Of the many skills needed to stay in business, knowing how to set fees for your services is one key to successful marketing. Yet the underlying methods and issues on setting fees are too often unfamiliar to service providers, consultants, and other entrepreneurs.
Pricing plays a central role in how much (or little) you earn for the work you do, and in the psychological subtleties of your business relationships. Set prices too high, and you may lose valuable business. Lowering prices may garner you assignments and projects you’d otherwise miss. But too-low prices can also translate to working unnecessarily long hours, to earning less than you should for your efforts, and, in the worst case, to earning less than you need to turn a profit.
There are several strategies you can use to set fees, ranging from asking for the going rates to raising your rates until clients say ouch. But the bottom line is cost-based prices–that is, fees that reflect what it costs you to be, and stay, in business. (You still may decide to negotiate different rates at times.)
Cost-based prices are relatively easy to determine. It will take you some thinking, perhaps a few phone calls, and then a little time with your spreadsheet or caculator. It’s an exercise all serious businesspeople must do, once or twice a year, even if they also set prices by other methods.
In return, you get real, bottom-line information essential to both starting and running your business. This article offers a step-by-step guide to basic fee-setting data, plus a simple way to get a rough estimate. The process applies to any business that sells time and knowledge.
There’s nothing mysterious about the process I describe here. You’ll find it in almost every book of self-employment and consulting. Yet a surprising number of self-employed individuals and small businesses I’ve talked with have never done this exercise.
Too often, people underestimate the full costs of starting up and maintaining a business, even if it’s something as simple as doing transcriptions using a computer.
Just like the real cost of running a car includes not only the purchase price, but also insurance, maintenance, repairs, gas, parking, tolls, auto-club membership, and an occasional car wash, running a business entails ongoing spending for recurring costs and fresh investments in equipment.
Costs fall into three categories:
1. Business and office expenses. You can start up a business on a shoestring–with only an answering machine and business cards, to be precise–but it’s hard to run one for long on that basis.
Day-to-day expenses are part of the cost of being in business. Your pricing must reflect these costs–that’s one reason that the rate you charge is different from what a full-time employee appears to be paid.
With few exceptions, you’ll need to run some kind of office, even if it’s a room where you live. You’ll have ongoing expenses, such as phone and electric bills, postage, copying, stationery and office supplies, and subscriptions.
Also, you’ll need to make regular investments in office equipment and furniture: computer purchases and upgrades, filing cabinets, fax machine, copier, desk, telephone headsets, and more. And you’ll quite possibly have business-related taxes, such as sales tax and service tax.
Excluding rent on office space, many home-based independents report that phone bills are their biggest expense, followed by major equipment purchases, like a new laser printer or a plain-paper fax machine. It’s also easy for memberships and subscriptions to add up to $1,000 a year.
One piece of good news: As a rule, business expenses come out of pretaxable dollars, subtracted on your Schedule C from your gross revenues to yield your taxable net income.
2. Salary and personal taxes. One rule of thumb for self-employment says you should plan to earn about what you’d get as a full-time employee–otherwise, being an employee may be a simpler way to pay your bills. Lower stress and higher satisfaction are important benefits of being self-employed, but economic issues must often come first.
Another way to start setting your fees is to determine what “salary” you need, in annual, monthly, or weekly terms. Don’t forget to consider personal taxes in your calculations. Underestimating or miscalculating the money due to the government out of each “paycheck” is a common pitfall.
As a Massachusetts resident, I pay state income tax in addition to federal income tax and social security. According to a graph I did recently, the total tax bite on my income runs about 40 percent. In other words, for every $1,000 I want for take-home pay and benefits, I need to earn about $1,600.
The prudent person will open a separate bank account, designated for Our Friend the Tax Collector, and put the appropriate percentage of each received check in it–so it’s there when payment times roll around, and earns interest until then.
3. Benefits. As employees, most people receive benefits: health, life, and disability insurance; retirement, profit sharing, and other plans; and other items, whose value can be as much as a third of your salary.
The amount withheld from an employee’s salary is usually less than the benefits’ real cost, and is usually only a fraction of what you’ll have to pay as a self-employed individual. Some expenditures for benefits are deductible on your Schedule C, some on your 1040; others cannot be deducted by individuals. Health insurance may cost significantly more for individuals than for employees. Disability insurance will definitely cost more, although the package may be more comprehensive.
ESTIMATES TO TRY OUT
Now that we’ve outlined the basic costs of running a business, let’s set up estimates for calculating cost-based fees.
For the purposes of this exercise, estimate business expenses of $30,000 per year, or $2,500 per month. And let’s suppose a salary-equivalent of $50,000 a year. Further, assume that health, disability, and term life insurance and other benefits will cost more than $400 per month, or $5,000 annually (to earn the money for these benefits, after taxes, means about $8,000 per year for an unincorporated individual). Let’s add $6,500 in annual contributions to a retirement fund, such as SEP-IRA. These contributions are exempt from federal income tax–but not from FICA, state, or other taxes–so we’ll add another $8,000 to required annual revenues.
This gives us annual costs as follows: $30,000 (business and office expenses), $50,000 (salary and personal taxes), and $16,000 (benefits). In other words, annual costs total $96,000, or $8,000 per month.
So, to make the equivalent of a $50,000 salary as an employee, you’re looking for annual gross revenues of nearly twice as much. You can get by on less; but this is the amount you’d like to earn, and you’ll want to base your fees on this total.
CALCULATING SALABLE TIME
On to the other leg of the equation: figuring out how much time you have to sell.
Overestimating billable time is the first trap most business planners fall into. “Let’s see, if I work 40 hours a week, 50 weeks a year, then if I charge this much . . .”
BRRAPP! That’s the sound of the alarm going off. Back up several assumptions and start again.
If you are going to treat self-employment like a job and a business, start by defining a realistic work scenario. From the 52 weeks in a year, subtract two weeks for holidays, two weeks for sick or personal days, and three weeks for vacation. You may never take all that time off, but you should still build it into your fees so that you don’t cheat yourself out of the same benefits you’d get as an employee.
The brings you down to 45 working weeks per year–pretty standard. But that’s not all billable, revenue-generating time, not by a long shot. To start with, you’ll need to spend time marketing. Count on making phone calls, attending meetings, contracting, negotiating, goint to trade shows, writing follow-up correspondence, and the like.
One hour per day, every working day, is one standard estimate for marketing.
The same amount of time or more is bound to go for administration, support, and overhead–reading trade journals, paying bills, installing and learning new software, doing taxes, reloading the fax machine, addressing envelopes for couriers, and so on.
That’s about a quarter of your working time that you won’t be reimbursed for. And there’s no certainly you’ll get enough work to be busy all the time.
So to be safe, let’s assume 40 working weeks per year, with six billable hours a day, for a true total of 1,200 billable hours (as opposed to our original guess of 50 weeks at 40 hours per wee, or 2,000 total hours). You may end up being able to sell more hours, particularly if you tend to do medium- to long-term jobs (four-week-or-longer assignments), so you could have 1,500 salable hours.
But don’t count on it. If you don’t base your calculations on a sane, realistic set of assumptions, you’re looking for trouble, burnout, and other unexciting forms of life stress.
For our exercise, let’s use the 1,200 figure.
READY, SET, CALCULATE!
To calculate your basic hourly rate, simply divide your annual costs by the number of salable hours. That is $96,000 (annual costs) divided by 1,200 (annual billable hours) equals $80 per hour.
In other words, to pay yourself a salary of about $50,000, plus expenses, benefits, and contributions to your retirement fund, you will need to charge about $80 an hour.
That may sound like a lot of money, but it’s certainly in line with what therapists, programmers, public-relations consultants, and other professionals get. Many consultants charge far more.
Obviously, there’s a lot of leeway in this $80 figure. You may find you’ll be able to go down to $60, $50, or even $40 per hour. For example, you may have minimal business expenses, defer socking away that retirement money, be willing to draw a much lower salary, or work more billable hours. Or you may find that your rate should be $100 or $150 per hour.
In any case, don’t apologize for you prices if they’re fair. They reflect the cost of you business or service, including all your overhead.
MORE PRICING STRATEGIES
Once you know what you must charge, you can do also consider other strategies to base you prices on, which take into account factors like circumstance and bargaining strength. For example:
Going rates. What do your fellow professionals charge? What are prospects paying? Call them and ask, or have a friend call.
Until they say ouch! Raise your rates periodically. Keep raising them in talking with new prospects until they fall off their chairs in shock. Also, leave opportunities to negotiate down.
Ask for a piece of the action. Base your fee on a percentage of sales or savings you create. Get the deal in writing.
Paying for priority. If someone needs immediate, drop-dead service, that’s often worth 25 percent to 50 percent more. Don’t be greedy, though, and try to let clients know in advance that fees will go up as time gets shorter.
And finally, always remember that it’s legitimate to have different sets of prices, such as for:
* Large corporations versus start-ups and small businesses;
* Agencies, job shops, contract houses, and so on;
* Regular clients;
* Standard types of projects;
* Individuals, based on a sliding scale;
* Nonprofits, charities, and other worthy causes.
Remember, you’re in control. You set the price, although clients may challenge it. Negotiating makes all the difference. But without knowing what you have to charge, you can’t go out and sell–and you won’t know when to say yes, when to say no, and when to say, “Let’s keep talking.” So pick up that pencil, fire up that spreadsheet, and start calculating.