The utilization rate is the working efficiency of an organization. It tells a company how efficiently its employees are working in terms of available working hours.
Calculating the utilization rate is easy and can be used to derive the profitability of a company.
Let us discuss what is utilization rate and how to calculate it.
What is Utilization Rate?
The utilization rate of employees means the percentage of work hours that can be billed as compared to the total working hours available for them.
Utilization rate is important efficiency and productivity metric. It is often used for service organizations where the profitability of an organization is directly linked with the efficiency of its employees.
Service organizations work on different projects with varying requirements. Therefore, it is important to calculate the profitability of each project in terms of employee capacity.
An organization can apply this rate to calculate its profitability per employee and also to calculate the optimal pricing.
Further, it can be used to compare the scheduled utilization and tracked utilization rates.
A scheduled utilization rate means the targeted or planned rate for employees working on a specific project.
The tracked utilization rate is the actual rate achieved by employees of an organization.
Comparing the two can reveal the difference between the planned and actual utilization rates of employees for an organization.
Formula
Although there are no set rules to calculate the utilization rate. That is because every service organization comes with different prospects when it comes to employee capacity.
For example, a service organization with around 500 employees would work differently from a small service organization with 15-25 employees.
Generally, we can calculate the utilization rate by comparing the planned work hours against the actual work hours of an employee in percentage terms.
For that, an organization would first need to set the benchmark for the actual work hours for an employee on a monthly or yearly basis.
Utilization rate formulas for individual employees and organization capacity can be written in the following formats.
Utilization Rate = (Total Billable Hours / Total Available Hours) × 100
Capacity Utilization Rate = (Total of all Employees Utilization Hours / Total No. Of Employees) × 100
Optimal Billing Rate = [(Resource Costs + Overheads + Profit Margin) / Capacity Utilization Rate] × 100
Ideal Utilization Rate = [(Resource Costs + Overheads + Profit Margin) / (Available Hours × Target Billable Rate)] × 100
It’s important to understand that companies of different sizes would include different resource costs, overheads, and profit margins. Therefore, an ideal utilization rate for one company may not be an ideal rate for another.
How to Calculation Utilization Rate?
An organization first needs to determine which employees from its staff should be included in the calculations. Some managerial employees would not contribute directly to commercial projects.
Therefore, an organization can either exclude the working hours of these employees or can calculate their utilization rate differently.
An organization can take a step-by-step approach to calculate the utilization rate.
STEP 01:
Determine the total available days or hours available for an organization for the estimation period.
For example, consider 52 (weeks) × 5 (days) = 260 days per year. Or 30 days for a month. Similarly, there are normally 40 hours per week which means a total of 2,080 hours annually.
STEP 02:
Calculate the billable hours or days worked by an employee per week and per year. It means to deduct any working hours that an employee missed for vacations or non-working activities.
For example, deduct the following:
- Entitled yearly leave; paid and unpaid
- Sick leave days
- Estimated internal activities; non-working
- Professional development days (Training)
STEP 03:
Divide the billable work hours calculated for an employee by the total available work hours and multiply the result by 100.
The resulting percentage is the utilization rate of an employee.
STEP 04:
Similarly, an organization can calculate the utilization rates for all employees. Then, divide the total of these percentages with the total number of employees.
The resulting figure gives the total utilization rate of an organization.
Utilization Rate for Individuals and the Company
Step four in our process above gives the capacity utilization rate of a company. It can be used to determine the ideal or target utilization rate by the company.
Suppose a company has 5 employees. It calculated the total available working hours and the billable working hours for each employee.
Let us suppose the utilization rates for these employees are 77%, 82%, 65%, 73%, and 85%.
The capacity utilization for this company can be calculated as:
Capacity Utilization Rate = (Total of all Employees Utilization Hours / Total No. Of Employees) × 100
Capacity Utilization Rate = (77% + 82% + 65% + 73% + 85%)/5
Capacity Utilization Rate = 76.4%
What is an Ideal Utilization Rate?
As mentioned earlier, the ideal utilization rate for a company can differ from any other in the same sector. Several factors contribute to the capacity utilization and profitability calculations.
Once a company calculates the capacity utilization rate, it can then calculate the ideal utilization rate.
Ideal Utilization Rate = [(Resource Costs + Overheads + Profit Margin) / (Available Hours × Target Billable Rate)] × 100
Utilization Rate, Billability, and Profitability of a Company
Continuing with our example above, suppose the company has the following data available to determine its utilization metrics.
- Resource Costs (labor, hiring, etc.) = $ 100,000
- Overhead Costs = $ 30,000
Profit Margin = 25% or (130,000 ×25% = $ 32,500)
Suppose the average maximum available hours are 2,000 for the company employees. Therefore, its optimal billing rate will be:
Optimal Billing Rate = [(Resource Costs + Overheads + Profit Margin) / Total available hours] × 100
Optimal Billing Rate = [100,000 + 30,000 + 32,500) / 2,000 = $ 81.25 per hour
Because a company has non-billable hours included in its total hours it must use the utilization rate as well. If we divide the optimal billing rate by its capacity utilization rate, we’ll get a better per hour rate.
Billable Rate = $ 81.25 / 76.4% = $ 106.3 per hour.
This rate is higher since the company must account for its idle or non-billable hours as well.
Now, the company can charge that billable rate if it continues to work at 76.4% capacity and above. If its capacity rate drops, it would need to charge higher.
That means the company can quickly become uncompetitive as customers will be unwilling to pay more for the same amount of work.
Therefore, the company should calculate an ideal billable rate.
Suppose the company wants to achieve the same 25% profit margin at its competitive per hour rate of $ 95.
Then, the ideal capacity utilization rate for the company to achieve these metrics will be:
Ideal Capacity Utilization Rate = [(Resource Costs + Overheads + Profit Margin) / (Available Hours × Target Billable Rate)] × 100
Ideal Capacity Utilization Rate = [$ 162,500) / (2,000 × $ 95] × 100
Ideal Capacity Utilization Rate = 85.5%
It means if the company wants to achieve its 25% profit margin and charge the competitive rate of $95, it must work at an ideal capacity utilization rate of 85.5%.
It also means if the company’s capacity reduces, it would need to charge more or its profit margin will reduce.
Why Use the Utilization Rate?
Using efficiency metrics like the utilization rate helps a company improve its working capacity and increase profitability.
A few key reasons to use the utilization are listed below.
Avoid Idle Labor Hours
Once a company calculates its ideal capacity utilization rate and sets benchmarks, it can work to minimize idle labor hours.
Non-billable working hours are inevitable. However, a company can make efforts to reduce its idle time and maximize the available work hours.
Manage Employee Workload
When a company knows the capacity utilization rates of its employees, it can assign work-related tasks accurately.
It also helps a company to share the workload for employees on existing commercial projects.
The company can calculate different capacity work hours for different departments since not all departments would be working on a commercial project directly.
Manage Staff Strength
Suppose a company is working at a 90% or above capacity rate. It means the employees are under a heavy workload.
Understanding the right utilization rate can help a company manage staff strength. The company can hire more staff in relevant departments or transfer additional employees.
Anticipate Utilization Rate Problems
A company’s capacity utilization rate should be optimal. A too low or too high rate would be inappropriate for the company as well as its employees.
Similarly, a company can forecast its utilization rate problems. It can compare the current rate with historic data and anticipate the utilization rate for the future.
Derive Profitability
Finally, a service organization can use the handy utilization rate metric to derive profitability.
As mentioned above, once a company knows its target profit margin and available work hours, it can calculate its optimal utilization rate and its rate per hour.
