 per hour in salary actually costs you just over £75 per hour in total. That’s if your overhead rate is 110%.
Once you’ve done that calculation for every employee, you’ll have the correct man-hour costs of every single individual in the business.
Remember, this calculation completely depends on what your overhead percentage is. Which is why it's really important to do your own calculations rather than rely on estimations.
As a general guide, the overhead percentage is usually more than the salary cost (but not always).
How do you know if your cost rates are correct?
To check your employee's rates are correct, take the total number of paid hours & multiply that by their utilisation percentage. From that, you’ll get the amount of time that the employee is expected to work on projects throughout the year.
Then take the cost rate and multiply that by the total hours spent on projects, you’ll end-up with an overall figure to recover the cost of the business.
Again, using Director 1 as an example, we can see that they should be spending 50% of 1950 hours on project delivery, which is equal to 975 hours. Multiply 975 by their cost rate of £75.42 & we end up with a total of £73,535 to recover.
Do this calculation for every staff member & add the resulting figures together, the total of that should equal the total cost of running the business.
If it doesn’t then you’ve done the calculation incorrectly.
Where can cost rates go wrong?
Even if you do all of those calculations correctly using the above techniques, it can still go wrong. There are a few reasons for this:
A lot of firms set these productivity targets for their staff and use that figure to calculate their man hours. Which is fine.
But they never actually go back & check if their staff are achieving those utilisation percentages.
So what often goes wrong (very quickly) is that staff productivity levels can actually be 10 – 15% less than what’s been accounted for.
The impact of this is that cost rates are too low.
In other cases, staff can hit much higher productivity levels than what’s been accounted for.
Therefore their cost rates are too high, which means that project profits are not as high as the real profits that are actually being made in the business.
You’d think that wouldn’t be a problem. But actually, if fees are higher than they need to be, then the business probably isn't as competitive in the market as they should be.
So you need to be checking that staff are meeting these productivity targets as regularly as possible.
You’d be surprised at how often people forget to go back and recalculate their cost rates when staff receive salary increases.
So if you give your whole company a salary increase, do remember to go back & recalculate your cost rates to ensure they’re accurate.
If you experience a fluctuation in staff numbers, it will have a big impact on your cost rates.
A reduction in staff means that you have less staff to recover the overhead, therefore your cost rates will go up.
Whereas an increase in staff means you have more people to recover your overheads on, so therefore your cost rates go down.
So any time your staff numbers change, you need to be recalculating your cost rates.
How often should you check your cost rates?
You should be checking & recalculating your cost rates every 6 months as a minimum.
Getting this into your diary as a bi-annual process provides the perfect opportunity to check staff numbers & salaries as mentioned above, further ensuring your rates are always as accurate as possible.
There are so many architecture practices out there operating with incorrect cost rates, meaning they're operating with incorrect fees & profits.
Make sure your practice isn't one of them by getting your cost rates correct as soon as possible.
If your rates are correct, your project profits will equal the profits of your entire business.
This will put you in a great position, where you only need to monitor your projects in order to be confident about how your business is performing as a whole.
Secondly, if you seek out fee calculations based on resources, you will know true the cost of delivering that piece of work. So, if clients start negotiating on fees, you know the bottom line – you know how far you can go.
About the author
Auria Accountancy Limited is a well-established firm of Chartered Accountants in London’s West-End, working primarily with architectural firms & professional services businesses in the creative sectors.
Michael Holmes has a 30-year career as an accountant in professional services firms, including 15 years as the Finance Director of CMAP clients Grimshaw Architects. His wealth of experience advising & supporting small-to medium-sized Architectural businesses is greatly supported by a deep understanding of the issues & challenges affecting them.