It’s simple, be nimble- Part 3
Pricing methodology shared below facilitates achievement of all the objectives discussed in the previous article i.e. Maximum utilization of the capacity, full cost recovery ( direct cost and indirect cost) , making sufficient profit, and efficient liquidity management .
Step 1: Ascertain direct cost per hour for every person in the firm engaged in rendering service to the clients (referred to as a direct employee in this series of articles), based on his maximum capacity
e.g.- If Mr. A ‘s total cost to the company (CTC) is ₹ 430000/ and his capacity (please see previous article) is 1912 hours per annum then his cost per hour would be 430000/ 1912 = ₹225
Step 2: Find required sales to achieve sufficient profit based on following equation
Sales – direct cost- indirect cost = profit
sales = Sufficient profit + direct cost + indirect cost
e.g.: Direct cost = CTC of all direct employees = ₹ 24,00,000
Indirect cost = ₹ 7,00,000
Sufficient profit = ₹ 35,00,000
The calculations based on above data: 2400000+700000+3500000=6600000
Thus with given data conclusion would be ,if the firm achieves sales ₹ 6600000 it will achieve targeted profit of ₹ 35 lacs.
Step 3: Ascertain ratio of sales to direct cost
6600000/ 240000 = 2.75
This ratio or multiple ( called productivity factor) indicates that for every Rupee of direct cost , if billing is done at ₹ 2.75, then the estimated sales and profit will be achieved.
Of course, if any of the underlying assumptions change significantly, the calculations can be revised.
Step 4 Ascertain billing rate per hour based on above multiple
Cost per hour of Mr. A as per step 1 = 225 X 2.75 = 619
Billing rate per hour would be ₹ 619
Step 5: Adjust the price or billing rate further to account for non-billable time
People may be doing certain work , value of which may not be realizable from the client. e.g. training, marketing, research, administrative work etc. Besides some persons may not have sufficient work and they may be sitting idle. All such time, called non billable time , needs to be taken into account for determining billing rates. If it is ignored then sufficient profit objective will not be achieved.
To deal with such a possibility , estimate of such non billable time will have to be worked out . Thus on the whole if the firm expects , that out of total available time 10% will be non billable, the billing rate worked out above for Mr. A , would be further adjusted as follows
619 x 110 % = ₹ 680 per hour. (Alternate formula 619 X 100/90= 688 per hour )
This rule can be followed for the billing rates of all the other people.
In other words even if billing is done only for 90% of maximum available time , still the sufficient profit objective will be achieved.
Thus Mr. A ‘s expected fees for the year would be – (billing rate X maximum capacity) and the cost for the year would be – (cost rate X maximum capacity)
The difference would represent his annual contribution ( or value addition) towards the firm’s overheads .
The actual calculations would be-
( 680 X 1912 ) – ( 225x 1912 ) = 1300160-430200= 869960 .
This equation would be useful for monitoring performance at individual’s level.
Whereas at the level of the firm the equation after adjustment for non-billable time would be- 6600000X 110% – 2400000- 7000000 = 4160000
Here the profit is higher by 10% of sales as compared to the original equation ,to cover reduction due to anticipated non billable time of 10% . This equation would be extremely useful guide or Sutra for monitoring actual performance of the firm .
This price may have to be adjusted further as discussed in the subsequent article.
What is most important is that the firms should be able to use the well-defined billing rates not only for the purpose of billing but also for the control of the cost or improvement of profit discussed in greater detail in the next part .
With purposefully defined billing rates the firms will be changing their style of management and culture radically.
With this radical change, I hope the nimble firms will move into the fast lane for winners with following powerful idea-
Sales – profit = cost
Sales – cost = profit
I would love to hear from the readers their interpretation of the above formulas.