When the term "Directors" is used below, it means those owners or partners who are rewarded by a distribution of profit and not a salary or wage.

1. Establishing a Cost Rate
   Information required
   1. An estimate of productive hours
      
   2. An analysis of estimated expenditure

2. Estimate of productive hours

   1. Estimate the hours which will be spent by Labor over a period (usually a year) spent making product.
      
   2. Include in this figure the estimated hours the Directors will spend on productive work.
      
   3. Exclude such things as cleaning time, tea breaks etc.

3. Analysis of Estimated Expenditure
   
   Analyse expenditure into:-
   
   1. Direct Labor - that is the cost of employees, plus a reasonable charge for the hours the Directors will spend on productive work.

   2. Variable overheads - that is, expenses which will vary according to the amount of work activity the Company has.
      Examples are: Consumables stores(such as oils, greases, rags), power etc.

   3. Fixed Overheads - that is expenses which do not vary irrespective of the amount of work activity. Examples are: Rent, Rates, Depreciation, Accountants fees, General Administration Expenses etc. In this category, include a reasonable charge, for the time the Directors spend on supervision, planning and administration.

4. Calculation of Cost Rates.
   
   

   1. Assumed figures for a hypothetical company are included to illustrate the calculations more clearly. The estimated total conversion costs, that is, total costs excluding direct materials, of this hypothetical company are $139,000.

   2. From the analysis specified in paragraph 3, cost rates are calculated as follows:-

      		Hand Work
      1.	Productive Hours	5,700
      		$
      2.	Direct Labor	94,000
      3.	Variable Overhead	_10,000
      4.	Total Variable Cost	104,000
      5.	Fixed Overhead	_35,000
      6.	Total Costs	139,000
      	Cost Rates per Hour
      7.	Variable Cost Rate   (line 4 ÷ line 1)	18.246
      8.	Fixed Overhead Cost Rate   (line 5 ÷ line 1)	6.140
      9.	Total Cost Rate	24.386

      
      
       

   3. The conversion cost of a job, taking (say) 5 hours would be:-

      	Hrs	Cost Rates $	Conversion Cost $
      Hand Work	5	18.246	91.23	Variable Cost
      		6.140	_30.70	Fixed Cost
      Total Conversion Cost			121.93

      
      
       

5. Addition for Profit Required.

   1. As the Labor input of the Directors to the Company has been included in the costs, the addition for profit is confined to the return required on the Directors investment in the Company.
      
   2. On the principle that the Company is selling its skills, the addition of profit should be related mainly to conversion costs.
      
   3. A return of twice the borrowing costs is recommended. Assuming the current borrowing rate is 14% and the investment in the Company is around $40,000 for fixed assets and working capital (excluding stocks of raw materials), the formula would result in target profit of $11,200 (40,000 x 14% x 2).
      
   4. Applied to the total conversion costs in the example above, this would be an addition of 8.1% (11,200 as a percentage of 139,000).
      
   5. In addition the Company will have an investment in stocks of materials. An addition to cover this should be made, by adding a percentage to direct material costs. Based on the hypothetical figures below, this should be calculated as follows:-

      Investment in stocks			 $4,000
      Stock turnover				  15 times per annum
      Direct material consumed		$60,000 (4,000 x 15)
      

      Using the same parameter of requiring twice the borrowing cost, the return required is $1120per annum. ($4,000 x 14% x 2)

      The percentage addition to direct material costs is therefore 1.9% (1120 as a percentage of 60,000)
      

   6. If it is assumed that the direct material cost of the job example above is $71. The total estimated cost of the job and the required price is calculated as follows:-

      		$
      Direct Material Cost		71.00
      Variable Conversion Cost		_91.23
      Total Variable Cost		162.23
      Fixed Conversion Cost		_30.70
      Total Cost		192.93
      Add:	Target Profit Materials   (71.00 x 1.9%)	1.35
      	Conversion Cost   (121.93 x 8.1%)	__9.88
      Required Selling Price		204.16

      
      

   7. The additions for profit calculated in this way appear quite small, but are in addition to the "salary rewards" for the Directors that are included in the costs. Nevertheless it serves to illustrate how easily the profit margin is eroded if jobs are not completed in the time estimated.
      
   8. It is important that employees know what is expected of them. For repetitive jobs, it is recommended that the estimated times are listed and displayed in the factory area in a prominent place. For non repetitive jobs, the time allowed can be conveyed to employees by a suitable job sheet method.

6. Pricing
   
   

   1. Consider the job cost above. If work is scarce and margins tight, a price obtained higher than the variable cost of $162.23 will be of benefit to the Company. Business should not be accepted at less than the variable cost.
      
   2. If demand is high and business is buoyant, then a higher price than the required price can be charged, if in the judgement of the Director(s) it is considered commercially possible.

Spreadsheet examples are available that are based on an actual business involved in both domestic and industrial office cleaning. The procedures and calculation principles will be applicable to any small Labor intensive business working on a contractual basis that is required to quote for work. With some knowledge of using spreadsheets you can substitute the information in the spreadsheet with that applicable to your business and calculate relevant charge out rates that will achieve your business targets and objectives. Please read the 'Read Me' notes before using the spreadsheets.

WARNING: Always check downloaded files for viruses before opening them
Spreadsheet program Microsoft Works Version 6.0
The Microsoft Works spreadsheet program is readily available to most computer users, being part of the bundled software issued with most desktop purchases. Being an entry level program, it can often be converted and used by other more sophisticated spreadsheet programs.

Click here to download Works Version 6.0 spreadsheet example.

Spreadsheet program Microsoft Excel 97 version.
The Excel spreadsheet is now the most widely used of spreadsheet programs. Its Work Book format provides for a cleaner presentation of the data and allows adjustments to be made more easily. If you have an Excel spreadsheet program download this file.

Click here to download an Excel 97 version spreadsheet example.

Click here for "Should Be" Profit info.

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