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Hourly versus flat rate labor pricing, which is best? In this article the author reviews the pros and cons of both labor pricing systems and then lets you make up your own mind. Either way their effectiveness depends entirely on the accuracy of your input data.
By William Joseph
Perhaps you work for a big company and thus have no responsibilities for setting service rates. If so, you may skip this article and congratulate yourself for your good fortune. At the same time, you may want to extend sympathies to your boss.
Setting service rates is a tricky business.
Of course, there are a number of owners and managers who feel they have solved the problem nicely. They simply find out what the guy down the street charges and set their own rates accordingly. The trouble is that he may well have set his rates the same way and both of you may find yourself going broke together.
Setting the price for labor is a vital part of the service business; it must be done professionally.
When you sell a repair part to a customer, determining how much to charge for it is a relatively easy job.
Every part in your inventory came to you at a specific cost. Arriving at the selling price is just a matter of applying the mark-up that you have decided to work with, or of referring to the recommended list prices widely available, through the latter practice can be dangerous.
By comparison, deciding the right price to charge for your labor is infinitely more difficult and exacting. When you or your technician complete a repair job, there is no invoice to tell you the precise cost of the finished product; yet this cost must be known if you are to establish the proper selling price.
And that's not all. Even after you develop expertise in determining your costs for labor and overhead, your pricing dilemma will be just beginning.
Factors that have no bearing on your own costs will rudely inject themselves into your computations. For example, the fellow down the street. What he charges for his labor will inevitably place limitations on the prices that would have solved all your income problems. Such are the joys of our free enterprise system.
Finally, we must consider the toughest part of the entire problem-the customer. No one, absolutely no one, enjoys paying for intangibles, and service is probably one of the least tangible products in our marketplace today. That last automobile you bought may have left a permanent scar on your financial hide, but it was your free choice. Now, you have several thousand pounds of steel and shiny chrome that you can show off to your neighbors. When you pay a labor charge for a repair job, all you can show for your money is the same article you had before the repair became necessary. The skill and time spent in completing the repair is but a fleeting memory, and it cannot be seen, heard, or held in the hand.
Price determines profit
Despite these problems, or perhaps because of them, your ability to set the correct prices for your labor will be one of your most important skills as a service dealer. The service dealer buys and sells the labor of skilled technicians. In today's marketplace, the price that must be paid for such skills is high. Once you have paid this price, you must re -sell at a professionally determined price.
There is a tendency for many service dealers to set their rates on the basis of past practice and what competition charges. These are valid considerations, but they cannot stand alone. To be sure, this may seem to be an easy way to solve a tough problem, but please don't let yourself do it.
One of the earliest lessons that you have probably learned in this matter is that there is nothing even approaching uniformity among service dealers when it comes to setting service rates or in describing them to the customer. Home service, for example, has given birth to a dazzling array of ways to quote service rates. There are trip charges, minimum charges, visitation charges, basic charges, flat rates, ad infinitum. Shop work is not much better with some dealers using flat rate pricing, some time and material, and others some combination of these.
Obviously, then, there is no one format for labor charges with which everyone agrees. In this article, we'll discuss the most popular of the systems in use and then step back to allow you to reach your own conclusions.
Let's talk first about the original format, and still one of the most popular methods for labor rates, the hourly charge.
As with every other system for setting rates, the hourly method has both advantages and disadvantages. From the viewpoint of the service dealer, it can be quite attractive. It assures the company of a known income for each productive hour of its technicians. The charge to the customer is computed simply by applying the fixed hourly rate to the time spent on the job.
Of course, this system can produce some interesting inequities. An inexperienced or inept technician can take much longer than necessary to do a given job. In such a case, the customer pays a premium to underwrite on-the-job training. The dealer, in turn, is protected against unusual physical circumstances that can greatly lengthen the time needed to do an otherwise simple job.
With all these advantages accruing to the service dealer, one could assume that knowledgeable customers would be opposed to the hourly rate. Well, some are and some aren't. There is at least one advantage to the customer that is considered significant in many quarters.
Under the hourly rate, the customer has use of the technician's time for the full period charged for. This is viewed by many people, both in and out of the industry, as a sort of discipline that tends to keep things on the up-and-up.
Perhaps this is why the hourly rate retains its popularity.
Let's say that you have chosen the hourly rate method for your operation.
Congratulations, you have completed the easiest part of the job. Now, how do you decide exactly what that hourly rate should be?
Remember, the first step in determining how much to charge for your labor is learning how much it is costing you to supply it.
The first part of that cost is obvious enough. For each hour worked by your technicians, you must pay them their hourly wage rate. This, as you know, is only a part of your total cost. All of the other costs of doing business must be added to your technical payroll in order to determine your full cost for each hour of technical productivity. One popular method for doing this requires that you determine your overhead ratio (or burden ratio as it is sometimes called).
Select a period of time upon which to base your calculations. Three months is a minimum and six months or a year would be better. For the period selected, add together all expenses for the business except technical payroll. Be sure not to overlook any expenses in this step. Include managerial and supporting payroll, occupancy expenses, advertising, depreciation, everything that is not direct technical payroll. The only exception that should not be included is the direct expense that can be identified with the parts portion of your business: cost of parts, payroll devoted exclusively to parts, etc.
Once you have determined your total overhead expense, divide that figure by the total technical wages paid during the exact same period (be sure to include any paid vacations or paid illnesses).
The result will be your overhead ratio.
Depending on the size and the efficiency of your business, your ratio may be as low as .8 or .9, or it may run as high as 1.5 or even higher. If your overhead expenses were exactly the same as your technical payroll, your overhead ratio would be 1.0. Get the idea?
Let's examine some figures from the hypothetical ABC Service Company.
Total overhead for the period $13,860 Technical payroll for the period $12,600 13,860 divided by 12,600 = 1.1 ABC's overhead ratio of 1.1 simply means that for every dollar paid to technicians, an additional $1.10 is needed to pay for overhead costs.
Take the average
The next figure we need is the average hourly wage paid to technicians. Let's say ABC pays one man $7.00 per hour, another $7.50, and a third $8.00. The average wage for the three men is $7.50. Assuming that its technicians average an eight hour day, the average daily rate is $7.50 x 8 = $60.00. In other words, on the average, ABC pays its technicians $60.00 for a day's work.
We have already determined that ABC has operating expenses amounting to $1.10 for each $1.00 paid to technicians (an overhead burden of 1.1). In order to get the total cost burden daily for each technician, we need only to add his average daily wage to his average daily burden ratio.
Technician daily wage average $60.00
Technician daily cost burden (60 x 1.1) $66.00
Total technician burden $126.00
That total of $126.00 represents the average cost to ABC for each technician working a full day. Put another way, it is the technician's breakeven point. If ABC's technicians went out and averaged $126.00 per day in labor charges to the customer, the company would break even.
Of course, that's not the idea. Your job is to establish rates that will generate a fair profit. If the service manager at ABC has set a 10% labor profit as his goal, he must divide his breakeven point by 0.9.
$126.00 divided by 0.9 = $140.00
Now we're getting down to brass tacks. Using the figures above we now know that each technician must generate service charges of $140.00 per day in order for ABC to make a 10% profit on labor. Computing the hourly rate is now easy. All we have to do is divide the $140.00 by eight. Right?
Determine productive time
To do so would be to assume that each technician is doing productive work for the entire eight hours of his working day. That, of course doesn't happen.
There are such things as coffee breaks, travel time, training time, shop clean-up, checking paper work, and on and on.
Industry studies indicate that only about 55% of the average technician's eight -hour day is spent actually doing repair work. That comes to about 41/2 hours. In some especially efficient or highly specialized operations that efficiency figure may run as high as 80 or 90%. For the purpose of our illustration, let's say that ABC's technicians are productive 70% of the time. That works out to about 5.6 hours per $140.00 divided by 5.6 = $25.00 per hour
For each full hour spent on the job, ABC must charge $25.00. Usually, this will be broken down into quarter hours or tenths of an hour increments. In this example, each quarter hour would be billed at $6.25.
For home service calls, most dealers will further refine the hourly rate to arrive at a minimum or basic charge which will cover up to a certain amount of time, after which the hourly rate applies.
In reading back over the example used, you will note that the productive time of the technicians is a factor that must be known. You can't hedge on this step. If you don't already know the productive time of your technicians (or even yourself) be prepared for a shock.
In order to compute productive time you'll need to add up the actual time spent on jobs as compared to the hours paid over a representative period of time. Don't use industry averages or guesswork for this step, it's too vital to your financial success.
Flat rate pricing
Incidentally, reducing the non-productive time of your techs will allow you to charge a lower rate to your customers, or to enjoy a higher profit margin, or some combination of both.
The flat rate system for labor charges represents an entirely different concept.
With flat rates, the labor charge for every type of repair is calculated in advance and remains the same regardless of the time required to do the job.
Proponents of the flat rate system point out several advantages over the hourly rate. On the surface, at least, there would appear to be advantages for both the customer and the service dealer in flat rate systems.
From the customer's standpoint, flat rates offer good insurance against surprises. The customer knows precisely how much his repair job is going to cost him even before the work is done.
The service dealer, too, enjoys some advantages in flat rates. Every repair job results in a known and fixed income. An additional benefit accrues to the dealer as a result of the technician not having to spend time making a record of starting and ending times and computing time spent on the job.
As you might imagine, preparing your own table of flat rate prices is no mean task. The job requires an immense amount of statistical analyses and, for all practical purposes, may be beyond the means of all but the largest service dealers. At least two different means of solving this problem have been put to use in recent years.
In one system, only a handful of prices need be set. All repair jobs are classified as home or shop, and each of these is further identified as major or minor.
Fixed rates are based on overall averages and assigned to each of these four categories. In some cases, an additional price or two may be listed for special jobs such as picture tube replacements.
This is obviously the easiest form of flat rate pricing, but it is also the least professional and may be the most difficult to defend against flat rate critics.
Another format that is gaining acceptance is the commercially available flat rate manual patterned after the system originally developed in the auto repair industry. The use of this form of manual offers the dealer the advantage of a much more extensive and detailed analysis of average times than could be developed locally. There is also a certain psychological advantage in having the customer see the technician referring to an "official -looking" manual for his prices.
One of the most popular of these pricing systems developed especially for the electronic service dealer is the Sperry Tech labor pricing guide.
Information can be obtained by writing to the company at P.O. Box 5234, Lincoln, Nebraska 68505. (Also see ET/D, May 1979, P. 32.) While it is true that flat rate systems are becoming increasingly popular for pricing labor in the electronic servicing industry, you will be well advised to remember that not everyone is enchanted with the idea.
Pricing by the book
It is in the auto repair field that the concept came into its own, and that is where the sharpest criticisms are still being aimed. Pricing from "the book" is so widespread in the auto industry that shopping around for the best price on a given repair job may well net the customer nothing more than six identical estimates and some extra miles on the speedometer.
Whether they are right or wrong, critics of the auto repair flat rate manuals claim that the average mechanic can and usually does complete jobs in less time than the manuals list. One well-known consumer organization claims to have performed its own repairs on a wide variety of autos and repair types and compared the actual time spent with the times listed in one of the most widely used flat rate manuals in the industry. The test, it is said, showed that the times listed in the manual were, on the average, 25% longer than the time actually spent by the mechanics during the test.
In fairness, this could mean that the mechanics used in the test were simply 25% faster than average-or it could mean that the times listed in the book do not represent a realistic expectation of the time needed by a reasonably competent mechanic to do the work.
In any case, you will want to keep yourself aware of the obvious risks and criticisms that may come your way if you adopt a flat rate program. If the times used in the listings have not been scrupulously and fairly computed, the flat rate system can indeed become unfair to the customer.
A reasonable option
Properly prepared and administered, the flat rate system of pricing is a reasonable option to the electronic service dealer. It is up to the dealer, however, to handle it in such a manner that the customer receives a fair deal. It is, after all, comforting for a customer to know exactly what a repair job is going to cost before the work is done. Whether the customer receives a fair deal is less a matter of the choice of pricing formats than of the integrity of the service dealer involved.
If you are using or are planning to use some form of flat rate pricing, there is one simple check that will help to satisfy you of its fairness: Jobs that require more time than listed should be in evidence as often as jobs that are completed in less time.
Remember, the basic premise of flat rate pricing is that every customer pays for the average time to complete a given repair job. If the average time is properly and accurately computed, neither the customer nor the dealer need have any surprises and both will have been treated fairly in the vast majority of cases.
As a closing note, let me remind you that the increasing militancy of consumer organizations makes it more important than ever that service dealers use a pricing system that is understandable to the customer, and that satisfies the "disclosure" legislation that is being enacted in more and more communities around the country.
In my view, a service dealer has every legal and moral right to set his prices at any level that he wishes, so long as the customer is made aware of what he is paying and what it is for. You cannot cheat a customer simply by charging high prices. If your prices are too high for the service that you are offering, the wonderfully effective forces of our free enterprise system will soon provide a solution to the problem; your customers will simply go elsewhere.
There are, of course, any number of service dealers who choose to charge premium prices for what they feel to be premium service. While my personal preference is more moderate, I know of no consumer organization or government agency that will dispute this right; so long as the customer is not misled and the rates are set forth in a clear and straightforward manner.
(source: Electronic Technician/Dealer, Jan. 1980)