How to calculate your hourly rate
There are many ways freelancers and small consulting companies calculate how much to charge per hour for their professional services.
As I explained on “How to charge for your work”, coming up with the right pricing for your services as a freelancer or consultant (individually or as a small company) requires you to take many aspects into consideration.
Some of the elements you have to consider a highly objective and quantifiable, others extremely subjective and abstract. As we continue to explore the subject of pricing, we’ll dig deeper into each of these aspects.
For now, let’s focus on the objective and quantifiable elements that help you come up with your minimum hourly rate. This is important because you start by figuring out the minimum monthly income you need to make in order to survive as a business and as a person.
Things get more complicated as you get older and accumulate more and more responsibilities… a family to support, buying a house, paying for your kids education, healthcare, retirement, etc.
You shouldn’t run your business at a loss (at least not forever). You need to be able to cover your basic costs or living and business operations. If not then go find a good paying job and forget about being a freelancer or running your own company.
Cost based pricing
To make sure you don’t lose while running you freelancing or consulting operation, you first need to know your costs and come up with your minimum monthly or annual income goal.
You need to figure out how much you have to generate in order to cover all of your living and operating costs.
Since the idea is to “be your own boss” and make a living out of running your own business, there is no other place your money will come from.
You should be able to cover all of your costs with the the income you generate by selling your services.
Knowing your costs will help you come up with that minimum income goal… then you can work backwards from there to come up with your monthly, weekly, daily and hourly minimum.
Setting an income goal
The income goal varies a lot from person to person. Each person has a different lifestyle, lives in a different city with different costs of living, etc.
Maybe you are a single 20-year-old living at your parents house… or you are a married 35-year-old with two children to support. So, the minimum income goal will be different for each person, but at the end that will determine that particular person’s lowest price point when it comes to adjusting to the competition.
If you have to go to the lowest price to win a client… then you know how much it is. Now… whether you should take a project that only pays the bare minimum or not, well … that’s another story (hint: no… you shouldn’t)
Let’s run the numbers with an example
The first thing we need to determine is how much you need to make per year to support your costs of living and lifestyle. This varies from country to country, so for the sake of this example let’s say that you live in Oompa Loompa land and you have determined that you need $48,000 per year to have the life you want.
Why $48,000? Well… you ran your numbers and you think you need to make $4,000 per month so you can pay for: Rent: $1,200 + Food: $800 + Transportation: $500 + Utilities: $400 + Health: $200 + Entertainment: $600 + Clothing and other things: $300.
First attempt to come up with an hourly rate…
OK, so you have to generate $4,000 in a month… and you can work 160 hours per month (40 per week approx.)
So that is $4,000 / 160 = $25/hr … boom! we are done! easy!
No, no, no… it’s not that simple.
What about taxes?
There are only two things certain in life: death and taxes.
In Oompa Loompa land, the trolls in government take 25% of all of your income… so each month you have to set aside $1,000 from your income to pay for taxes at the end of the year. Damn! Now you are $1,000 short each month.
Well… you either cut expenses (you can say good bye to entertainment and clothing… and you are still $100 short) or you can make more money.
So… let’s increase the goal so you make enough to keep $4,000 per month after paying those lazy trolls their damn taxes.
The formula here is:
Monthly income goal = Monthly expenses / ( 1-tax rate)
So… Goal = $4,000 / (1–0.25) = $4,000 / 0.75 = $5,333.33
OK… so with that, you will pay those filthy politicians their 25% = $1,333.33 and keep your $4,000
Now, your new hourly rate is: $5,333.33 / 160 = $33.33/hr … boom! done! let’s go open up our business… right?
No, no, no… not yet.
What about vacations… sick days … months without any clients ?
On your previous calculations you are being a little naive, assuming two things:
- You assume you are a workhorse or some sort of a robot. Working 160 hours per month, every month of the year, without stopping.
- You assume you are so awesome at business and marketing that from day one clients will fall from the sky and never stop coming to you… filling up all of you 160 hours per month = 1,920 hours in a year.
And also a third thing… you are assuming all clients will pay (not all do… some just leave without paying… trust me on this)
So… instead of assuming what industrial engineers call “full utilization”, meaning that you are selling all of your available capacity of production, you should assume a more realistic number.
Some of the factors you can apply to make numbers a bit more realistic are:
Vacation: On this weird Oompa Loompa land, the year only has 48 weeks … and out of those you will probably want to take 4 weeks off during the year for vacations, traveling, or event attending conferences and events that prevent you from working full time during that period.
So, once you factor this, you will not work 48 weeks but only 44 weeks in the year. Your previous calculations were based on 48 weeks x 40 hours per week = 1,920 hours per year. Now you have to run the numbers with 44 weeks x 40 hours per week = 1,760 hours per year. That is 1,760 hrs / 12 months = 146.66 hours per month.
So now, your new hourly rate is: $5,333.33 / 146.66 = $36.36/hr
Sick days? Remember, you are not a robot… so you will probably get sick a few days in the year. Let’s be conservative here and say in total only one week will be lost due to you not feeling well enough to work.
So now its only 43 weeks in the year… run the numbers and that’s only 143.33 productive hours in the month = $5,333.33 / 143.33 = $37.21/hr
What a about months without clients at all? You should probably keep 2 months worth of expenses on a savings account so you can keep paying your bills even if there are a few months without new clients (or just a week here and a week there that by the end of the year add up to two months of unpaid time).
So… this takes two months out of the whole equation… after running the numbers again you end up with $5,333.33 / 116.66 = $45.71/hr
You get the idea by now…
As you think through all of the uncertain aspects of life, costs of running a business (like office space, equipment, software licenses), other unforeseen expenses, wanting to build up a savings account, being able to buy more and better things, etc… we can continue on this “what about ____?” game for a while… and on this example end up with an hourly rate of around $65/hr.
But that is good… that way you are preparing for uncertainty, you are bullet proofing your freelance or consulting operation from going bankrupt at the first little hiccup on the way.
Avoid setting yourself up for failure
By running the numbers like this (ideally with a spreadsheet where you can run different scenarios) you will get a better sense of your minimum monthly income requirements and boil it down to an hourly rate.
In some cases (and in some countries) clients are not used to getting billed by the hour and they prefer a fixed quote for the deliverable on a project. Well… the same logic applies, first you have to come up with that hourly rate and then estimate how many hours you expect this project to take … then add some time as a buffer for uncertainty and multiply those hours by your hourly rate... boom! you have a price to quote to your client.
Time for a Reality Check… Can you charge that much?
Great, so now you can go ahead and have your desired lifestyle, charging the rate you have calculated? Not necessarily… you have to test this against the reality of the market.
You need to check how much the clients in the market where you want to operate at are paying for the skills you are offering. For example, in the United States, highly specialized lawyers can charge $100 — $500 per hour depending on their expertise. But other services that are not as specialized and more of a commodity could not make more than $20/hr.
So, if you find out that your expectations for income to support your desired lifestyle costs don’t match the reality of the market value of the services you offer, then you could take some action:
- Lower your expectations and lifestyle costs. You could look for a cheaper place to live, share expenses with a roommate, cut costs on eating out, don’t spend so much on entertainment and clothes, etc…
- Increase your market value by learning new skills that are more specialized and in higher demand… for example learn a new language, learn how to code, get a college degree in law, accounting, finance, etc.
- Sell your services on a higher value market. For example, if you live in a low cost of living country in Latin America, and your skill is something you can offer and deliver using the internet, you can become an offshore freelancer and look for clients in countries where they pay more (some times 2x – 5x what they pay in your country).
What if you have the opportunity to charge more than that hourly rate you calculated with this approach?
Of course! If you have the opportunity to charge more, then do it.
Remember that this is just a cost based approach. This just considers the minimum amount you need to survive with a lifestyle that makes you happy (and makes you feel miserable about your career choices). You want to enjoy working as a freelancer or running your own business.
The point of running these numbers is to know your baseline. But as you deal with clients and build your successful portfolio and track record, you will find opportunities to charge more… and once you do, you will stay on those higher levels. Then, more clients willing to pay at those levels will knock on your door and you will grow your income… profits will increase and the business will grow.
What else is there to know about pricing?
A lot more. In a future post we’ll discuss a little more about “value based pricing” which is the other side of this.
If cost based pricing is the floor… then value based pricing is the ceiling.
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