Time and Material Pricing in Service Companies:
Learning Objective of the Article:
- Define and explain time and
material pricing.
- Calculate and use billing rates used in time and
materials pricing.
Contents:
-
Definition and explanation of time and material pricing.
-
Time component
-
Material
component
-
Example
Some companies--particularly in service
industries-- use a variation of cost plus pricing called time and
material pricing. Under this method, two pricing rates are
established--one based on
direct labor time and other based on the cost of
direct materials used. This pricing method is used in repair shops, in
printing shops, and by many professionals such as physicians and dentists.
The time and material rates are usually market determined. In other words,
the rates are determined by the interplay of supply and demand and by
competitive conditions in the industry. However, some companies set the
rates using a process similar to the process followed in the
absorption
costing approach to cost plus pricing. In this case, the rates include
allowances for selling, general and administrative expenses; other
direct
and indirect costs; and a desired profit. This page will show how the
rates might be set using the cost-plus approach.
The time component is typically expressed as
a rate per hour of labor. The rate is computed by adding together three
elements:
- The
direct costs of the employee,
including salary and fringe benefits.
- A pro rata allowance for selling, general,
and administrative expenses of the organization.
- An allowance for a desired profit per hour
of employee time.
In some organizations (such as a repair
shop), the same hourly rate will be charged regardless of which employee
actually works on the job; in other organizations, the rate may vary by
employee. For example, in a public accounting firm, the rate charged for a
new assistant accountant's time will generally be less than the rate charged
for an experienced senior accountant or for a partner.
The material component is determined by
adding a material loading charge to the invoice price of any
materials used on the job. The material loading charge is designed to cover
the costs of ordering, handling, and carrying materials in stock, plus a
profit margin on the materials themselves.
To provide a numerical example of time and
material pricing, consider the following:
Quality Auto Shop
uses time and material pricing for all of its repair work. The following
costs have been budgeted for the coming year:
| |
Repairs |
Parts |
| Mechanics'
wages |
$300,000 |
|
| Service
manager--salary |
40,000 |
|
| Parts
manager--salary |
|
$36,000 |
| Clerical
assistant--salary |
18,000 |
15,000 |
| Retirement
and insurance--16% of salary and wages |
57,280 |
8,160 |
| Supplies |
720 |
540 |
| Utilities |
36,000 |
20,800 |
| Property
taxes |
8,400 |
1,900 |
|
Depreciation |
91,600 |
37,600 |
| Invoice
cost of parts used |
|
400,000 |
| |
|
|
| Total
budgeted cost |
|
|
The company expects to bill customers for
24,000 hours of repair time. A profit of $7 per hour of repair time is
considered to be feasible, given the competitive conditions in the market.
For parts, the competitive markup on the invoice cost of parts used is 15%.
The following schedule shows the calculation
of the billing rate and the material loading charge to be used over the next
year.
TIME AND
MATERIALS PRICING
| |
Time Component: Repairs |
Parts: Material Loading Charge |
| |
Total |
Per Hour* |
Total |
Percent** |
| Cost of
mechanics' time: |
|
|
|
|
| Mechanics'
wages |
$300,000 |
|
|
|
| Retirement
and insurance (16% of wages) |
48,000 |
|
|
|
| |
-------- |
|
|
|
| Total cost |
348,000 |
$14.5 |
|
|
|
For repairs--other cost of
repair service. For parts--cost of ordering handling, and storing parts: |
|
|
|
|
| Repairs
service manager--salary |
40,000 |
|
|
|
| Parts
manager salary |
|
|
$36,000 |
|
| Clerical
assistant salary |
18,000 |
|
15,000 |
|
| Retirement
and insurance (16% of salaries) |
9,280 |
|
8,160 |
|
| Supplies |
720 |
|
540 |
|
| Utilities |
36,000 |
|
20,800 |
|
| Property
taxes |
8,400 |
|
1,900 |
|
|
Depreciation |
91,600 |
|
37,600 |
|
| |
-------- |
|
--------- |
|
| Total cost |
204,000 |
8.50 |
120,000 |
30% |
| |
-------- |
|
-------- |
|
|
Desired profit: |
|
|
|
|
| 24,000
hours × $7per
hour |
168,000 |
7.00 |
|
|
| 15% × $400,000 |
|
|
60,000 |
15% |
| |
------- |
------- |
------- |
------- |
| Total
amount to be billed |
$720,000 |
$30.00 |
$180,000 |
45% |
| |
====== |
===== |
====== |
==== |
| *Based
on 24,000 hours |
| **Based
on $400,000 invoice cost of parts. The charge for ordering, handling,
and storing parts, for example, is computed as follows: $120,000 cost /
$400,000 invoice cost = 30% |
Note that the billing rate, or time
component, is $30 per hour of repair time and the material loading charge is
45% of the invoice cost of parts used. Using these rates, a repair job that
requires 4.5 hours of mechanics time and $200 in parts would be billed as
follows:
| Labor
time: 4.5 hours $30 per hour |
|
$135 |
| Parts
used: |
|
|
| Invoice
cost |
$200 |
|
| Material
loading charge: 45% $200 |
90 |
290 |
| |
-------- |
------ |
| Total
price of the job |
|
$425 |
| |
|
===== |
Rather than using labor hours as the basis
for calculating the time rate, a machine shop, a printing shop, or a similar
organization might use machine-hours.
This method of setting prices is a variation
of the
absorption
costing approach. As such, it is not surprising that is
suffers from the same problem. Customers may not be willing to pay the rates
that have been computed. If actual business is less that the forecasted
24,000 hours and $400,000 worth of parts, the profit objectives will not be
met and the company may not even
break even.
|
