shop rate

Pricing in a Job Shop: Setting the Shop Rate

by Tom Gray | on Mar 28, 2012 |  Comments

A “job shop” sells custom-made parts, produced according to customer specifications, usually in small quantities. Job shops develop a price quote for each job, rather than establishing a standard list price per product.

Their “shop rate” is a bundled price applied to billable labor hours (those spent on the job being quoted), designed to capture enough revenue to cover labor costs, overhead, and target profit. Setting the right “shop rate” is the key to their profitability.

This article provides the techniques for calculating a shop rate. For example, employees may earn $25/hour, but the company may need to charge its customers $75 to $100 per hour spent on a job, to recover overhead and profit as well as labor costs.

Step One: Estimate Costs and Target Profit

First, estimate the costs to be recovered by the shop rate for the coming year. For our example, we assume the following costs are passed through to the customer without markup: materials, subcontractors, shipping. This means the shop rate must recover labor, overhead, profit, and sales commissions.

Labor includes hourly wages (whether or not they are billable on jobs) plus benefits and related payroll taxes. Overhead includes the owner’s salary, benefits, and payroll taxes, plus fixed costs such as rent, utilities, insurance, maintenance, computers, vehicles, depreciation on equipment, etc.

Profit will be a dollar amount, not a % of revenue at this point, because revenue is unknown. Assume the profit target is an amount equal to the owner’s salary.

Sales commissions might normally be 5% of revenue, but we do not know revenue yet. Use one-sixth of salary plus overhead (excluding labor) as an estimate, based on the assumption that salary plus overhead will turn out to be 30% of revenue.

For this example, assume the following: owner’s salary is 50K; other overhead aside from labor is 100K; profit is 50K; sales commission is 25K; non-billable labor cost is 80K and billable labor cost is 120K. This assumes 60% of paid labor time is billable on jobs. The rest is setup/cleanup, training, paid time off, and miscellaneous. Thus the shop rate must recover 425K.

Step Two: Estimate Annual Billable Hours and Calculate the Shop Rate

Second, estimate the number of billable hours for the year. Billable labor cost of 120K less 10% payroll tax and 10% benefits leaves approximately 100K. Divide that by $25/hour to get 4000 billable hours.

The resulting shop rate is 425K / 4000 hours or $106.25 per hour. This is an illustration, not a recommended price! Your shop rate depends on your own numbers: overhead, salary, profit, wage rate, etc. However, note that it is not unusual for the shop rate to be 3 or 4 times the hourly wage rate.

Avoid Two Common Errors

One common error in calculating the shop rate is omitting the target profit. Another is assuming all paid labor hours are also billable hours.

Job shop owners should review their shop rate at least annually. The tip about small changes having big results (see Pricing Tips: Start High; Big Results from Small Changes) applies here as well: raising your shop rate by $2 may increase your profits by 20%. Use your own numbers, and check it out!

Tom Gray helps owners save and grow their companies. He is a management consultant focused on small business and telecom, a Certified Turnaround Professional (CTP), a Certified Business Development Advisor, and a Certified SCORE Mentor. He can be reached at 630-512-0406 or tgray@tom-gray.com. See www.tom-gray.com.

 

13 Week Cash Flow Part 4 – Forecast Complexity & Conclusions

by Tom Gray | on Jan 01, 2011 |  Comments

When developing a 13 Week Cash Flow Statement in a job shop, forecasting future business seems especially difficult due to the variety of jobs that might be won in future weeks. The solution is to select a few typical product or job types from experience, and forecast those as representative of the type of work that might come in. Choose job types significantly different from each other.

For example, 60% of the work might be small parts you have built before, 30% might be new jobs with simple designs, and 10% might be new complex designs. Probably the more complex jobs will have longer durations, so that you incur cash costs but do not receive cash payments during the 13 week period. You might use different percentages if you choose to do best case and worst case scenarios too.

Is Your Forecast Reasonable?

Once you have a forecast, check it to see if it is reasonable. How does it compare to your cash flow from prior weeks? It should not be radically different.

Do you have enough labor to do the work you forecasted? Do you have enough space and machine time? Does the forecast imply more time spent on quotes and selling than you yourself have available, given the time you will be spending on production and perhaps bank negotiations?

Split Your Labor Cost

A common error is double-counting or under-counting labor. Many company bookkeepers show all payroll as a “fixed” cost because that is the easiest way for them to calculate payroll taxes. But that means you cannot know the margin per product, because you don’t assign the labor costs to the product.

Part of your payroll is a variable cost, that is, labor requirement per job or task. Since employees always have some paid time not assigned to particular jobs, a reasonable forecast will need to show non-productive labor time and cost as an overhead or fixed cost, separate from labor hours assigned to jobs as variable cost or COGS. Payroll taxes should be split the same way.

Non-productive labor time can be as much as 45%, so this is important! Your accounting software (e.g. Quickbooks) entries showing payroll as a fixed cost are only a starting point.  Use MS Excel to split payroll into productive and non-productive components to forecast margin and cash flow by product type.

Drawing Conclusions

The business owner should draw two types of conclusions from the Cash Flow forecast: product profitability and business viability.

Analyzing the cash flow by product or job type as shows you the margin per product before overhead. If overhead is 30% of total company revenue, and your product generates a 30% margin (revenue less variable cost / revenue), then you break even and have no profit.

In this example, if you want a 15% profit before tax, your products must generate a 45% margin on average. If they don’t, you must reconsider your price, perhaps raising your “shop rate”, or discontinue products that fall short of the target profit. See Pricing in a Job Shop: Setting the Shop Rate | Thomas H. Gray

Business profitability depends on product profitability, as above. The bank asks for a 13 week view because it knows that a near term forecast is more reliable than long term. But the business owner who has long duration jobs often decides to forecast cash flow for six months (26 weeks) to be able to see the cash payments for long duration jobs, rather than just the costs. In this case, a longer view is needed to get the most realistic picture of business viability.

Forecasting cash flow from unknown future work in a job shop can be done by choosing representative product or job types. Key issues include double-counting or under-counting labor, nonproductive labor time, shop rate, and margin per product or job type.

Tom Gray helps owners save and grow their companies. He is a management consultant focused on small business and telecom, a Certified Turnaround Professional (CTP), and a SCORE Mentor. He can be reached at 630-512-0406 or tgray@tom-gray.com. For information on the scope of Tom’s activities, see www.tom-gray.com. For more on SCORE services, see www.scorefoxvalley.org.