In today’s post, we’re going to review the concept of a “burden rate” and why it is important. This term may have differing names by industry or have varying calculation methods, but the underlying reason for doing it is the same: you must know the cost it takes you to produce revenue. Let’s look at an example to illustrate this point.
A construction subcontractor submits a bid on a job for $10,000. This is a 5-day project that is expected to generate $2,000 in profit. Of the $8,000 of costs, $6,000 is dedicated to materials needed to complete the job and the remaining $2,000 is for labor. The construction subcontractor must know the burden rate of each employee that will be working on the job so that he can estimate how many hours the team has to complete the work while remaining in budget. The burden rate is often used to generate the proper price. The markup on labor can vary by industry, but generally should be 2-3 times the burden rate.
A standard burden rate calculation is focusing on the direct costs of every hour worked by an employee. The hours used in the calculation are also called the employee’s “working hours”. Don’t include time-off in this calculation, so holidays, PTO, and sick time are excluded. If an employee is working 40 hours per week but has 2 weeks of vacation and 3 sick days, the working hours would be 1,976 (2,080 – 80 – 24). The reason you do not include these days is because the employee is not working at all. You need to know the true cost of every hour worked in order to properly price your services.
The next step is to figure the hourly rate of all compensation, and that’s not just their wages. You must factor in the employer’s portion of the payroll taxes, unemployment, and company paid benefits. The total is the employee’s gross compensation package and cost to the employer. Divide this number by the employee’s working hours and that is your burden rate.
A burden rate is often $4-7 higher per hour than the employee’s hourly wage rate. Even though you are paying someone $21 per hour in wages, it may cost the employer $25 per hour to cover all these benefits.
Now that you have a burden rate for your employees, you can properly price your services. Let’s go back to our construction example. In order to stay within budget, the construction subcontractor can send two employees with $25 burden rates out to the site to perform the work for the entire week (40 hours each) and the cost to the employer would be $2,000.
Our discussion today has centered on labor hours, but a manufacturer would do the same thing. They would want to know down to the widget how much it costs to manufacture that item. While it doesn’t have a labor burden rate per se, the cost of the man hours needed to manufacture it would be included.