How to calculate your hourly rates
One of the most challenging problems you'll face when you start out with a consulting business (or any business where you charge by the hour) is how much you should charge. Even when you've been in business for a while, you may want to review your rates from time to time to see if they're still where they need to be. I don't charge out by the hour any more, but my favorite tool for checking rates is still the same. In this article, I would like to show you:
- how to calculate your rates using this simple calculator;
- what you should do about competition and what others are charging; and
- why you shouldn't be charging by the hour in the first place.
Let's start with the simple calculator.
A simple way to calculate your rates
My simple calculator is best used as a spreadsheet. I'm going to show you an example using Google Sheets - you can view the spreadsheet here and save your own copy so you can edit it.
Step 1: How many weeks are you going to take off?
We're going to start with just writing down the number of weeks in the year and then decide how many weeks you're going to reserve for vacations, sick leave, family emergencies, and so on.
Here's what this looks like (items in red are calculated):
It may seem excessive to "take off" 12 weeks per year, but I've included 8 weeks of vacation, 2 weeks for sick leave and another 2 weeks for family emergencies. It actually doesn't matter how many weeks you decide on now - you can adjust this later.
Step 2: How many hours can you charge out?
The next step is to calculate how many hours you're going to work every week and how many of those you can charge out. Here's what this looks like:
The key here is the Billable Hours Ratio - this is the percentage of your working hours you believe you will be able to charge out to clients. My recommendation is that you never go above 50% - you're going to need the other 50% for marketing, sales, admin and other back office tasks.
In the example spreadsheet, I can bill out 800 hours per year.
Step 3: What's your hourly rate?
Now you need to decide what you would like to earn. You can adjust this later - for now I've decided on $120,000 per year. Divide this number by your billable hours and you get your hourly rate:
In this example, to earn $120,000 per year you will have to charge your time out at $150 per hour and work 40 hours per week for 40 weeks of the year assuming you can charge out 50% of your working time. (It sounds attractive to say you're going to work 40 hours per week for 20 weeks a year, but it rarely works out that way.)
Step 4: Play what-if
Now you can play around with the numbers to see how things work. Just by changing the Weeks Off number from 12 to 8, for example, your hourly rate goes from $150 to $136:
This simple spreadsheet has been a quick and easy way for me to sanity check my consulting rates. Using the calculator I can start thinking about whether my rates are reasonable for me - but not necessarily whether clients will pay these rates.
What about the competition?
After the basic calculations, the first question I usually get asked is what about the competition?
If you're in a situation where you have to compete with others providing the same service as you do, you have only two choices:
- lower your rates so you remain competitive; or
- set yourself apart in some way to justify higher rates.
Competing on price is a race to the bottom
The first option is not attractive - competing on price is always a race to the bottom and no one wins - including your clients. The short-term cost advantages for your clients are quickly outweighed by shoddy work because price, not quality, is now the deciding factor. And it's even worse for you - you have to work longer and longer hours to make the same income. And there's always going to be someone cheaper than you.
If you have to compete on price, you can make the same calculation but start with your hourly rate to see how much you can earn in a year at that rate:
Competing on price is a no-win situation - for you and for your clients. A much more attractive option is to set yourself apart from the competition so you don't have to compete on price.
Stand out so you don't have to compete on price
There are two fundamentals to setting yourself apart from the competition:
- Start by specialising in a well-defined, niche market. Rather than give yourself out as a business consultant, position yourself as a "business efficiency expert for small construction businesses". Or, rather than saying you're a graphic designer, you could specialise in "kick-ass packaging for Etsy makers". Read this article for more information on how this works.
- Then you need to productise your services. Rather than charge out by the hour, you package your services as fixed-price "products" so your clients know what they're paying for and you know what you need to deliver. Read this article for more information on how this can work for you.
These two fundamentals are the key to standing out from the competition - and in the process getting out of billing by the hour.
Let's take another look at why billing by the hour is so bad for everyone.
Why you shouldn't be billing by the hour
Billing by the hour is a time-honoured way of getting expertise when a business needs it without the overheads of full- or part-time staff. For you, as a consultant, it seems good too because the more you work the more you get to charge.
And there precisely is the problem.
Billing by the hour is an incentive to go slow
When you're charging by the hour you have no incentive to get the job done as fast as possible. In fact, the opposite is true - even subconsciously you will be motivated to work more hours to boost your income.
Your clients have to judge whether your time is reasonable
I can hear you protest "but I would never do that". Maybe you won't, but the person who hired you is very aware that you're charging by the hour, so they will be looking at your invoice and time sheet just to make sure what you're charging seems reasonable. And if they don't think it is, you're going to have to justify every hour you spend on the project.
You're forcing your clients to consider cheaper alternatives
The very first time a client questions your invoice, they will also be wondering if they can get the same work done for less. It's not about quality any more, it's about price. And that race only heads to the bottom.
There's no incentive for you to get better
On the flip side, billing by the hour is a disincentive for you to get better at your craft. As you get better you will work faster, and therefore be able to get the same work done in less time. That's some justification for charging more to your clients, but I've yet to see the client that buys this as an argument. (Your client wouldn't know if you're twice as good as someone who charges half the price.)
There's a lot more to be said about why billing by the hour is bad for you (and for your clients) - for more on that topic read this article.
Summary
To summarise what we've covered:
- You can calculate what your hourly rates should be using a simple spreadsheet. Use this as a sanity check to see if you're close to what you would like to earn.
- Avoid competing on price by specialising. A specialist gets to charge more because they know a specific topic better than anyone else.
- Rather than charge by the hour, productize your services so your clients know what they're getting and how much they're paying for it. It's a better deal for you and for your clients.
What you can do now
In this article I've mentioned three more bits of reading you'll find useful if you want to get out of billing by the hour:
- The power of specialisation and how it works.
- Why you need to productise your services and how it works.
- Billing by the hour is bad for you and for your clients.
These three articles are a good place to start thinking different about how to calculate your rates - and why you don't want to be charging by the hour.
And here's that link to the Google Sheet again (save your own copy so you can edit it):
Good luck building your business.
