Overhead Rate and Break Even Rate are two extremely important financial concepts to know for Practice Management and Project Management. I’m going to cover them both here because Overhead Rate and Break Even Rate are directly related to one another.
All the sample problems we’re using are from a Financial Formulas Course I created with Christiana over at ArchiFinance.
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Alright, enough talk. Let’s get started.
292,600 / 210,000 = 1.39
This is within that 1.3-1.5 target range. So it’s good!
$32.5/hr * 2.39 = $77.675/hr
Round this up to $80/hour and that’s your Break Even Rate. This means if you charge a client $80/hr for this employee they will earn enough to cover their salary and their portion of indirect expenses. All your expenses are covered…but you won’t make any money either
To actually make money you need a profit margin. If you want to add a profit margin of 20% you would divide the hourly rate from above by the inverse of the profit you want. 20% profit means you would divide by 80%, or 0.8. $80/hr / 0.8 works out to $100/hr, which is what you would bill your clients so that you can actually turn a profit.
OVERHEAD RATE
You probably already have some understanding of what Overhead Rate is. In super general terms, it’s the money you need to make to cover things like rent, software, computers, utility bills, etc. For the ARE 5.0 exams you will need to get a slightly deeper understanding. Overhead Rate is the measure of the cost of operations not billable to any project. The Architect’s Handbook of Professional Practice defines Overhead Rate as the ratio of total of indirect expenses to total direct labor. If you have a Profit-Loss Statement, these are both key line items. Line B is your Total Direct Labor and Line C is your Total Indirect expense. So the formula for your Overhead rate is C / B or Indirect Expenses/Total Direct Labor. Overhead Rate will always be a number with no units, like 1.45 and not $1.45. If you are asked to find the Overhead Rate (or any calculation on the exam) it’s important to know what the final answer is supposed to look like. Let’s look closer at Indirect Expenses and Total Direct Labor.INDIRECT EXPENSES
An Indirect Expense is everything you pay for that is not attributable to a project. Rent, software and taxes are all big ones, but there are other Indirect Expenses as well. Things like office supplies, in-house printing, marketing and the salaries of admin staff (HR, accounts, etc) go into it as well. This will be a dollar amount, like $750,000, either given to you in a table or in a word problem.TOTAL DIRECT LABOR
Total Direct Labor is a dollar amount that represents the salary and benefits that are accounted for when people are working on projects. In some instances you may see labor represented in hours, so it’s important to keep in mind that when dealing with Overhead Rate or Break Even Rate you are going to want to find a total dollar amount, just like we did above. If you have an employee that costs you $100/hour that includes salary, benefits, payroll taxes, etc. No matter what, whether they are working on a project or not, they cost you $100/hour. You want that person to be working on projects because when they are, that’s Direct Labor. Note that this is for accounting and understanding the finances of your firm only…the paycheck doesn’t change. There will be a few ways you can get Direct Labor depending what they give you on the exam. 1) Line B of your Profit-Loss Statement is “Total Direct Labor Salary Expense.” 2) Utilization rate and total hours worked. For example, if they worked 1,000 hours and they have a 60% Utilization rate that means they worked 600 hours of Direct Labor. You have to convert that to a dollar amount by multiplying their salary. $75,000/yr is $37.5/hr so 600 hours results in $22,500 of Direct Labor 3) Timesheet. You may have to look at a timesheet, pick out items where they are working on a project, add those up and convert them to dollars.BACK TO OVERHEAD RATE
Whichever method you get the above information, just make sure that at the end you have a total dollar amount. Overhead Rate is a ratio, a number without units, so you can’t end up with Dollars / Hours or vice versa. They both have to be in dollars. The target overhead rate for a firm will be between 1.3 – 1.5. Larger firms may have a higher overhead rate because they may have more salaries that go into indirect expenses, possibly higher rent, etc. Smaller firms will have fewer of those expenses and will have lower overhead, which in turn can lead to a lower cost of services to provide.SAMPLE PROBLEM
HF Copper and Associates incurs $292,600 in indirect expenses and $210,000 in direct labor. Calculate the overhead rate for the firm. Is this a desirable rate?
292,600 / 210,000 = 1.39
This is within that 1.3-1.5 target range. So it’s good!
ANALYSIS
For every $1 you spend on salary while someone is working on a project, you have to spend $1.39 on your cost of business, to keep your business running in the first place. Rent, taxes, software, salary when people are not working on projects, all of these are 1.39 times the amount that you are paying people to do actual work, and you can’t directly bill this to a client. However, you have to get that money coming in, right? That’s where the Break Even Rate comes in.BREAK EVEN RATE
You are probably familiar with this concept as well, but again, we need to understand the math behind it for the ARE 5.0. Break Even Rate is the the amount you have to charge so you end up with $0 at the end of the day. You charge a client enough money to cover all your costs so you end up with no debt, but you also end up with no profit (this is not ideal). So before you figure out your profit margin, you have to figure out your Break Even Rate. The technical description is that Break Even Rate is a measure of the total cost of operations for each dollar spent on direct labor. In the Architect Handbook of Professional Practice Break Even Rate is defined as the Overhead Rate plus the unit cost of 1 hour of salary. So the formula is Overhead Rate + 1.00. The Target rate is 2.3-2.5 which is exactly 1 higher than our Overhead Rate of 1.3-1.5. This is how you account for all those indirect expenses and account for the money you're paying to the employee doing the work. The Overhead Rate covers all the indirect expenses, and the 1.00 covers the money you pay to the employee. If you have an employee that costs $100/hour, they are going to cost $139/hour of overhead. You have to charge the client the $139/hour PLUS the $100/hour that you pay the employee. This means you have to charge the client $239/hour. Note these are probably Principal billing rates and an intern, Project Architect or Project Manager would probably have a billing rate between $60 – $140 per hour, depending on the firm.SAMPLE PROBLEMS
1) Using the Overhead rate for the previous problem, calculate the Break Even Rate for HF Copper and Associates. ANSWER 1.39 + 1.00 = 2.39 2) An Intern Architectural Staff II employee earns a salary of $65,000 based off of a 2000 hour work year. What is the Hourly billing rate of this employee as billed to clients. (Round up to the nearest $10 Increment.) This is a little more like what you might see on the ARE where you start with some given information and have to convert it a couple times to get the final answer. Let’s get into it. You know that this employee is going to make $65,000 and that they are going to work 2,000 hours a year. You have to first figure out how much you’re paying them per hour, then you have to multiply that by the Break Even Rate to see how much you have to charge the client, then round up. $65000/2000hrs = $32.5/hr
$32.5/hr * 2.39 = $77.675/hr
Round this up to $80/hour and that’s your Break Even Rate. This means if you charge a client $80/hr for this employee they will earn enough to cover their salary and their portion of indirect expenses. All your expenses are covered…but you won’t make any money either
To actually make money you need a profit margin. If you want to add a profit margin of 20% you would divide the hourly rate from above by the inverse of the profit you want. 20% profit means you would divide by 80%, or 0.8. $80/hr / 0.8 works out to $100/hr, which is what you would bill your clients so that you can actually turn a profit.
