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Establishing an appropriate rate for charging those services to customers is a commercial matter. The price at which a contract is sold is often determined subjectively, taking into considering how badly the supplier needs the business and how much it is thought the client is willing to pay. This may be entirely reasonable. However, in order to deliver these services at a profit, it is necessary that the price is at least as high as the true cost to the supplier of delivering those services.

This paper looks at some of the “hidden costs” of doing operations and proposes a model for determining the “Full Economic Cost” of a company. The goal is to define an objective methodology for setting a reasonable economic daily charge-out rate for use in project costing and management.

Why use a Charge-out Rate?

The purpose of establishing a charge-out rate is to:

1. Ensure that projects costs are realistic so that costs are absorbed and profits are made
   Putting the emphasis on recovering full economic cost through charge-out rates reduces the risk that project budgets do not generate sufficient contribution to cover overheads.
2. Simplify the process of project costing and budgetary control
   Revenue from projects should not only cover direct costs but should also generate enough “profit” to pay for the overheads of the total business.  In high volume manufacturing where costs and production volumes can be more accurately measured, management accounts usually focus on direct costs and seek to cover overheads through “contribution” from operations. In services businesses, however, management accounting usually builds profit targets into the charge-out rate used to cost a project, achieving the same goal but without needing to run each project as a profit centre
3. Anonymise true salaries between team members
   When several people work on a project, particularly when these come from different departments and levels in an organisation, it is not appropriate to discuss direct salary costs in project accounts. At some point these costs would become visible to members of a project, whether in proposals, meetings or reports.  Charge-out rates are therefore used to mask variations in individual salaries and costs.

How do you use Charge-out rates?

The charge-out rate is the standard mechanism by which you set a price for a project: The price of a project is the estimated effort multiplied by the charge-out rate for each individual or level of project member  (different levels of team member may have different prices), plus a contingency for risk.

The same charge-out rates are also used to monitor the financial status of projects, either by reducing the available balance by each day that is worked at the charge-out rate and/or generating a “production” figure that is charged against the project later. This cumulative figure should also reported in the management and financial accounts of the business as “work in progress”.

Computing the Charge-out Rate

The charge-out rate for an individual needs to include a number of elements.

Direct Costs

• The employee’s salary and any direct salary costs.  These costs include:
  • Expected personal bonuses and taxable financial benefits.
  • Non-taxable benefits such as pension contributions.
  • Employer’s national insurance charges, calculated on salary, taxable and some other non-taxable benefits
• Training costs and costs of maintaining competence (examinations, professional membership)
• Travel if this is not recovered as a project expense
• Tools and materials unique to an individual employee

Indirect Costs and Overheads

• Semi-variable and fixed costs of the company that are necessary for it to operate. These include:
  • Fixed and semi-variable premises costs (rent, rates, heating and lighting costs): These costs are not attributable to an individual but vary step-wise as the company grows/contracts. 
  • Indirect consumables such as stationery, telecoms costs: These costs may not be enormous and are difficult to attribute to individuals, but they do vary in proportion to the number of employees, consequently it is normal to budget for these at a fixed price per individual
  • Depreciation of office equipment, computers and other capital costs. Each individual needs a desk, chair, PC and other basic “tools”.  Note that furniture and office equipment is usually amortized over 5 years (sometimes less), whereas desktop computers and operating software are usually written off in the year of purchase 1 year, unless they have a realistic usage life that is much higher (HMRC accepts that amortizing over 1 year is realistic these days, particularly in businesses that are heavily dependent upon IT)
  • Other costs of doing business such as training, travel and subsistence for example when visiting conferences and exhibitions, marketing budget and similar activities
• Company administration costs. These include:
  • Accountancy, operations and other management services that may be purchased by the company from external parties
  • Sales and marketing costs, including salary costs commissions of full-time sales personnel and referral fees paid to third parties
  • General management costs. If the company does not employ a full time general manager, then it may need to pay for the services of an interim or part time manager/mentor to fulfil those task

A provision for profit:

• If all direct costs and overheads are absorbed at the charge-out rate, the company will not make a loss.  However the purpose of the company is also to make return on capital for the shareholders, therefore a “profit” element should be included in the charge out rate.  15% is not unreasonable in the case of small project: 10% or less may be the norm in multi-year projects.

Annual to Daily Rates

To calculate the charge-out rate, all these cost elements need to be factored in on an annual basis, and then this should be converted to a daily rate.  Normal convention in industry is to consider 195 to 198 days productive days per year to account for annual holidays, statutory/bank holidays, and a reasonable allowance for sickness and days lost for administration, company meetings etc..  In highly specialised fields, it may also be reasonable to make an additional allowance for training and maintenance of competence in other areas.  Some companies also factor in time for “productive fun” (e.g. Google).

Stephen Oliver is Director of Expraxis Limited, a consulting company that works with academics, entrepreneurs and inventors who need help bringing new ideas to market. We help people set their priorities, plan for their business, build relationships with partners that can help them, and work with them to help turn those ideas into reality. Expraxis has long experience in cost analysis for services businesses and has a range of analysis tools to assist companies in understanding their marginal cost base.

The 2010 conference is in Boston Oct 4^th – October 6^th.  It’s a beautiful time of year to be in Boston and the speaker lineup is once again, awesome.  Folks like Seth Godin, Eric Ries (Lean Startup Guy), Scott Farquhar (of Atlassian) and of course, Joel Spolsky himself.  Check out the schedule, and if you can go, you should go.  Just ask someone that’s attended in prior years.

The 2009 conference was held in San Francisco and the title of my talk was “Ideas For Building Better Software Businesses”.  There are essentially two parts to the talk — the first half is about inbound marketing (how to pull customers in using Google, social media and blogs).  The second half (which starts at about 37 minutes) is about customers and sales. If you enjoyed my talk in 2008 titled “Everything I Know About Startups”, you’ll likely enjoy this one too. 

Video: Ideas For Building Better Software Businesses

Some notes from the video, for your convenience:

1. My objective for this particular presentation was to improve the odds of your survival and your success if you’re growing a software company. 
2. Types of risk:  Development risk (given an idea, can you actually build the product?), Market risk (if you do indeed build it, will anybody pay for it?), financial risk (will you have the necessary capital to build a business?) and execution risk (assuming you’ve mitigated the other risks, will you manage not to screw it up?).
3. Introducing the concept of smarketing (sales + marketing). 
4. Charge early.  Like pre-alpha early.  Like it sucks so much I’m surprised people don’t go running out of the room, early.
5. Sell early not because the revenues are going to amount to anything (they’re not), but because the data from paying customers is exceptionally valuable. 
6. Sell often, because you want reliable, negative feedback too.  Selling early tells you whether people will buy — selling often (i.e. charging smaller amounts in regular intervals) tells you whether they’ll stay.  Let customers vote with their dollars (by giving them the option to cancel their subscription). 
7. Don’t hire sales people too early.  In the early days at a startup, regardless of what your title is, you should be bringing customers on board.
8. Consider creating a sales waterfall chart that shows you daily, how the business is tracking against your sales goals.  This proves invaluable as you scale and surfaces problems in the business early.
9. Keep pricing simple in the early days.  You’ll have plenty of time to make it more complicated later.
10. In most big markets, you can afford to get pricing wrong in the early days.  If your potential market is thousands of customers, then selling the first hundred at a “sub-optimal price” is not fatal.  If you end up getting thousands of customers, getting pricing wrong for the first 100 won’t matter.  If you end up getting just 100 customers, getting pricing wrong for those 100 won’t matter.
11. You should Implement something like the HubSpot Customer Happiness Index (CHI).  It’s a quantitaive method for measuring how happy your customers likely are using available data (like their product usage pattern). 
12. Things that you can likely include in your CHI:  Frequency of product usage, breadth of product usage and actual benefit received.   
13. The CHI can be used for many things, the most important of which is predicting which customers are likely to cancel (because they have a low CHI score and are likely unhappy).  Other uses include compensation for sales people, calculating the quality of leads that marketing is generating, and making product roadmap decisions.

If you attended this talk or took the time to watch the video, would love to hear your feedback I can make my talk this year more valuable.  Hope to see you at Business of Software 2010!

Dharmesh Shah