Why the Difference? Rates Paid vs. Rates Charged

Have you ever participated in a conversation that focuses on various aspects of your job? Of course you have. Favorite topics might include a troubleshooting issue on an aircraft, the number of hours that you work, the type of work that you do, the opportunity to learn new skills, the tools that you use, the condition of the facilities in which you work, or the relevance of the four principles of management and their importance. Actually regardless of the profession, conversations will eventually turn to work.

Of course, discussions of this nature are always mixed with facts and the ever-present rumors and misleading information. As a result, and by the end of a typical conversation, you are probably basing certain conclusions on a foundation of information that is less than solid. In some instances that’s probably OK because you don’t have much influence over the final decision or outcome. However, for conversations that are more directly associated with you, having good information or understanding the issues is much more important.

One subject that is relevant and important to each of us regardless of the job or profession is the amount of pay we receive for doing a job. One aspect of pay is best summarized with the following comment and question.

My company pays me $20 per hour as a technician, yet they charge customers $70 for each hour that I work. Why?

Have you heard similar comments? When you were involved in a discussion of this nature, were you able to offer an answer based on facts rather than misinformation? Is there a logical explanation for the difference?

To answer this question, I will use an approach that considers three elements. The first two elements deal with costs. The last element deals with activity. The first element deals with costs that are directly associated with the technician. These costs are not always evident but they are there, nonetheless. The second element deals with costs that are indirect to the technician but are an important aspect of the maintenance department. Not only are these costs not evident, but their value is often questioned. The final element applies the first two elements and helps an organization determine what it should charge for its services.

Direct Costs

Let’s assume a company pays an individual $20 per hour for each hour of work performed. Unfortunately for the employer, the $20 per hour does not represent the full cost of retaining the individual. This is unfortunate because too often employees do not recognize the full value of employment, and employers do not emphasize their total compensation package. In either case, the total cost or value is not evident to the employee.

The following list illustrates the type of costs that are part of this first element; costs that are directly related to an employee.

  • Taxes — Each employee is expected to pay 12.4 percent of his or her salary or wages for Social Security and 2.9 percent for Medicare. Fortunately for the employee, the company is expected to pick up half of this, or 7.65 percent. Multiplying the $20 rate by 7.65 percent, the employer is incurring a cost of $1.53 for each hour paid. If you are self-employed, you would have to pay the full 15.3 percent.

  • Training — Costs associated with training can accumulate quickly when training occurs off-site and requires travel. Oftentimes travel can equal or exceed the cost of the training. If an employee attends a week-long training session, costs could exceed $5,000. If that is a reasonable assumption, then dividing $5,000 by 2,080 hours in a year, the hourly costs associated with the employee for that year is $2.40 or slightly more than 10 percent of the hourly wage.

  • Health insurance — While the direct cost of health insurance has in recent years shifted more to the employee, many employers still absorb much of the cost associated with it. If we assume the employer’s portion of health insurance is $600 per month, then the cost per hour is $3.46.

  • Pension/retirement plan — Traditional pension plans cost employers significantly but recent trends have moved toward 401ks, Simplified Employee Pension (SEP), and other employee-funded or employer-partially funded plans. Using a more conservative assumption, let’s use a retirement plan to which the employer makes contributions in the amount of $3,000 per year.

(This is a little more difficult to get a good representative average due to the many plans that are now available.) Using the $3,000 per year, the employer incurs costs of $1.44 per hour.

The employer may pay other benefits such as tools, uniforms, education, and other forms of insurance such as disability, workers’ compensation, and life.

It is generally agreed that the direct costs associated with an employee can range from 25 to 40 percent of the base salary or hourly rate. Some would argue that direct costs are even higher. You can see that with the examples above, the employer would incur about 44 percent of the hourly rate (Taxes - $1.53 + Training - $2.40 + Health Insurance - $3.46 + Pension/Retirement Plan - $1.44 = $8.83 / $20.00 = .44 or 44 percent). For our example, let’s assume that the direct costs associated with an employee are 40 percent. Applying the costs from the example, the employee now costs the employer $28.83 or almost $29.00 per hour.

Indirect Costs

Another term to use for indirect costs is overhead. Different types of overhead costs exist, but most can be categorized as operations and general and administrative.

To keep our example simple, let’s assume that the organization is a maintenance facility for external customers only. Additionally, it only has one technician that works on the customers’ aircraft. What other types of costs will this organization encounter to run the maintenance facility?

Let’s make the following assumptions.

  • Hangar and office facilities — The current operation is small but the climate and other environmental factors dictate that this maintenance operation requires a hangar and offices for its executive and administrative staff. Let’s assume that the company pays $4,000 per month or $48,000 per year.

  • Inventory — Even though the maintenance facility only has one technician, he/she stays busy with a constant flow of aircraft. Unfortunately, the types are varied, which necessitates an inventory that is larger than normal, say around $200,000. While the organization won’t charge the cost of an item in inventory until it is consumed, it will incur costs associated with holding the inventory such as insurance, floor space, shelving, computer system, and climate control. Commonly accepted estimates of holding costs are 25 percent of the value of the inventory. In this case, $50,000 worth of ongoing annual expenses for having an inventory of this amount.

  • Director of maintenance — Actually, an organization of the size in our example couldn’t afford many administrative or executive personnel but it must have some employees in this area, whether it’s contract help or another person performing a variety of roles. Again, to keep the example simple, let’s assume the maintenance operation has one person that serves in this role. The annual cost of this person is $60,000.

A typical maintenance organization will have addition-al indirect costs such as ground equipment, office furniture, computers, special tools, cleaning services, and a variety of insurance and safety requirements. You can probably think of many more, but these should be enough to serve our purposes. Indirect costs can vary between organizations; however, a competitive organization will ensure that these types of costs do not become too burdensome.

In our example, we have estimated the annual indirect costs at a total of $158,000. If the technician in our example stayed busy every day of the work week for eight hours a day for the entire year, then the cost per hour for indirect costs would be $76. If we combine this amount with the direct rate of $9 and the hourly pay rate of $20, then we have a total rate of $105 per hour in costs. From this simple example, you can see how quickly a base rate of $20 can become a much higher amount. And, there is still one more element necessary to determine what an organization charges for its services.

Basis for Applying Costs

Estimating an organization’s costs accurately is only part of the equation that leads to its success. The organization must also know how it is going to recoup its costs, which means they must have some unit of activity to which they can assign costs. We already know from our earlier buildup that the organization must charge $105 per hour to cover its direct and indirect costs. That’s assuming the technician’s productive time is 2,080 hours in the year (8 hours a day x 5 days a week x 52 weeks in the year). But is it realistic to expect the technician to work this much?

What about vacation, time off for holidays, sick days, or level of chargeable hours? If the organization estimates the first three items (vacation, time off for holidays, sick days) will total 25 days off (10 days vacation, 10 holidays, five sick days), then it will be applying its direct and indirect costs to a smaller base of 1,880 (2,080 hours in full year less 200 hours of time off). In this case its cost per hour will increase to $116 ($60,320 in direct costs plus $158,000 of indirect costs).

Up to this point, we have not considered the level of chargeable hours. Is it reasonable to expect the technician to work each day that he/she is present the full eight hours? Will the work flow through the facility at a rate that will keep the technician busy each hour of the day? Probably not. Even if the work did flow at a steady and constant pace, is it reasonable to expect the technician to be productive eight hours a day? What about time that cannot be charged to the customer; training for example?

Let’s assume, the technician can reasonably be expected to charge 80 percent of his/her hours worked. The new rate that the organization needs to charge is $145 per hour if it wants to cover its costs ($60,320 in direct costs plus $158,000 of indirect costs)/1,880 hours x .80). It is also important to point out that the base labor rate portion of the total rate is also increasing in this scenario. While the organization is paying the technician $20 per hour, without benefits, for every hour worked, it is not recovering its cost at the same rate if the productivity level drops below 100 percent. So what seemed like a constant rate actually is constant only in the sense of dollars out (pay to the technician), not dollars in (payment to the organization). For example, if the technician only has 1,504 (1,880 hours available x .8 chargeable hours) billable hours, then the organization must charge about $28 per hour to recover the technician’s annual income of $41,600 (2,080 annual hours x $20).

These are all variables that, while difficult to predict, are necessary to predict if the organization wants to have a chance for financial success. If the organization overestimates the number of chargeable hours, then by the end of the year the organization will not have charged enough to cover its costs. If the opposite is true, then the organization has a nice situation.

Up to this point our calculations have not even considered a profit for the organization. Any reasonable for-profit organization would certainly need to consider this as part of the equation. A profit target would also increase the required rate to charge.

That’s how an organization gets from the rate that it pays the technician to the rate that it charges a customer. A lot of hard work and careful estimating goes into what might appear at first glance to be an easy process. But as we leave this subject, I would like for you to think about one more element. We have not discussed one of the more dynamic and difficult-to-predict elements in the cost equation. It is also an element that has the potential to overshadow everything we have already covered and one that an organization would have difficulty controlling. What is the competition’s rate?