Recently a colleague of mine solicited rates for a design contract. Following good procurement practice, his solicitation provided a list of normalized labor categories and asked for a detailed break-down of the hourly labor rate for each of the listed labor categories.
The majority of the Vendors complied, submitting their individual hourly rates as requested. One stand-out supplier decided he was uncomfortable quoting individual rates and decided to present a single “blended” rate that he proposed as his hourly rate for all of the work to be performed.
The rate seemed generally favorable and my colleague was inclined to accept it until we ran a few pricing models.
What are Blended Rates
Blended hourly rates refers to the practice of averaging out the billable hourly rate of a group of individuals. This is done in lieu of quoting and/or billing individual hourly rates.
Blended rates can also be derived from a weighted average where hourly rates are weighted according to the amount of time an individual will devote to a project.
One of the first questions my colleague had was whether I had ever used blended rates on a project? I could only think of one time that I ever saw blended rates used. In that example, a Client had an existing contract which they had accepted and were actively using. That existing contract was a time and material contract with a single blended hourly rate.
The Client suspected that he had made a mistake allowing the blended rate and asked me to evaluate whether his suspicions were right. In this example the Client had accepted a rate based on an average (not weighted) rate.
Cost Modeling of Blended Rates
We modeled the work the Vendor was performing using actual hours from his invoices. Since we did not have each individual’s hourly rate, we used benchmarks and ran several models apportioning the number of hours by labor category. We used percentage break-downs from similar projects to apportion the hours by labor category.
What we found was that because the majority of the work was being performed by lower cost resources, the average of rates resulted in a gross over-payment. This Client was paying more than 20% above what they would have paid if they had been billed individual hourly rates.
We went a step further and modeled the project using a weighted average blended rate. The results were less dramatic, but because we were unable to fully validate the actual hours worked from each resource, we concluded that even a weighted average blended rate was unfavorable.
The weighted average model resulted in the same final price as long as the apportioning of hours did not change. As we all know when you are working with hourly rates, the number of hours is always variable. The risk of significant changes affecting the number of hours made the weighted average blended rate inextricably dependent on the estimated hours. As soon as the apportioning of number of hours shifted towards a lower cost resource, the Owner would find themselves at a deficit. If the apportioning of hours shifted towards higher cost resource, the Vendor would be in a deficit.
Our models determined that both parties were at risk using the weighted average blended rates and the Owner was at extreme risk using an unweighted average.
As you might imagine, I talked my colleague away from the Vendor offering the blended rate. While the blended rate may look favorable, when you consider that the majority of the work is performed by lower cost resources, the final price will always be inflated.
Time and material contracts are inherently high risk. The variability of the hours alone is enough to steer clear of such agreements. Owner’s should ONLY use time and material agreements for short term limited engagements. That said, there are circumstances when time and material agreements are the right choice, but you should never accept blended rates. It’s simply not favorable to either party and these are especially bad for Owner’s.
What do you think? Have you used blended rates before? How did that work out for you? Tell me your stories.
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