Time and materials pricing is used in the service and construction industries to bill customers for a standard labor rate per hour used, plus the actual cost of materials used. The standard labor rate per hour being billed does not necessarily relate to the underlying cost of the labor; instead, it may be based on the market rate for the services of someone having a certain skill set, or the cost of labor plus a designated profit percentage.
Thus, a computer technician may bill out at $100 per hour, while costing $30 per hour, while a cable television mechanic may only bill out at $80 per hour, despite costing the same amount per hour. The cost of materials charged to the customer is for any materials actually used during the performance of services for the customer. This cost may be at the supplier's actual cost, or it may be a marked-up cost that includes a fee for the overhead cost associated with ordering, handling, and holding the materials in stock.
Under the time and materials pricing methodology, a single hourly rate may be charged irrespective of the experience level of the person performing the services, but usually there are different rates for different experience levels within the company. Thus, an associate consultant will have a lower billing rate than a consulting manager, who in turn has a lower billing rate than a consulting partner.
Industries in which time and materials pricing are used include:
- Accounting, auditing, and tax services
- Consulting services
- Legal work
- Medical services
- Vehicle repair
If a company chooses to base its labor rate under time and materials pricing on its underlying costs, rather than the market rate, it can do so by adding together the following:
- The cost of compensation, payroll taxes, and benefits per hour for the employee providing billable services
- An allocation of general overhead costs
- An additional factor to account for the proportion of expected unbillable time
The Time and Materials Pricing Calculation
ABC International has a consulting division that charges out its consulting staff at a level that covers the cost of consultant labor, plus a profit factor. In the past year, ABC incurred $2,000,000 of salary expenses, plus $140,000 of payroll taxes, $300,000 of employee benefits, and $500,000 of office expenses; this totaled $2,940,000 of expenses for the year. In the past year, the company had 30,000 billable hours, which is roughly what it expects to bill out in the near future. ABC wants the division to earn a 20% profit. Based on this information, the division charges $122.50 per hour for each of its consultants. The calculation of the labor price per hour is:
$2,940,000 annual costs ÷ (1 - 20% profit percentage) = $3,675,000 revenue needed
$3,675,000 revenue needed ÷ 30,000 billable hours = $122.50 billing rate
Advantages of Time and Materials Pricing
The following are advantages to using the time and materials pricing method:
- High risk situations. This pricing method is excellent in situations where the outcome of the work is in such doubt that the supplier will only take on the work if it can be properly reimbursed.
- Assured profits. If a company can keep its employees billable, then this pricing structure makes it difficult not to earn a profit. However, the reverse situation can arise if the proportion of billable hours declines (see below).
- Additional profits. The seller may be able to build additional costs into the fee structure, such as overhead charges, that further increase the net profit earned.
Disadvantages of Time and Materials Pricing
The following are disadvantages of using the time and materials pricing method:
- Lost profits. A company that provides highly value-added services could potentially use value based pricing, where prices are set based on the perceived value delivered to the customer. Not using this approach could result in lost profits.
- Cost basis ignores market prices. If a company sets its time and materials prices based on its internal cost structure, it may be setting prices lower than the market rate, thereby potentially losing profits. The reverse situation may also occur, where market prices are lower than internally-compiled prices. If so, a business will find itself unable to generate much business.
- Customers will not allow. This pricing format allows a company to potentially run up its hours billed and charge more than the customer expects. Thus, customers prefer a fixed price to time and materials pricing.
- Low billable hours situations. The basis of the time and materials pricing system is that a company will be able to bill enough hours to offset its fixed costs (usually the salaries of its employees). If the number of billable hours declines and headcount does not decline in proportion, then the company will lose money.
- Price negotiations. More sophisticated customers will negotiate reductions in the billable rate per hour, eliminate any mark-up on materials, and impose a "not to exceed" clause in any time and materials contract, thereby limiting profits.
Evaluation of Time and Materials Pricing
Time and materials pricing is a standard practice in many services businesses, and works well, as long as you set sufficiently competitive prices and maintain a high rate of billable hours. Otherwise, the amount of revenue generated will not offset the fixed costs of the business, resulting in losses.