Setting charge out rates to maximise agency profitability and remain competitive
Traditionally and as a rule of thumb, many agencies have set their charge out rates at an arbitrary three times the hourly cost of billable staff. However, every agency is different and will not necessarily achieve the desired return by using a basic multiplier. There are a range of factors that should be taken into consideration when setting charge out rates to maximise profitability. I discuss these considerations and with a worked example, explain how UK agencies can set charge out rates. If working with numbers isn’t one of your strong points, you are welcome to request a copy of our spreadsheet which calculates the rates based on the information you input.
For agencies which do not price work on cost plus but on a value priced outcome, it still makes commercial sense to calculate charge out rates to confirm that projects will return the required level of profitability and give staff a guide as to the time that should be spent on each project.
Employment taxes and pension
When working out the annual cost of staff, we need to add the pension and employer’s national insurance costs to the base salary. In larger agencies with a wage roll of £3m or more, the apprenticeship levy will also be incurred. If an agency has no intention to utilise their apprenticeship levy fund on training then this should also be recognised as a staff cost as it is incurred.
Let’s take the example of a chargeable member of staff earning £60,000 with a flat 3% employer pension contribution on all earnings in a smaller agency. To work out the employer national insurance cost we deduct the annual threshold £9,100, and multiply by the current rate of 13.8%.
Employer pension contribution
Total staff cost
Please note, there can be other factors which can affect the calculation of the cost of employer's NI or pension such as offering a salary sacrifice pension or making pension contributions on qualifying earnings. Our spreadsheet calculator takes these into account as well as offering a calculation for the apprenticeship levy.
Once we know the cost of each staff member, we need to look at how many chargeable hours are available to service client work. To do this we set the utilisation rates for each team member and factor in paid holiday days and absences.
Utilisation – This is the expected proportion of time available to service billable client work and ideally targets are set for all chargeable staff. The utilisation is dependent on the role and seniority of an individual. The more senior the person, the lower the utilisation rate will be due to time spent managing staff, working on new business proposals and pitches amongst other responsibilities. Managing directors or partners, if chargeable at all, would have the lowest utilisation with the additional responsibility of running the business.
Working days and hours – Agencies in the UK typically have a 37.5 to 40 hour workweek from Monday to Friday, which is a maximum of 260 days a year (5 days x 52 weeks). The amount of holiday entitlement differs by agency and can differ by employee with increased holiday being earned with service. The number of holiday days together with bank holidays are deducted from the maximum working days. Average paid sick days can also be deducted.
In our example, there is a 37.5 hour working week (7.5 hours a day) with a holiday entitlement of 25 days, 8 bank holidays and the company average for sick days is 3. The employee is expected to have a utilisation rate of 70%.
Available working days
Available working hours for this employee are 1,680 (224 days x 7.5 hours) and chargeable hours are expected to be 1,176 (utilisation of 70% x 1,680 hours).
This individual’s hourly employment cost based on chargeable hours is £59 (annual staff cost of £68,824 / 1,176 annual chargeable hours).
The overhead base needs to be included in our charge out rate calculations to ensure that these costs are covered. Typical overhead costs may include rent, rates, non-billable support staff, staff benefits, business development, marketing, heat and light, insurance, computer and software, depreciation and professional fees (including your accountant!).
Some overheads will vary with headcount so factor in expected changes in the team size for these costs, whilst others will remain fixed. For example, the cost of software licences and benefits will vary with headcount but you can probably remain in the same office space with some change to headcount and therefore rent and rates would remain the same.
For our example, the total expected overheads are expected to be £600,000 and the total chargeable hours for all billable staff is 30,000. Our overhead rate is expected to be £20 / hour (£600,000 / 30,000). When the hourly payroll rate of £59 is added to the overhead rate of £20, the total cost is £79 an hour.
We know for our example that our costs are covered at £79 an hour but we need to know what this needs to be uplifted by to achieve the desired profit margins. Agencies should be looking to achieve a minimum operating profit of 15%, ideally 20% and more if the agency is looking to have a bonus pool to incentivise employees. The margin an agency feels it can make and ultimately the price it can set will be based on where the agency is positioned. A fledgling agency looking to book in work may set their margins lower whilst the more established and reputable agency should be charging a higher price.
For our example, we are looking to have a 25% operating margin before bonus which means the £79 an hour cost is 75% of the total charge out rate. The charge out rate for this individual is calculated as £105 an hour (£79 / 75%) earning £26 profit an hour.
If the agency is regularly writing off time, this can be included in the charge out rate calculation. Ideally, the agency will identify the causes of time write offs and work to minimise them to remain competitive and deliver a healthy margin. Reasons for write offs of billable time include unbilled scope creep, under scoping, overservicing or inefficiencies in delivering work.
Following on with the example, the agency has found that it is recovering 90% of its chargeable time. The individual had 1,176 hours chargeable hours a year with a utilisation rate of 70%. Based on the recovery rate of 90%, around 118 hours will be written off leaving 1,058 chargeable hours to be recovered from clients. This pushes up the individual’s employment cost per chargeable hour to £66 (employment cost of £69,460 / 1,058 billable hours). The total recoverable hours for the agency drops from 30,000 to 27,000 (90% of 30,000) which causes the overhead rate to increase to £22 an hour (£600,000 / 27,000). The total cost per chargeable hour increases to £88 an hour (£66 + £22) and therefore the charge out rate is £117 an hour (£88 / 75%).
Charge out rates per role
It would be impractical to have a different charge out rate for each employee and would also reveal too much about how much individuals earn. A charge out rate should be set per role based on the average or median charge out rate for everyone in that position and rounded, say to the nearest £5 or £10. With salary bands set for each position, there should not be a great difference from the lowest to highest charge out rate for that role.
Part time staff – Full time equivalent salaries and chargeable hours should be used when working out part-time employee charge out rates.
One rate card or multiple rate cards – Apart from the odd bit of lo-bono work, some agencies will have all their clients on the same rate card and will not discount their rates at all for commercial clients. For other agencies, there will be discounts given to high volume or retainer clients or where there is a budget gap in revenue. Some may charge a premium to be asked to work on a brief at short notice. For whatever the reason for adjusting rates, the easiest way to adjust the rate card is by amending the profit margin.
Competitor rates - Whilst often not freely available, occasionally competitor rate cards are obtained from clients or colleagues that have worked at a competitor agency. It is worth reviewing them where available to see how their charge out rates compare to your own.
Please get in touch if you need any assistance with setting your fees and rates or would like our spreadsheet file for calculating charge out rates, available for Microsoft Excel or Google Sheets.