Estimating your costs, also known as your overhead, helps you set up the framework for what you will charge for your services and how you will structure your business. It’s important to understand what kind of income you need to generate each month to cover your overhead. Once you’ve hit this number, the rest will be considered profit. Read on to learn more about calculating your overhead, setting the right rate, and choosing the right pricing strategy to ensure a profit.
Understanding how to estimate your anticipated total salaries, overhead cost, and desired profit and your combined working and billable hours is essential to operating your business. Below is a simple formula that will help you come up with a reasonable estimate that can guide your hourly rate setting.
1. Calculate Your Hourly Rate
One of the most common ways to calculate your hourly rate is:
Actual and anticipated total salaries
plus actual and anticipated total overhead cost
plus desired profit
divided by the total working hours in the year for all employees combined
Below is an example of how this might work for a typical business:
Calculating actual and anticipated total salaries
Senior Designer: $50,000
Junior Designer 1: $35,000
Junior Designer 2: $35,000
Quality Control Professional: $30,000
The total combined salaries -$225,000.
You should also add all other costs associated with labor: payroll taxes, benefits, workers compensation insurance, bonuses (if pre-determined), etc. As a rule of thumb, tack on about 20 percent, or about $45,000 for these.
The total would then be $270,000.
Next, figure the total number of labor-hours that the firm could charge in a year. Assume 8 hours a day, times 5 days a week, times 52 weeks, times 4 people (the Quality Control person represents non-billable time).
Total working hours possible: 8 x 5 x 52 x 4 = 8,320 hours. But, obviously no designer can be expected to charge every hour of their time. Allowances have to be made for vacations, legal holidays, sick days etc.
7 legal holidays 8 x 7 x 4 = 224 hours
2 week vacation 8 x 10 x 4 = 320 hours
1 week sick leave 8 x 5 x 4 = 160 hours
8,320 hours – 704 hours = 7,616 hours
You must also make an allowance for other non-billable hours – time when the designer might be cleaning up, filing, working on skill improvement etc.
Allow approximately 25 percent for non-billable hours.
7,616 hours x 25% = 1,904 hours
7,616 hours -1,904 hours = 5,712 hours
Now divide the number of billable hours (5,712) into the annual cost of salaries ($270,000) per-hour cost of labor.
$270,000 / 5,712 = $47.27 per hour
(We’ll round up to $48 per hour).
This represents a blended rate of all members in the agency. Using a blended rate can simplify the resource planning process for your firm if you are just starting out.
In order to cover only the cost of salaries, you need to charge $48 per hour.
2. Calculate Your Overhead
Overhead represents what it costs to be in business, as opposed to labor, which is what it costs to do the work. Overhead costs include items like rent, internet service, electricity, insurance, phone, equipment, software, postage, stationery, art supplies, magazine subscriptions, accounting fees, advertising, and marketing costs. These are expenses that are passed on to a client indirectly by building in an add-on percentage into billable time.
For the sake of this illustration let’s assume these costs total $100,000 per year. That equals 37 percent of the total salary cost.
$100,000 / $270,000 = 37%
$48 per hour (labor costs) x 37% (overhead percentage) = $17.76
$48 + $17.76 = $65.76 (rounded to $66)
In order to cover the cost of salaries (about $48) and the cost of overhead (about $18), you need to charge $66 per hour. This is the price per hour to recover the cost of salaries plus overhead expenses and is often referred to as “breaking even”.
3. Calculating Profit
Profit isn’t just money-made. It should also be viewed as a tool that you can use to cover periods of slow business, replace old equipment and cover any appropriate bonuses or raises. It can also be used to secure a line of credit or finance growth. Keeping comfortable profit margins allows you both flexibility and opportunity.
Now that you’ve calculated what you need to cover your salaries and your overhead ($66), calculating your profit margin is simple. A minimum profit margin of 10 percent is desirable; 20 percent is preferable. So if you want to calculate a 20 percent profit margin, just take your price ($66) and divide it by 80 percent.
Price = $66 ÷ 0.8 = $82.50 (rounded to $83)
You should keep a close eye on your profit margin each month and adjust as needed to hit your goals. Remember that profit is a tool that allows flexibility and potentially growth.
4. Considering Value
You should also consider value when calculating your rate. Value is intangible, complex and there is no set formula. Value is unique to your business and it is what differentiates you from your competitors.
Value can be defined as the reason that your clients choose to work with you over any other agency and it’s tied closely to your reputation. A few examples of value would be:
- The reputation of the designers in your agency. Pentagram is a great example of this.
- Your agency’s client list. A client might choose to work with you based on who you’ve worked with in the past. Do you serve a particular industry? This adds to your value because you have insider knowledge and are able to provide the client with unique insight.
- Your agency’s reputation for always meeting deadlines while still producing high-quality work.
A component that can affect value is competition. You don’t want to overvalue your service and charge a premium rate if you have a lot of competitors since you might price yourself out of the market. You will also want to continuously focus on building value for your agency. You can do this with consistent quality and also by taking on the kind of work that you want to continue doing. Showcasing big projects, awards and outstanding work can help add to your agency’s value.
There isn’t a set formula for calculating your value and it might fluctuate over time. Consider all of these aspects and make a reasonable estimation of what your value is and use that number to calculate your hourly rate.
5. Tracking Your Clients’ Return on Investment (ROI)
Closely related to the value of your work is the return on investment that your customer can measure, but only after the project is finished. Measuring things like increase in web traffic, increase in sales, increase in leads to their business, or other metrics that provide hard numbers pointing to the success of the design work you’re creating for the clients you work with will help you build your perceived value. As your reputation grows you can show these figures and stats to potential clients as “proof” that you provide a strong ROI. This information can also be used to justify price increases with existing clients.
Clients rarely want to pay more than they have to but if you can make a reasonable case that spending X on your design work can result in a 10X or 50X return on investment, you will find they are much more willing to work with you at a higher price. If the case is well supported by a consistent track record of high ROI, they should be very happy to spend the money because it ultimately means more money for them.
Keep these objectives and methods in mind when determining price:
- The objectives of pricing:
To establish a clear and definitive price that clients understand; a price that they can work into their budget, and that they are willing to pay.
- To place the design firm in a reasonable position relative to its competition.
- To allow the design firm enough flexibility to adjust its fees depending on the situation.
- To pay the design firm a fair price relative to its talent, experience, and efficiency, and relative to its total contribution to the client’s ultimate profits.
The four basic methods for determining price:
- Average hourly rate/ flat bid
- Hourly Rate
- Individual hourly rate
- Sales price
Each of these methods has advantages and disadvantages and is best applied in certain situations.
This method involves estimating how many hours your agency will spend on a project and multiplying it by your hourly rate. This approach sounds simple, but it can be tough to estimate how long a project will actually take.
You will need to work in time for:
- Any stock photography or video used
- Quality control
- File Prep
- Account Management/ Project Management
It’s also important to consider who will be in charge of production on this project. Different designers take different amounts of time to complete a project and designers with more experience will typically work faster. It’s always safer to overestimate and a good rule to follow would be to always add from 30 to 50 percent more to the total estimated time.
If you are working with a team where an Account Manager is the main point of contact, it is typical to add about 20 percent more to the true estimated total to account for their time, services, and hours spent on the project.
- In organizing your estimate, you also create a plan for implementing the job once the estimate is approved.
- This method breaks the job down into small budgets and schedules, which help in project management. Your team has a clear goal to stay under budget and keep the project profitable.
- It identifies areas where changes may be negotiated. If the final estimate is too high, you might get the client to agree to involve less stakeholders or to cut aspects of the project.
- It presents the work in a way that the client can appreciate the time and effort that good design typically takes.
- The more complex the job, the longer it takes to break it down into smaller tasks.
- It’s easy to underestimate how many hours a project will take, resulting in lost profit. Overestimating could cost you the job if the client chooses a lower priced competitor.
- If a project is going off track of your estimates, you’ll need to manage those expectations with the client and decide how you want to handle the overage.
This involves establishing an hourly rate with your client based on your desired profit. You might give the client the opportunity to negotiate this rate based on how many hours per month they promise. This is called a retainer and applies when the client makes a recurring monthly payment, and you work with them on a long-term project, or provide them with access to services each month. The hourly rate agreement is fairly straightforward since the client simply agrees to a certain hourly amount and you bill them for the amount of hours spent.
Some clients may want to purchase a set amount of hours per month for support. In this instance, once a set budget has been agreed upon, you can charge a higher fee for any overage for having to expedite projects, extend resources, etc. This higher rate can be used as a tool to encourage the client to purchase a larger support package from you. In this instance you will want to let your client know if and when you have reached 80 percent of that month’s hours.
- There is no risk of underestimating the amount of hours that you will spend on a project since that number is not set.
- There is less pressure to work as quickly as possible, which decreases the chance of errors or subpar design work.
- You will need a reliable and organized way to track hours spent per project – we recommend tracking your hours in a program like Toggl, Harvest, or Teamwork.
- You will need to bill for the time used for: research, meetings, revisions, stock photography etc. Unless you show these individual items in the bill, the client might be surprised at how many hours a project took.
- The client doesn’t get a complete understanding of what efforts have gone into a project and might end up requesting that you provide a more detailed breakdown or that you notify them when the project hits a certain amount of hours.
Individual Hourly Rate
This is a variation on the average hourly rate. The difference is that you use a different per-hour fee for each task, based on the salary of the individual who will actually perform the task. The per-hour rate is replaced by one rate for a senior designer, another for a junior designer etc.
- The estimate tends to be more precise than the flat bid method.
- All the other advantages of the average hourly rate method also apply.
- It adds another layer of complexity, which makes estimating more time-consuming to organize.
- If, for any reason, the people who actually end up doing the work are not paid the same salaries as the people on whom the estimate was based, actual costs could be far above or below the quoted price.
3. This type of estimating forces a choice between accurate pricing and flexibility in using personnel. If salaries are not interchangeable, then personnel become locked in by the way the job is priced.
Value-Perceived/ Value-Based Pricing
In this method you focus on your client’s goals, desires, and challenges and put your agency in context as a trusted advisor. You’ll then be able to identify a sales price that seems to be what the client is willing to pay. Then it works backward, allocating overhead and profit to the job in order to determine the number of labor-hours to assign to the job.
For example, you determine that your client is willing to pay around $3,000 for a 3 page website. By subtracting the hoped-for profit and operating expenses, you arrive at the budget for labor charges as well as the number of designer’s hours budgeted for the job:
$3,000 (sales price)
Profit desired: $1,000
Expected operating expenses: $66
$1,000 (hoped for profit)+ $66 (operating expense) = $1,066
$3,000 – $1,066 = $1934 (budget for labor charges)
$1934 / $83 = 23 ½ hours allocated to the job
- The highest priority is put on getting the most for the job.
- It clearly identifies a goal (x hours) to work toward.
- The budgeted labor-hours may not be enough to do the job properly. It’s possible that the job could be designed poorly, or overtime is required to maintain the schedule and reduce the losses.
Each of these methods has its advantages and disadvantages. You must use your judgment in deciding which method applies best in a specific situation. You may feel more comfortable with one method than another. Still, there is no requirement that you use one method exclusively. No method will be perfect for all situations and it’s likely that you will change how you approach pricing many times over your career. You can use different methods client to client and even project to project.
Agency Metrics for Profitability
As you grow your agency, there are two metrics that will be key to your success, Utilization and Realization. Each metric is connected to productivity and profitability. Setting goals for each, and monitoring on a weekly or monthly basis will allow you to see where team members or projects may be underperforming.
Utilization Rate is the number of hours worked in a week divided by the total number of available hours to work. So if an employee clocked 32 hours out of an available 40 hours in the week, they have a utilization rate of 80 percent. The goal should typically be 80 percent utilization. This will require time tracking on projects and should be monitored monthly, or weekly as your team grows. Different roles may have different “expected” hours billed per week. For example, a director level may only be expected to bill 15 hours/week to a client, whereas a junior designer is expected to bill at least 32 hours to client work. This metric is important for making sure your team is spending time on productive projects and working efficiently.
Realization is different than utilization in that it is tied directly to revenue. Realization is calculated by taking the total number of hours billed to a client and dividing by the total billable hours. For example, out of 100 hours worked on a project, 75 of those hours were billable, and 60 of them were billed to the client, resulting in revenue. This project would be 80 percent realized. This metric is important for keeping track of revenue and comparing it against projections and project proposals and estimates.
Chapter 4 Conclusion
As a business owner, you should always keep close track of your profit margin and make sure that you are hitting the appropriate numbers. If you are not making more money than you’re spending, you will need to make adjustments to what your spending, what your charging, and how much work you are bringing in.
Most importantly, remember that any of these methods, if followed properly and if based on accurate per hour and overhead costs, can allow you to create an estimate that will assure your firm an operating profit. There are many good time tracking programs and services as well as accounting tools that will help you see the bigger picture over time. As you complete more work and track your time, profits, and expenses you will begin to see patterns emerge that can inform your pricing structure for certain kinds of projects and certain kinds of clients. Make it a point to set aside time to review your numbers quarterly and fine tune as needed. Reviewing with your accountant can be a great way to get an outside and financially savvy perspective about what is working well and what may need to be adjusted.
This chapter was written with the help of Jaime Sunday, Senior Account Manager at Groove: Creative Marketing, Design, and Development in Baltimore MD.