Setting service rates is a key part of ensuring the success of your business. It’s more than just finding an amount customers are willing to pay. Few contractors understand how to arrive at a profitable hourly service rate. As a business owner, you need a pricing strategy which reflects your direct costs, indirect costs, overhead and accounts for profit. In this post, I’ll take you through setting the perfect service rate for your business.
Step 1. Understand Your Costs
Before you can decide on a rate to cover your costs, you have to determine what your costs are. When you’re running a business, there are two types of costs to identify: direct and indirect costs.
A) Direct Cost: Direct costs are costs you can attribute to the service you’re providing. In the service and maintenance industry, these costs can include: parts or materials for a specific job.
- Labor expenses; technician wages, benefits, disability insurance, payroll taxes, etc.
Calculate Your Labor Expense
Your most important direct cost to consider is your labor expense. When determining your labor expense, base it on your highest paid field staff's compensation. Include added benefits, employment taxes, workers compensation and other costs. You’re looking at about 40% in addition to the top hourly wage.
Example: If you pay your most expensive field staff member $25 an hour, estimate another $10 for a total labor expense of $35 an hour.
Your labor expense can be further divided into applied time (also known as billable time) and unapplied (or non-billable) time. Applied time is when your field staff is earning money for the company, such as when they’re installing equipment or making repairs. Unapplied time refers to staff activity which does not directly make your company money. We’ll further discuss unapplied time below.
B) Indirect Cost: Indirect costs can't be billed directly to your customer for a project. They’re sometimes described as overhead, or “the cost of doing business,” and it’s important to factor them into your hourly rate. Indirect costs include but are not limited to: your office staff’s time; dispatchers, managers, etc.
- Rent and utilities.*
- Marketing and advertising expenses.
- Office equipment; printers, desktops/laptops, cell phones, tablets and data plans.
- Vehicle expenses; lease terms, fuel, maintenance.
- Uniforms, tools, shop supplies and other costs not directly billed to a project.
- Interest, bad debt, bank fees, dues, etc.
- Unapplied time: The service department killer.
* Tip: To get a clear understanding, consult with your accountant to determine your fixed costs, like rent, and which costs are variable, like utilities.
What Is Unapplied Time?
Unapplied time is a critical part of establishing your hourly service rate. You'll want to periodically track these activities when employees are in the field. Any time technicians are talking to dispatch, driving to a customer’s location (consider typical traffic conditions), picking up parts, or filling out paperwork, that’s unapplied time. Call backs, from a billing perspective is lost time. For some, that could be two to four hours of every day; they're working, but not making money for your company. This time can’t be billed to customers but is an expense of doing business and should be taken into account. The idea is to reduce unapplied time. You won't cut unapplied time altogether, that would be impossible. You need to charge a high enough service rate so unapplied time is not a detriment to your business.
How to Calculate Your Overhead Rate
- Add up your indirect costs for one month.
- Divide that number by your direct costs for one month.
- Multiple the result by 100%.
- The percentage is your overhead rate.
1 month indirect cost = $1,200
1 month direct cost = $4,400
$1,200 / $4,400 = .27 x 100 = 27%*
* Tip: Aim to keep your overhead rate no higher than 30%
Track Installation and Service Separately
Record revenues and costs for installation and service separately. The labor requirements and billable hours are different for each, and as a result, overhead costs are different as well. By splitting them up, you’ll be able to determine which department is more profitable and where you may need to make pricing adjustments.
Step 2. Factor in Profit
It’s common for new business owners to neglect profit from their pricing. They’ll assume profit is what’s left over after expenses. Sometimes they’ll account for profit, but let their expenses go unchecked, and end up having nothing left or lost money at the end of the month. Factoring profit into your pricing upfront and controlling expenses will help ensure you’ll turn a profit.
A profit margin can be realized as a dollar amount or a percentage. Using percentages when making calculations and projections will be more accurate as dollar sales and expenses change over time. What you use for a benchmark will depend on your business goals and may change as your company grows. At the very least, plan for 10% profit.
Don’t Just Follow Your Peers on Pricing
There’s a benefit to finding out what the competition is charging, but setting your prices as a comparison to theirs without considering what it means for your business is a weak strategy.
It’s certainly important to keep your prices competitive. But your pricing needs to be based on your business and its goals, not someone else’s. If you can charge less than your competition and still meet your numbers every month, then you have found a strategy that works. But lowering prices without considering the effects on your projections can leave you with an unpleasant surprise at the end of the month or quarter.
Set your prices for where you want to be, not where you are. If you factor overhead low, you may find yourself having to quickly raise prices to stay afloat. Covering overhead effectively and adding in your desired net profit can put money in the bank to help you grow when the economic and market conditions are favorable to a growth strategy.
Pro Tip: Don’t rely on profit to compensate yourself as the business owner. Pay yourself a salary based on your labor contribution.
Step 3. Calculate Your Hourly Service Rate
Total Revenue (for one month) = $47,000
Direct Cost (for one month) = $21,000
Total Hours (per day per tech) = 8.0
Non-billable Hours (per day per tech) = 3.5
Labor Rate (best tech, including benefits) = $31.50
Desired Profit Percentage = 10%
To set an hourly service rate, you’ll first need to figure your gross margin percentage. That’s your total revenue minus direct costs, divided by total revenue. Multiply by 100% to get the percentage.
Gross Margin = Total Revenue - Direct Cost (this is in dollars)
Gross Margin = $47,000 - $21,000 = $26,000
Gross Margin Percentage = (Gross Margin / Total Revenue) x 100% (this is a percentage)
Gross Margin Percentage = ($26,000 / $47,000) x 100% = 55.3%
Next, calculate the Direct Cost percentage by dividing Direct Cost by Total Revenue and multiplying by 100%:
Direct Cost Percentage = (Direct Cost / Total Revenue) x 100%
Direct Cost Percentage = ($21,000 / $47,000) x 100% = 44.7%
Now you need to calculate your productivity factor. For example, 4 billable hours out of an 8 hour day is a productivity factor of 50%.
Productivity Factor = (Total Hours - Non-billable Hours) / Total Hours
Productivity Factor = (8 hours - 3.5 hours) / 8 hours = 0.5625
Finally, with the $31.50 an hour labor expense offered above, divide by 44.7%, then divide by a productivity factor of 56.25% for an hourly rate of $125.28 per hour. Multiply that number by your profit percentage of 10% and add that to the hourly rate for a rate that includes profit: $137.81 per hour.
Hourly Service Rate before Profit = (Labor Rate / Direct Cost Percentage) / Productivity Factor
Hourly Service Rate before Profit = ($31.50 / 44.7%) / 0.5625 = $125.28
Hourly Service Rate with Profit = Hourly Service Rate before Profit + (Profit Percentage x Hourly Service Rate before Profit)
Hourly Service Rate with Profit = $125.28 + (10% x $125.28) = $137.81
If you’re thinking that seems like a lot of money, realize consumers pay those kinds of rates all the time. Many other service industries charge with flat rate. For example: Your dentist doesn’t charge you $500 an hour for a new crown; he bills one flat price for the entire procedure. When you get a haircut, you pay for the haircut; the cost is not prorated on a cost-per-hour basis. Instead, the salon uses an hourly service rate to establish a price per haircut.
Step 4. Test and Evaluate Your Pricing
Now that you’ve come up with an hourly rate, it’s time to test it. You will need to know what’s going on in your marketplace. Over time, keep an eye on your service sales and gross margins. That’s how you’ll know if you’ve set your prices correctly.
The price point that works for you is the price the customer is willing to accept, and that can vary whether you use time-and-materials or flat rate pricing. The market may also influence what your rates will be — if your customers push back against your pricing because your competitors have lower rates, then you need to take a look at it. You may provide higher value than your competition for your prices — better response times or better equipped and stocked vans, for example. After a brief time, say two to three months, and several conversations with your customers, you may find your pricing is just too high for your market. Keep in mind that it’s easier to adjust overhead and profit in a flat rate pricing system, because customers aren’t focused on the hourly rate.
Some customers will always complain about your rates. Complainers will always complain. However, if 20% of your customers are questioning your rates, you may need to make adjustments. Before doing so, check to see you're communicating effectively with your customers about your services and service rates. Proper discussion will build value in the minds of your customers. Don’t overreact to a few customer complaints about your service fees. There may be an underlying reason for the customer to believe they did not receive full value for the dollars they spent.
Pro Tip: If a service fee adjustment is in order, ask the customer what he/she believes is fair. The customer may request a smaller discount than what you had in mind.
Flat Rate Pricing: How to Set Diagnostic Fees
You need to make it worth your business’ time to respond to a service call. The customer is paying for your service employee’s expertise, troubleshooting ability and opinion; build value into the service/diagnostic fee charged by the company. It usually includes approximately 30 minutes of travel time and 20-30 minutes of diagnostic time to determine what repair(s) or service(s) is required.
Once the system is diagnosed, the discussion about the cost of repair is a crucial one. When a company uses flat rate pricing, customers know in advance what they’ll be paying no matter how long the repair takes. The office person should always quote the service call/diagnostic fee and mention the service employee will quote the repair fee. That sets the stage for the customer’s expectations. When the field employee quotes the repair fee upfront, the customer is informed throughout the entire process. Time-and-materials pricing is a bit more challenging because the customer doesn’t really know the final price until the work is completed. It’s an open-ended contract that may give way to customer concerns because repair costs increase as more time goes by.
To ensure repeat business, your goal should be to make your customers’ experience as pleasant and predictable as possible. Quoting upfront helps customers relax and takes pressure off of your service staff.
Pro Tip: Avoid using the term “Trip Charge” because it implies that you are charging just for the drive to the customer’s location. Ultimately, that term reduces the customer’s perceived value of the services you provide.
Does Geography Matter?
Many business owners think their pricing should be based on whether they’re in a rural or urban area, but that assumption could be a costly one. Installations and repairs are completed the same way whether they are performed in a city neighborhood or in a small farmhouse miles from town. The variable is travel. Often service companies that cater to a rural community think their rates should be lower than big city rates. However, the amount of time it takes to get to a service call may be significantly longer in a rural location. City traffic, longer driving distances...there’s not much difference.
A geographic area may support a certain price point, but pushing that up or down simply because of the location without considering how that will affect your internal numbers is not a good business decision.
You may get pressure from customers or staff to charge more or less depending on where you’re located. But it’s important to remember that what you charge should be based on your direct costs, overhead and desired net profit. Careful consideration of costs you might have in a rural area or urban area—spending more on gas, for example, to drive to remote areas— will help you adjust your service rates accordingly.
Calculating an hourly service rate that’s tailored to your business is one of the most important things you can do to assure profitability for your company. There just isn’t room for guesswork—service companies need to base hourly service rate on hard numbers to cover expenses and make a profit. In addition, tracking the numbers that go into an hourly service rates help you anticipate and budget for seasonal booms and slowdowns, instead of simply reacting to market demand.
Vicki LaPlant, Vital Learning Experiences
Jim D’Amico, Profit Strategies
Ruth King, On The Ribbon