There’s a lot of confusion in the agency space about what should or shouldn’t be factored in when calculating your billable employee cost-per-hour. We’re sharing our tested employee cost calculator tips in this step-by-step guide.
The ultimate question we’re all trying to answer is – how much does an employee cost per hour?
Should I include overhead in employee cost? What about worker’s compensation? State unemployment tax, social security, 40k? Should a fully loaded employee calculation be based on their gross capacity or just their billable capacity?
What about employees that are part-admin and part-billable? What about benefits and insurance? Production software? You can understand the actual cost is very different than the hourly wage.
What should and shouldn’t be included in employee cost?
There’s a lot of mud in the water, and you’ve probably read a lot of conflicting information on the subject. So we’re helping you answer how much does an employee really cost your agency.
That’s why I’m writing this guide to give you a clear answer. I want to help you understand how to calculate this important metric in the different contexts you might encounter in your agency.
What’s in this guide:
- Fully Loaded Employee Calculator – The Method
- The Steps to Calculating Employee Cost-Per-Hour in Your Agency
- Using Employee Cost Per Hour In Your Agency
- Calculating Gross Margin
- Calculating Pass Through Expenses
- Agency Gross Income Calculation
- Calculating Direct Labor Costs
- Calculating Gross Margin on Projects or Clients
- Try the Overhead Cost Per Employee Calculator
Why do so many people calculate employee billable cost-per-hour the wrong way?
In my experience, most of the confusion around what to include and what not to include here comes down to not being clear on how this cost-per-hour number is going to be used. (And what questions it’s going to help answer.
I see this most often when questions about overhead and billable capacity come into the fold. This usually happens when someone is trying to work backward from project-costing to net-profitability.
I could go on a lengthy rant about why I don’t think trying to calculate net-margin on projects and clients is a worthwhile pursuit. (And why it’s actually more useful to understand gross margin on projects or average billable rates). But that’s a whole other post on its own.
The bottom line is that if we’re looking at the project/client level – we generally want to focus on Gross Margin first. This is because it helps us understand how efficient we are at earning revenue in our agency or service business.
It’s also a metric that allows us to benchmark things against each other both internally and externally because it removes variable costs like overhead from the equation.
You can think of Gross Margin similarity to EBITDA in this context. It’s especially useful because it levels the playing field and allows us to compare virtually any subsection of our business to another both within our agency or against the industry as well.
That’s why I recommend focusing on Gross Margin when assessing client or project level profitability and reserving net margin analysis for broader contexts in your agency.
Another important reason we want to focus on Gross Margin or Average Billable Rates is that it’s the foundation for the profitability of the entire agency.
If we can’t consistently protect gross margin on projects and earn our revenue in an efficient way, getting healthy net profit will be extremely difficult (or impossible)
So for the context of this post, I’m going to discuss how to Calculate Billable Employee Cost Per Hour for the purpose of calculating Gross Margin on clients & projects. Simply put, we’re going to use employee cost per hour to better understand what it costs us to earn revenue, and how efficiently we’re doing that.
Why is this important to establish before we talk about employee cost per hour? Because without being clear about what question is being answered with this metric, it’s difficult to justify what does and doesn’t get factored into the calculation.
If we agree that we’re using cost-per-hour to calculate gross margin, it immediately becomes more clear that we should not be factoring in overhead of billable capacity to this calculation for most employees.
What all of that said, what exactly is the formula for calculating employee cost per hour in your agency? Let’s jump in!
Fully Loaded Calculator: The Formula
In this context, Cost-Per-Hour is expressed by the following formula:
Fully Loaded Cost / Gross Capacity
This means we need to identify two things in order to Calculate Billable Employee Cost Per Hour:
- Employee Salary + Benefits (Fully Loaded Cost)
- Gross Capacity
Some notes before we begin:
- In the context of this post, Billable Employees refers to team members whose primary responsibility is doing work for paying clients.
- If you have team members who are Partially-Billable, you should allocate a portion of their salary based on the % of their time spent on billable work and adjust their capacity (in hours) accordingly.
- We define Billable Work as any time spent doing anything for clients that pay you money. (Regardless of how you charge that client, or whether or not that time actually brings in any additional revenue.)
- We’re not going to factor in overhead in these hourly costs. Since the primary objective of this exercise is to assess the Gross Profit margin at the project level. (The most common application of this metric in our experience)
The Steps to Calculating Employee Cost-Per-Hour in Your Agency
I – Calculate the Fully Loaded Cost of Your Employees
The first step in getting to an accurate number is looking at the loaded cost of your billable employees.
What Are Overhead Costs?
Overhead costs are recurring expenses that sustain your business but don’t contribute to income. They are often called indirect costs because they are not part of business activities that generate revenue. The overhead costs can be divided into three categories: fixed, variable, and semi-variable.
For example, buying software license required to deliver work on a specific project is a project overhead that doesn’t apply to the entire company. You pay for overhead expenses regardless of whether you engage all your specialists in projects or half of them end up on the bench.
Overhead costs add up beyond the flat hourly rate you pay your employees, so let’s discuss those.
This means tallying up the following things in this fully loaded cost list:
- Payroll Taxes
- Training & Development
- Perks, Equipment & stipends
- Any other expenses that are directly related to employing this individual
For a more comprehensive list, check out this blog article by MIT
An easy way to model this is to add what we often refer to as a “Burden Cost” to an employee’s salary as a percentage. Sometimes you hear the phrase fully burdened labor rate, and that’s what we’re dealing with here.
As a rule of thumb, an additional “Burden Cost” will generally be about 15-30% of a person’s salary depending on your perks and benefits packages.
I know labor burden cost isn’t a very fun name, so you’re welcome to call that whatever you want.
As an example of this labor cost:
To thoroughly calculate the cost of an employee, you’ll want to build out this kind of chart for each employee, or at least figure out what the blended average “Burden Cost” % is for your company and apply it across your team to model full loaded cost.
Be sure to also calculate any state unemployment costs you are required to pay, or paid time off according to labor laws, and other health care costs. Additional costs are usually where things can deviate. Speaking to your payroll service to get a complete understanding of how these costs vary for your team is a good way to gain clarity.
II – Find Yearly Available Hours per Employee
The next step is to figure out what each employee’s capacity is, so you can figure out their cost per hour.
This is fairly straightforward but is often done incorrectly. So we’re going to break it down.
A – Calculate Gross Capacity
The first step is to figure out each employee’s Gross Capacity. This is the total number of hours you’re essentially purchasing in bulk via your employment agreement.
Generally, this is 40 hours per week X 52 weeks in a year which comes out to around 2080 hours per year.
Generally, we think about this in terms of how many hours per week we’re paying them for in a given period of time. We want to make sure to include any “paid time off”. This includes sick days or vacation days that we’re compensating them for, even if they’re not working for us during that time.
You might be asking yourself, “shouldn’t we be basing this cost per hour on the amount of billable time they have available in a given time period”
I can understand why you might think that, but I’ll remind you that we’re using this cost per hour number to calculate our Gross Margin. Non-billable time like this will end up in our Gross Margin calculation in the accounting software when things get reconciled – although your accountant may want to call this contribution margin (that’s cool).
But for the purpose of modeling gross margin on a project or client level, we want to leave these overhead costs out of our calculation. This is because billable expectations, vacation time, sick days and other benefits can vary dramatically from one organization to another, or even one employee to another within your company, we want to remove those factors from this calculation so we can create a ubiquitous metric that can be used across all our projects, clients, or subsections of our agency reliably and consistently.
To compensate for the fact that we’re not adjusting cost for billable capacity, we simply set our gross margin targets high at the project level (we recommend 60-70% as a target)
This bakes in the assumption that at the agency-wide level on an annual basis, we’ll lose 15-25% margin on utilization gaps and time off, and then another 20-30% on overhead ideally leaving us with a healthy net margin of 20-30% on the year-end P&L.
III – Calculate Employee Cost-Per-Hour
Now to calculate the hourly cost of each of your team members, you’ll need to bring these pieces together.
In this context, Cost-Per-Hour is expressed by the following formula:
Fully Loaded Cost / Gross Capacity
You’ll want to divide your Loaded Annual Cost by your Capacity to get to your Cost Per Hour for each employee.
That’s it! You now have an accurate calculation for Employee Cost-Per-Hour. You can use it to figure out your gross margin on projects, as well as calculate the cost of internal project investments in your agency!
If you’re looking for an easy way to calculate this for your entire team, as well as lots of other awesome tools for improving your agency’s profitability; Check out the Agency Model Generator Template that’s included in our Free Agency Profitability Toolkit:
Download the Agency Profitability Toolkit!
Get the same templates & guides we use with consulting clients to get them results fast.
Check your inbox for your free toolkit!
IV – Using Employee Cost Per Hour in Your Agency
Now that you’ve calculated employee cost per hour for each of your team members, how should you be using it in your agency?
The most common application we’ve seen has been trying to assess the profitability of projects and clients either in the scoping phase of a project or retroactively.
We wrote a pretty in-depth blog post on this topic, so if you want to go deep check that out, but here are the spark notes:
Calculating Gross Margin using Employee Cost Per Hour
The formula for Gross Margin is as follows:
Revenue – COGS = Gross Margin
Where COGS = Pass Through Expenses + Direct Labor Cost
So we need to know two things in order to calculate gross margin:
- Pass through Expenses
- Direct Labor Costs
Calculating Pass-Through Expenses
Examples of Pass-Through Expenses would be:
- Stock images
- Outsourced Work (contractors/freelancers)
- Website Templates
- Equipment rentals
- Travel costs related to production
- Any other cost that passes through you and into another vendor in order to deliver work to the client. (These may or may not be marked up – either way, it doesn’t affect this math)
Removing pass-through expenses from your gross revenue on a project produces a number we call Agency Gross Income (AGI). This is an important metric for you to be paying attention to, since it’s the number we benchmark all your spending and profitability on.
If you want to go deeper on AGI, check out this post.
Example of Agency Gross Income (AGI) calculation:
|Total Project Revenue||$100,000|
Calculating Direct Labor Costs
Next, we want to figure out how much it costs to earn our AGI based on the labor costs incurred on the project.
We do this simply by taking all of the time logged against
the project or client and multiplying it by the Cost-Per-Hour of the employees involved.
|Employee||Cost Per Hour||Hours||Total|
Calculating Gross Margin on Projects or Clients
The last step is to subtract Labor Costs from Adjusted Gross Income (AGI) to get to our Gross Margin.
Example of Gross Margin calculation:
|Total Project Revenue||$100,000|
|Adjusted Gross Revenue (AGI)||$65,000|
How to Calculate Overhead Cost Per Employee (Try This Calculator)
And of course, if you want a head start, we’re here to help. We put together this cost per employee calculator to try.
Next Steps – Determine the Real Overhead Rate of an Employee
How you calculate employee cost-per hour is an important thing to define internally so you can ensure consistency in the way things are modelled, especially when it comes to project profitability.
I encourage you to keep an up-to-date record of these figures and use this cost calculator often in your scoping and estimation process – even load them into your time-tracking tool if it allows you to do so allowing you to more easily and quickly get a directional sense of earning efficiency on your projects.
How you calculate fully loaded employee pricing is a critical part of nailing your earning efficiency, which is the foundation of your agency’s profitability.
Understanding how well you’ve earned revenue across your clients and projects allows you to compare them to one another and identify opportunities.
One of the best ways to improve your profitability is paying attention to outliers (both positive and negative) and facilitating conversations with your team about why projects do or don’t go as planned in order to refine your processes.
If you’d like to get access to a complete system for measuring, reporting on and facilitating process improvement based on earning efficiency – download our free agency profitability toolkit which walks you through exactly how we implement this process for our consulting clients.
If you’re looking for a tool that will help you understand your exact gross margin on projects during the scoping process, as well as help you generate more accurate scopes of work in half the time using your historical data – try Parakeeto’s estimation software absolutely free!
Take our cost calculator and formula for a spin. Have questions? Leave us a comment, we’re here to help.
Marcel is an agency profitability optimization consultant, keynote speaker and the CEO of Parakeeto. He’s on a mission to help the average agency get the information they need to be more profitable. From sharing educational content and resources to creating tools at Parakeeto to make measuring the most important metrics easier – everything he does is aimed at making agency profitability more accessible.