The Circular Rate
The rate depends on chargeable hours, which depend on work won, which depends on price, which depends on the rate. How the loop closes without spiralling.
The rate depends on chargeable hours. Chargeable hours depend on how much work is won. Work won depends on the price. The price depends on the rate. The loop is real and it closes, but it can close in the wrong direction, and in a downturn it closes fast.
The calculation in “The Circular Rate” depends on reliable source records as well as a documented accounting rule. For organisations researching online timesheets for client billing, see this Monitask resource can supply consistent time and project context, while the allocation basis and financial interpretation remain decisions for the organisation and its advisers.
Understanding the loop is what stops an operation pricing itself out of the market while believing it is covering its costs.
For a separate reference relevant to “The Circular Rate”, consult Corporate Finance Institute resources. Compare the general material with the organisation’s actual contracts, accounting policy and jurisdiction.
The spiral
Volumes fall. Chargeable hours fall. The rate, rebuilt on the lower hours, rises. The higher rate raises prices. Higher prices lose work. Volumes fall further.
- Volumes fall.
- Chargeable hours fall with them.
- The rate, rebuilt on fewer hours, rises.
- The higher rate raises prices.
- Higher prices lose work, and volumes fall further.
Three cycles of this and the operation has priced itself out while following its own costing policy exactly.
Where the loop is broken
By using budgeted chargeable hours rather than last period's actual, and by holding the budgeted figure at a normal level rather than chasing the downturn.
The rate then stays stable and the shortfall appears where it belongs: as under-recovery, visible in the accounts.
Normal capacity
The accounting term for the hours an operation expects to charge in a typical year, averaged across the cycle rather than taken from the last twelve months.
Using it as the divisor is the standard remedy for the spiral and it is widely recommended and narrowly practised.
What under-recovery then means
That volumes were below normal. It is a demand fact, reported as a variance, and it does not contaminate the rate.
Rolled into next year's rate instead — which is tempting — it becomes the spiral.
The opposite direction
A boom. Chargeable hours exceed normal, the rate falls, prices fall, more work is won, hours rise further.
Less painful and equally distorting: the operation under-prices during its busiest period and discovers it when the boom ends.
Setting the normal figure
From three to five years of actual chargeable hours per head, averaged, adjusted for anything structural that has changed.
It should move slowly and deliberately, with a stated reason, rather than every year with the data.
When to change it
When something structural has changed: a new service that requires more quoting, an automation that removed administration, a permanent shift in the mix.
Not because last year was busy or quiet. That is exactly what the figure is designed to absorb.
The conversation with whoever sets prices
They need to know that the rate is built on normal volume, and that the rate will not fall if this year is busy or rise if it is quiet.
That stability is what makes the rate usable for pricing at all, and it needs saying because the instinct is the opposite.
Where the real decision sits
If volumes are permanently lower, the answer is not a higher rate. It is fewer people, or different work, or a different cost base.
The rate is an accounting device. It cannot fix a demand problem and raising it to try is how the spiral starts.
The marginal question underneath
In a downturn, the relevant number for whether to take a job is not the full rate but the marginal cost of the hours, which in a salaried operation with spare capacity is close to zero.
That is a dangerous number to use routinely and the right one to use deliberately, and it has its own note later here.
The rate as a signal to the market
Where a rate is published to customers, a rate that rises in a downturn signals that the supplier is struggling, at exactly the moment it most needs to look stable.
Holding the rate at normal capacity is therefore a commercial decision as well as an accounting one, and it is easier to defend when the policy was written down before the downturn rather than during it.
Where the loop bites hardest
In operations with high fixed cost and volatile demand: professional services in a slow market, specialist manufacturing between contracts.
There the gap between normal capacity and actual can be thirty per cent, which means a rate chasing actual hours would move by thirty per cent year to year. No customer tolerates that and no estimate built on it is comparable with the previous one.
The number to watch instead of the rate
Recovery: rate times actual chargeable hours, against the pool. One multiplication each period.
It falls immediately when volumes fall, which is the signal the rate is deliberately not giving. Watching recovery while holding the rate steady is how an operation sees a downturn early without transmitting it into its own prices.
The four lines to publish
The normal chargeable figure, the actual, the variance, and a statement that the rate is built on the first.
Four lines. They are what let a finance function and an operation discuss a bad year without the costing system making it worse.