Establishing Hourly Rates
To establish an hourly rate, a contractor needs to know they are charging enough to cover the bills. Establishing hourly rates is quite complicated with employees. The bottom line is, whether you prefer to use a fixed price contract or a time and materials contract, it is critical to make enough to cover expenses.
Researching local hourly rates by talking to other contractors is the primary way hourly rates are established. There isn’t a set of rules for establishing hourly rates, and there are many methods and reasons behind how an hourly rate is determined. Many factors go into establishing hourly rates. The type of jobs, experience level, and local market conditions are just a few.
Let’s dig a bit deeper to see if your hourly rate is adequate. The break-even point is the minimum amount needed to avoid losing money. We look at living expenses, operating expenses, and company labor costs to find the break-even point, which can help establish an hourly rate.
Living Expenses
Simply put, living expenses are the costs for day-to-day living. The easiest way to calculate these expenses is to make a list of everything you pay throughout a month, then add them up: rent, utilities, food, credit card, etc. Include business vehicle expenses with business operating expenses. Don’t forget property tax and insurance that are paid less often.
Finding your monthly living cost is a good starting place to determine the break-even point for the hourly rate.
Example: What is the hourly if living expenses are $2,000 a month?
1. Find the weekly living cost. Divide the monthly living expenses by four to find the weekly living cost. For simplification, we are using four weeks in a month.
$2,000 ÷ 4 = $500/week
Living expenses are $500 a week.
There are 51.142 weeks in a year. Use 13 months (52 weeks) to convert to yearly figures.
$500 x 52 = $26,000/year
$2,000 x 13 = $26,000/year
Living expenses are $26,000 a year.
2. Reduce living expenses to an hourly rate. Divide the weekly living cost by the weekly billable hours to find a break-even point for living expenses. If 30 hours are billed, what is the hourly amount?
$500 ÷ 30 = $16.67/hour
The break-even point for living expenses is $16.67.
Operating Expenses
Costs unrelated to a project are called operating or indirect expenses. These expenses include insurance, office expenses, licensing, office employees, rent and utilities, vehicle expenses, tools, etc.
An Income Statement, also known as a Profit and Loss Statement, shows monthly operating expenses. If an accounting system hasn’t been established, start by making a list of all your operating expenses.
Example: A contractor bills 30 hours a week, and the monthly operating expenses are $1,000. What is the hourly cost for operating expenses?
1. Find the weekly operating cost. Divide the monthly operating expenses by four to determine the weekly operating costs.
$1,000 ÷ 4 = $250/week
Operating expenses are $250 a week.
$250 x 52 = $13,000/year
Operating expenses are $13,000 a year.
2. Reduce operating expenses to find an hourly rate. Divide the weekly operating cost by the weekly number of billable hours. If 30 hours are billed, what is the hourly amount?
$250 ÷ 30 = $8.33/hour
The break-even point for operating expenses is $8.33.
Break-even Point Before Taxes
Add the hourly break-even points for living and operating expenses together to find the hourly rate before taxes.
$16.67 + $8.33 = $25.00/hour
The combined hourly living expenses and operating expenses are $25.00 per hour.
| Billable Hours | Hourly Break-Even Point | Weekly Expenses | |
| Living Expenses | 30 | $16.67 | $500.10 |
| Operating Expenses | 30 | $8.33 | $249.90 |
| Total Expenses | $25.00 | $750.00 |
- Weekly living expenses are $500 a week.
- Weekly operating expenses are $250 a week.
- Total living expenses and operating expenses are $750 a week.
Recheck by dividing the weekly hours billed by the total weekly expenses.
$750 ÷ 30 = $25.00/hour.
To recap: Billing 30 hours a week, the hourly rate is $16.67 to cover living expenses plus $8.33 to cover operating expenses; the hourly rate is $25.00 per hour.
Break-even Point with Taxes
Using the hourly rate of $25.00 per hour and 30 billable hours, find the hourly rate after taxes.
1. Find the weekly income to cover expenses.
$25 x 30 = $750/week
The weekly amount is $750 before taxes.
2. Calculate the weekly self-employment taxes. Determine tax costs by multiplying the weekly amount by 15.3% (12.4% for social security and 2.9% for Medicare) for self-employment taxes.
$750 x .153 = $114.75.
Weekly self-employment taxes are $114.75.
3. Find the hourly self-employment tax rate. Divide the self-employment taxes by the billable hours to find the hourly self-employment tax rate.
$114.75 ÷ 30 = $3.83
The self-employment taxes are $3.83 per hour.
4. Find the hourly breakeven point. Add the hourly self-employment tax rate to the hourly rate.
$25.00 + $3.82 = $28.83.
The hourly breakeven point after taxes is $28.83.
Labor Rate
The employee labor rate includes base pay, overtime, taxes, benefits, and paid time off and allowances. If the weekly hours worked are inconsistent, a more accurate picture would be to look back historically and average a more extended period. For instance, look at three months to find a weekly average.
Let’s use this simplified example to illustrate how the total hourly rate for employees is found.
Example:
- A construction company has two full-time employees; one is paid $16 per hour, and the other is paid $18 per hour.
- The state unemployment rate is 3.7%.
- Workers’ compensation insurance rate is $3.00/hour.
- The company offers a Simple IRA, matching the employee’s 3%.
- The insurance premium is $400 for each employee, and the company pays 50% of the cost.
Hourly health insurance calculation: The employer portion is $200 per month, $50 per week. A full-time employee works 40 hours per week. Divide the monthly amount by 4 to get the weekly insurance cost. Then reduce the weekly cost to an hourly rate.
$200 ÷ 4 = $50.00/week
$50 ÷ 40 = $1.25/hour
Insurance would cost the employer $1.25 per hour per employee.
Add together the base pay rate, the tax amounts, and the benefits to determine the total hourly wage rate.
| Base Pay Rate | FICA 7.65% | FUTA .06% | SUTA 3.7% | Workers’ Comp | Retirement Plan 3% | Health Insurance | Total Hourly Rate |
| $16 | 1.22 | 0.01 | 0.59 | 3.00 | 0.48 | 1.25 | $22.55 |
| $18 | 1.38 | 0.01 | 0.67 | 3.00 | 0.54 | 1.25 | $24.85 |
The Hourly Rate with Employees
Calculations with employees can quickly become complicated. Many variables must be taken into consideration. As employees are added, the contractor’s labor shifts from the job site to providing management and oversite. As the company grows and wages are raised, the cost for some positions may be higher than the hourly rate.
The math is pretty straightforward for a contractor who works on the job site and has one or two crew members. We determined the breakeven point is $28.82.
We can see we have a breakeven point of $28.82 and two hourly rates of $22.55 and $24.85. Let’s see what happens when we round up slightly using $30.00 for the hourly rate
| Rate | Wage | Difference | |
| Owner | $30.00 | $28.83 | $1.17 |
| Employee #1 | $30.00 | $22.55 | $7.45 |
| Employee #2 | $30.00 | $24.85 | $5.15 |
| Hourly Profit | $13.77 | ||
| Daily Profit | $110.16 |
The hourly labor profit is $13.77 per hour.
What happens when employee #1 takes the day off?
| Rate | Wage | Difference | |
| Owner | $30.00 | $28.83 | $1.17 |
| Employee #2 | $30.00 | $24.85 | $5.15 |
| Hourly Profit | $6.32 | ||
| Daily Profit | $50.56 |
The hourly labor profit is $6.32 per hour.
$110.16 – $50.56 = $59.60
The daily labor profit drops by $59.60.
Non-Billable Hours
Consider that the actual employee billable hours each day does not always equal the hours worked. Productive work time and payroll will fluctuate due to several variables. Some can be planned for, and others are unknown.
Variables:
- Downtime.
- Power outages
- Broken tools
- Material shortage, wrong materials
- Warranty work
- Training time
- Travel time
- Company and safety meetings
- Paid time off
Conclusion
Understanding costs is the best guide to establishing the hourly rate. Finding the hourly rate for a business owned and run by one person is pretty straightforward. The formulas used to determine an hourly rate can become quite complicated with employees. Finding the minimum rate helps to establish a break-even point. Any less would result in a loss to the business.
Ultimately the hourly rate needs to be competitive and high enough to provide a living for the owner; with planning, the hourly rate will allow the company to be profitable and grow. An accountant can provide better information to help establish hourly rates.
