How to calculate your hourly rate
makaluinc.com
makaluinc.com
Hourly billing is a method of setting prices by looking at the cost of the product you are selling. In fact a customer does not care what it costs for you to deliver a product or service. You could be delivering a product that is made of diamonds and unicorn horns. It doesn't matter.
What matters is the value of your product or service to the customer. Your job, as a business owner, is to set your price based on the customer, not based on your costs.
Set your price based on the value that you deliver. Then adjust the inputs (hours of worker time, etc.) until you can deliver the value at that price. Mercedes Benz adjusts the inputs for a C-class car until it hits the target price. It adjusts the inputs differently for an E-class or S-class car.
There is a lot of information out there in the wide world about this. It is not "fixed pricing." Call it "value pricing." Fixed pricing is just computing the cost of your inputs, adding a margin, and declaring a price. Value pricing is a matter of working backwards from the customer's value desires to set the price.
For you math people, this is an "area beneath the curve" problem.
I'm an international tax lawyer. I make far more money (and have happier customers) when I charge a declared price than when I bill by the hour.
All that being said, one of the points in the article is exactly right: raise your prices and you will get better quality customers.
Go see www.verasage.com as a jumping-off point for discussions of pricing in professional service firms. All business are alike. Don't think that advice to an accounting firm is inapplicable to you. It's not. It's all "delivery of a service to a human being in exchange for money".
The difference is that now I am working on much bigger deals for people who appreciate my value. I cannot tell you how important this is to my general sense of happiness.
But what if you end up working on a product for a company that never makes them any money at all? You haven't provided any direct business value, although you may have done quite a lot of work--maybe months or years. Are you going to charge them nothing?
Rates are a proxy for value that accounts at least in part for the risk of project failure. High-risk individuals might account for this by trading equity for hourly rate or accepting some other form of in-kind compensation, as many startup employees do. But you have to be a strong believer in the project in order to do so, and most freelancers, to put it bluntly, aren't. Otherwise they'd be employees.
Nonetheless, don't start at the bottom by calculating costs. There's a market value for your services in the area where you live. If you can, start by asking other freelancers and consulting firms. The value of a good is what people will pay to get it, not what it costs to make.
The first is easy to quantify. It also means there is an upper cap on your income. The upper cap is the amount of tax saved. As your price approaches that number, the likelihood of a "yes" decreases.
Do not set your pricing based on easily quantifiable criteria, unless you're working on huge deals where you can take a small fraction of the value as compensation. (By small I mean low single digit percentages).
The second is where the true value sits. People are willing to exchange money for a peaceful brain. People are willing to exchange money in exchange for more time in their lives. It is here that personal value choice discontinuities work in your favor. Set your pricing based on intangibles.
A business owner is willing to throw money at a problem to not have to think about the problem at all. This frees up the owner's brain to think about stuff that really matters and will make money.
An hour spent by a CEO looking at tax returns could be an hour taken away from making a deal that brings in $1 million for the company. It's worth spending $1,000 to make the problem go away. You are happy to take the $1,000 because it takes you $125 of time input to solve that problem.
I have seen this with very large companies. There is a reason why their compensation packages include "your employer will pay for a lawyer, accountant, and personal financial planner." You don't want an executive with 10,000 employees under him/her to be sweating credit card payments, or "Is my will up to date?" or any trivia like that.
Moreso, however, I see this with entrepreneur-driven companies. The owner is the manager and this person's time is incredibly valuable and should not be spent on trivia, especially emotion-laden trivia.
Yes I am. As a business owner, I completely agree with this statement. After a while of running a business, one day you will calculate how many dollars per minute your expenses are and it will scare the hell out of you. Then you will understand why you throw money at problem X to make it go away, because you need to focus on opportunity Y to bring in more revenue.
If you're being paid to do work (you're not working for free) in this situation, you can conclude that either a) you actually are providing roughly $YOUR_BILLINGS of value to your client or b) your client is a moron and is paying for zero value. You may not be able to directly quantify the value you're providing, but your client certainly is aware of the value you're bringing. The point is to try to more accurately quantify your value and capture more of it.
> Measuring value in software development is difficult.
Again, your client has a ballpark of what value they expect you to deliver. Measuring the value is difficult for the contractor. This is a great area for discussion with the client.
Summary: if you're being paid, your client perceives that you are providing business value.
In a small company, probably, but in Enterprise contracting, I would be surprised if this is usually true.
If they can't or won't look past an hourly rate, then you probably don't want to work for them, because their other expectations may be equally as baseless.
Somebody in the enterprise is responsible for ensuring that projects aren't run without any expectation of creating value; that's the person/group to talk to. If you're not talking to that person/group, then you're right that value-based pricing is going to be hard/impossible to pull off.
If the buyer doesn't have any idea how much value you can/are creating, then your first task is to help them quantify the value (this is good for them no matter who they hire).
If Apple ask you to bid on creating the iPhone, how would value that? (The world hasn't seen an iPhone.) If you're capable of designing the iPhone and the best your competitor is capable of is creating a Galaxy, would the two bids be equal under the assumption of ideal value pricing?
This isn't something that happens to you, this is something you choose. It's your responsibility as a consultant to pick your clients carefully.
If you're talking about a project that everyone expects to have an enormous upside, but doesn't, and it's not your fault, you base your rates from the outset on the client's expectation of value returned, not what the actual result is.
In the mobile industry, (and the web dev industry as well), the market functions on the basis that 90% or so of projects won't make the return, and the industry is carried by the 10%. In some sectors (consumer) this is higher, in others (B2B) it's lower, but it's about the right frame of reference give or take for most projects that ordinary people on HN perform.
Now if you are a professional investor a 90% failure rate is easy because you just do 20 projects at once and you're fine. Similarly, if you are a large size consulting shop you're basically an investor with other people's time, so same story, just do 20 projects and 2 or so blow it out of the park and the rest are a waste and you get the quarterly bonus.
However, if you're an individual or a couple of guys in a broom closet somewhere, 20 projects is a very long time. Unless you are independently wealthy and can just float many years of work, you can't make any money. And if you are independently wealthy, you have a higher chance of success becoming the large consulting shop or being a professional investor (or starting your own startup) than you have doing lots of free projects for other people.
So what you are saying is nice in theory but for the average mobile/web developer thinking about contracting they don't have the volume necessary to assume the risk that the market ordinarily bears for development projects.
I know VERY "average" mobile web / mobile app developers who can charge well in excess of $100/hr. People without a single major hit. Seeing the quality of their output, I would never pay that much, and yet somehow they have all the work they need. (Note: they're not marketing geniuses either.)
Just look at the rates people ask for, and get. They're way up there. Because there are so few of these people around, relative to demand, and because every Joe Schmo who wants to do a mobile app expects to strike it big, they can charge anything they want.
That's true, but customers will consider your costs when deciding what price they think is fair for them to pay, so neither metric is isolated from the other.
I don't mean to sound trite, but that's basically a resolution of the whole debate between the subjectivist/marginalists and the "labor theory of value"/"cost the limit of price" camp.
It might sound strange, but most service providers are "selfish" in their pricing. Meaning, a rate is determined by looking inward — how much do I need to charge to make more than my monthly fixed expenses? What's the equivalent hourly rate when I was a salaried employee? What are my peers charging?
I've been able to continuously raise my rates over the years ($50 -> $250+/hr) by getting better at understanding the business problem at the root of a project request (i.e. they don't "want a new website designed", they really just want more walk-in customers) and tailoring my proposal, discussions, and execution toward that end.
As long as you can position yourself as an investment instead of an expense, and wield your technical + business skills to make your client's business better off than they were before hiring you, your ceiling is whenever the project cost outweighs the potential payoff.
(FYI, I wrote a book on this: http://doubleyourfreelancingrate.com)
In practice that cap works out to a hard ceiling of 350K.
Which is pretty good considering you need to feed only one family of it.
Sure you can charge more than $1k / day. It's just that at that rate you'll find it hard to book 350 days / year. Billable days are anywhere from 125 to 200 / year depending on your rate, reputation and skillset. If you bill $2k/day (definitely doable) you'll find that it gets harder to book all your days, it's simply demand and supply. Elsewhere in this thread someone is charging $800 / hour, which is great, you would only have to work a very small number of hours at that rate to have a living, or you could work a much larger number of hours and save like crazy. But I don't see that as the norm for IT consultants, programmers (Ruby, PHP, Java that sort of thing: $80 to $150 / hour, clojure and other 'exotic' stuff $120 to $250 / hour, M&A work $300 to $500 / hour but that is definitely not the kind of work that you could reasonably speaking book a whole years worth of unless you are the pet of some VC and involved in every deal in the pipeline).
I'd argue the reason your customers are happier with a fixed price is not to do with value (after all, what is value - can a customer tell you?), but to do with predictable expenditure and risk. It's a good policy and popular with clients (and also helps to make scope very clear and costed), but it's popular with customers because it gives you a very good incentive to finish on time and on budget, as compared to hourly billing. I'm not sure that's really comparable to shopping for a car.
"Guy walks along and sees Pablo Picasso chilling in a cafe watching the world go by, the man goes up to him and asks, 'Wow nice to meet you, can you draw me a sketch on this napkin? I'll pay you for your time!' Picasso scribbles on the napkin for a minute or two and hands it to the man, the man asks 'Thats great, how much?' Picasso replies '$5,000', astounded the man says, 'but it only took you a few minutes! I'm not paying that much!', Picasso says 'Yes, but it took me decades to be able to do that in a few minutes, you're paying for the decades of experience, and in decades to come, that drawing will be worth a lot more.'".
My point being that you shouldnt be leasing your time, you should be providing $100k worth of value and charging $20k for it, regardless of how long it takes.
And if i'm the customer and i know that you can provide $100k of value to my company, then i'll happily pay you $20k to do it.
When I was doing IT advisory work for vendors, a fairly small percentage of my time was spent doing direct billable work for clients over and above annual subscriptions many of them paid us. The rest of the time was spent researching, being briefed by companies, talking to journalists, writing, etc. When we did do a specific project (for which we generally charged for a deliverable--although that deliverable could be a day of advisory work), we charged what would seem to most people a really high hourly rate because we had to capture all the non-billabel time (and, of course, because our rates were in line with industry norms for this type of work and companies apparently felt we delivered sufficient value to capture those rates).
By contrast, I did some legal work as well and for that was paid on an hourly basis at a much lower rate. But, because it was a big block of work and I could charge for any time related to the project--including travel, background reading, etc.--it was pretty good work.
If you want to do value based pricing, you need to have a sales pitch that differentiates you from the market, or risk pricing yourself out of said market.
Making a lot of money per <hour|day|week|...> doesn't come down to just asking for it. You have to market yourself.
As others have stated elsewhere in this thread: there are people who are willing to pay you a lot of money so you can free up their time and let them focus on activities that generate a boatload more money than $10K. These are the people who will happily choose the $20K offer, and these are the people you want to work with.
Love to hear if there are tips out there for the sales pitch when doing these kinds of bids...
That gives you the room to be flexible.
The original article adds extra in as they have a different structure, but they start with $75k and year and end up with $85 an hour. Which seems to me to be close enough.
I used it when I started by company. I think it was good advice.
One of the most important things I ever did was work out my hourly rate, using exactly the method outlined in this post.
If you're early in your career, you can't just waltz in and say you're going to charge someone $4,000 to write them an email responder sequence.
By working out the inelastic base hourly rate at which you need to work in order to earn a level of salary you ensure that:
1) You know exactly what your opportunity cost is versus getting a job (ie. you are making a conscious decision to work for $40k/year instead of the $90k/year you could earn if you went and got a job somewhere)
2) You know that when it's time to scale, what you'll have to be able to charge in order to hire someone at "market rates"
3) It makes your negotiating position much much stronger - when people try to screw you down on price you know precisely where your "bottom line" is - at what point am I losing money here?
If you want to bill based on value created, that's great and it's something you can achieve once you've developed a strong position in the market and a bit of a track record.
Up until that point (and even afterwards) it's vitally important to know the base cost of an hour of your (or your employees time).
Saying that someone shouldn't work out their base hourly rate because we should all be billing based on value created is like saying that you should run a retail shop and sell everything according to the maximum you think people should pay, but never look at the cost of purchasing the stock in the first place.
But I will bring up a neglected point, which is that this formula assumes that all employees hours are equal, or at least indistinguishable enough that you can take an average, and completely ignores the idea of leverage in professional services. Leverage is how you make a professional services firm a profitable, growing business, and not just a series of contractors that you farm out.
To start thinking about leverage, you need to realize that not all of your employees are the same, so a globally blended rate doesn't make sense. Some of them are junior level employees who are smart and capable, but still learning the ropes. They benefit from your firm's intellectual property, so they're able to add value greater than their salary would indicate. At the top, you have the firm's principals or partners, who tend to have less time to spend doing work, because they're busy trying to market the firm and win new business. So even though their rate may be higher, it's spread across fewer hours. In the middle are either technical experts or managers who are able to command a higher rate, and can mentor others, but aren't quite ready to bring in new business on their own.
As your employees learn and become capable of better work, they also become more valuable to you, which means you should pay them more, which means their rates should go up accordingly. But now you need them to do more valuable work, so you also need to find new junior people to replace them. This is how you help your employees grow, and it's how you help your firm grow.
Your firm's profitability comes from the fact that you can charge greater than an employees costs to your clients. That's the basic idea behind a services business, otherwise you're all just independent contractors. So your source of profits is the amount you charge on top of your employee costs, and that could vary by level.
The number of people at each level, and the amount you charge for them, depends on the nature of your work and your firm. Figuring out the rate balance and the right growth rate is one of the most important parts of managing your firm (probably second to creating a great culture, although the two are related).
The reason that the firm in the article is able to raise more revenue by raising prices is because they've been undervaluing their own work this whole time. Once the price starts to better reflect value, the way you grow is by sustainably hiring in new people and growing them with the firm - the price mechanism is money that's currently being left on the table, it's not a growth mechanism.
He told me that he had tried different approaches over the years, and the best approach was to charge the maximum rate for all roles on the project. The working assumption is that senior workers will tend to do the work faster and on their own, but junior developers will require oversight from senior developers. That justifies the higher rate for juniors; it offsets the time that seniors have to spend mentoring them, which also ensures that the same quality of work is produced whether it's done by a senior or junior.
Charging the same rate for everyone greatly simplifies budgeting, especially if some parts of the project turn out to be over-estimated while others were under-estimated when the initial budget is put together. If all hours are the same price, you can shift them freely where they're needed as reality starts to beat up your plan. When hours have different prices, it's a lot more complicated to do that.
When I founded my company (with a different business, i.e. not around web development for clients) in 2000 after a year of freelancing, I set my hourly rates ridiculously high (about 18 times my previous rates) because I didn't really want to do any development for clients at that time and to my surprise, I still got some clients who felt that I must be particularly good. So while you cannot generelly expect to make more money on average by setting your rates very high, it's foolish to set them based on your cost calculation and general demand only.
The earning potential looks considerably above the salary employee potential. My current skills & expertise are very much "backend", and I don't have networking connections with people who could offer significant amounts of cash for the solutions I could offer. (Put another way, I only know very small business owners, as they are the dominant employer in the area).
It seems as if the best way in is to get hired at a consulting firm and really understand how tech can drive business value. Am I off?
It was a bit easier because I was not making a lot at the job anyhow-- I basically had to sell one small project a month to replace the income on the job (maybe 3 or 4 days of work), but after that I simply tried to be nice to folks, super available, and really knowledgable. Your situation may be different.
It doesn't hurt that I'm 90mi outside of Austin, so there are a) no jobs here to tempt me, and b) a whole lot of possible work within a small drive.
But I also have to have a lot more going on than just my specific tool chain of computer skills-- I have to do a lot of business strategy and networking things, even if that usually just means eating lunch with folks I've worked with just to keep in touch.
Big consulting companies are all about applying a predefined framework to business problems.
VARs or similar companies partner with bigger fish to provide pro services to markets that aren't valuable enough for the parent company. An IBM partner will peddle servers and implement IBM products, etc.
A freelancer is all about subject matter expertise. Your either an expert in technology x, or an expert in implementing technology x to vertical market y or integrating technology x with technology z. Your customer might be the end-user, or you may be a subcontractor.
So, in order to make the same $75k/year the employee makes in the example, the manager would have to hire around 6 employees with the same structure and have at least 6 projects per year.
Once a company got the size of needing non-billable managers, I assume that you'd add a fraction of that person's salary to the overhead numbers.
But you're right in the general case, that a company whose income is from billed hours needs to bill enough to cover the whole company.
In nations that are more work-centric (eg. the US) the possible billable hours will be nontrivially higher and thus the hourly rate will be significantly lower.
For instance, I know people who get only 10 days off per year minus holidays, meaning that they take a maximum of 10 days per year total. This also entails working ~8 Saturdays per year, which comes out to roughly 1850 hours per year.
It seems as though this type of calculation will vary widely based on location.
I took a reasonable paycut to get the gig, but its totally worth it.
10 days off a year is a joke.
[Shameless plug since it's my own pet project :)]