"How to Set Prices for Your Services"
A Step by Step Guide to Calculating What You Must -- or CAN -- Charge
by Daniel P. Dern
(c) Copyright 1992, 1994, 1997 Daniel P. Dern
[ Versions of this article have appeared over the years, in Home Office Computing (October 1991), newsletters of the Boston Computer Society and of the Free-Lance Editorial Association (FLEA), and probably lots of other places. - dpd ]
Of the many "business of being in business" skills, knowing how to set prices for your services is one the key skills for any business. (Other important areas include your marketing/sales process, billing and collecting, and office-support mechanisms.) Yet the underlying methods and issues are all too often unfamiliar to home-based service providers, consultants and other start-up entrepreneurs. Pricing plays a central role in how much (or little) you earn for the work you do, and the psychological subtleties of your business relationships. Set prices too high and you may lose valuable business. Lower prices may garner you assignments and projects you'd otherwise miss. But too-low prices can also translate to unnecessarily long hours, to earning less than you should for your efforts, and, in the worst case, to failing to earn enough to pay yourself the salary you need and still stay in business. There are a number of strategies you can use to set prices, ranging from the going rates to "Until they say Ouch!" and "A Piece of the Action." But you need to start from COST-BASED PRICES -- prices that reflect what it COSTS you to be in, and stay in business. You may decide or 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 minute or two with pencil and maybe a calculator. In return, you get real, bottom-line information essential to starting and running your business. (You may discover that what you need to charge is more than people will pay. Perhaps you can change your underlying business assumptions -- or maybe you'll want to look into a different business.) This article provides a step-by-step guide to figuring out your essential price-setting data, plus a "quick-and-dirty" way to get a rough answer. The process applies to anyone selling time and knowledge as service: contractors, management consultants, health care services, accountants, programmers, artists, translators, tour guides, writers, editors, dance instructors, etc. (Selling products -- donuts, computers, ties, etc. -- adds issues like materials and inventory, all outside the scope of this article.) There's nothing mysterious or secret about this 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. CALCULATING COSTS The first step is to determine your costs -- what it will cost you to be in, and run, the business you're looking to start. People who haven't previously run a business more often than not underestimate the full costs of starting up and maintaining a business, even if it's something as simple as doing transcriptions using a computer perched on your kitchen table. Just like the full 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 requires on-going spending, for recurring costs and fresh investments in equipment. Costs can be categorized as follows: o Business and office expenses o Salary and personal taxes o Benefits. Business and Office Expenses: You can start up a business on a shoestring -- an answering machine and business cards, to be precise -- but it's hard to run one on this basis for long. This is part of the cost of being in business -- the cost of running your business, to be precise. Don't underestimate its importance -- or the probable level of costs. Your pricing has to reflect these costs -- and it'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 on-going and recurring expenses, such as phone and electric bills, postage, copying, stationary and office supplies, memberships, subscriptions, travel, professional services such as advice from accountants and lawyers... Plus you'll need to make on-going investments in office equipment and furniture: computer purchases and upgrades, filing cabinets, fax machine, copier, desk, telephone headsets .... And quite possibly business-related taxes -- sales tax, service tax. Excluding rent on office space, many home-based independents report that phone bills are their biggest expense, followed by on-going computer purchases, like a new laser printer, or a bigger hard disk, better monitor, or back-up power supply, or a laptop computer. It's also easy for memberships and subscriptions to add up to a thousand dollars a year or more. Put together a business budget. Ask some people running their own business what categories of expenses they have, and how much they spend. Some expenses can wait until you're established, and have a predictable cash flow. But as a start-up, some of your expenses will be higher. You're gearing up a business -- you may not have any office equipment or furniture, and may need to make larger investments in marketing. One piece of good news: As a rule, these expenses are PRE- TAXABLE dollars, subtracted on your Schedule C from your gross revenues to yield your taxable net. For purposes of this article, assume business expenses of $30,000 per year, or $2,500 per month. Salary and Personal Taxes: You are going to be running a business. You're working for yourself. Even if you don't write yourself "paychecks," the principle is the same. One rule of thumb for self-employment is you should plan to earn more or less 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 also important benefits, but economic issues usually must come first.) Another way to answer the question is to determine what salary-equivalent you need, in annual, monthly or weekly terms, If you're part of a family unit, what salary equivalent do you consider appropriate? Taxes: DON'T forget to consider personal taxes in making this calculation. Forgetting, underestimating or miscalculating the tax bite is another all-too-common pitfall for start-ups -- the money due to the government out of each "paycheck" before you can start paying bills of your own. These taxes include: o Federal Income Tax o Social Security Tax (twice the employee bite, although you get to take some of this as deductions) o State and City income taxes o Other (property, real estate, etc.). As a Massachusetts resident, I pay a 6% income tax in addition to Federal and Social Security. The tax bite on my income runs about 40-42%, according to a graph I did recently. In other words, for every $1,000 I want for take-home pay and benefits, I need to earn about $1,600. (Tip: 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.) For this discussion, let's try assume a salary-equivalent of $50,000 a year. It's possible that you can afford to need less salary -- if your spouse works, you have savings in the bank, etc. But don't include these factors in your calculations at this point -- because you're determining what your prices should be, for a self-sustaining, long-term business. Benefits: As an employee of a company, most people receive "benefits" -- health, life and disability insurance, retirement, profit sharing and other items, whose value can be as much as a third of your salary. Don't underestimate the cost of providing your own "benefits" and its impact on your rates -- the amount withheld from your salary as an employee is usually less than their real cost -- and only a fraction of what you'll have to pay to "roll your own" as a self-employed individual or a small organization. Some of these expenditures are deductible on your Schedule C, some in your 1040, others can't be deducted by individuals. (There are tax pros and cons of incorporating, and having your corporation pay for certain benefits, versus paying them out of take-home pay.) Health insurance may cost significantly more. Disability insurance will definitely cost more (although it may be for a more comprehensive package.) For this article, let's assume that health, disability and term life insurance and other benefits costs slightly over $400 per month, or $5,000 annually. For an unincorporated individual paying out of after-tax income, to earn the money for this, after taxes, this means about another $8,000/year. Let's also add in $6,500 in annual contributions to a retirement fund, such as an IRA SEP (Simplified Employee Pension). These are exempt from federal income tax (but NOT from FICA, state or other taxes!), so let's add another $8,000 to required annual revenues. # This gives annual costs as follows: Business/Office Expenses $30,000 Salary and Personal Taxes 50,000 Benefits (Insurance, IRA, etc) 16,000 ------- TOTAL $96,000 / year = $8,000 / month In other words, you're looking for annual revenues of nearly hundred thousand dollars, or eight thousand per month. You can get by on less -- but this is the amount you'd like to earn, and you'll want to base your prices on this. CALCULATING SALABLE TIME On to the other leg of the equation: figuring out how much time you have to sell. Over-estimating salable time is the first trap most start-up business planners fall into. "Let's see, if I work forty hours a week, fifty weeks a year, then if I charge this much--" BRRAPP! That's the sound of the alarm bell going off. Back up several assumptions and start again. You don't have fifty or fifty-two working weeks to sell time from. If you are going to treat self-employment like a job and business, start by defining a real (and realistic) work scenario. Sure, you are bound to work harder -- because that's what it may take, and because you know that YOU get the rewards, and even because it is more emotionally satisfying. But if you need to work much harder than you would as an employee, it's time to rethink your basic assumptions. From the fifty-two weeks in a year, subtract: o Two weeks for holidays o Two weeks for sick/personal days o Three weeks for vacation That brings you down to forty-five working weeks per year -- relatively standard. But that's not all billable, revenue generating time -- not by a long shot. Depending on how your business works, you'll need to spend some to lots of time doing marketing and selling. Interviews, phone calls, meetings, contracting, negotiating, going to trade shows and conferences, professional meetings, writing follow-up correspondence, creating your marketing literature, attending seminars, and the like. One hour per day, every working day, is one standard estimate for marketing The same or more is bound to go for administration, support and overhead time -- 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 you won't be reimbursed for. And there's no certainly you'll get enough work to always have "pay copy" to work on. # To be safe (read, paranoid), let's assume FORTY working weeks per year, with six billable hours a day, for a total of 1,200 salable hours, as opposed to your original guess of 50 weeks x 40 hours = 2,000 salable hours. You may end up being able to work and sell more hours. Particularly if you tend to do medium-to-long-term contracting and temping (4+ week assignments) -- perhaps 1,500 salable, sold hours. But don't count on it. If you don't base your calculations on a sane, reality-oriented set of assumptions, you're looking for trouble, burnout, or other unexciting forms of life stress. For this article, let's use the 1,200 number. READY, SET, CALCULATE! To calculate your basic hour rate, divide your annual costs by the number of salable hours: COSTS: $96,000/year --------------------------- = $80/hour HOURS: 1,200 hours/year In other words, to pay yourself a salary of about $50,000, plus associated office expenses and insurances, plus contribute to your retirement fund, you will need to charge about $80 an hour, or $600 per day. That may sound like a lot -- but it's certainly in line with what professionals like therapists, programmers, PR consultants, and others get. Many consultants get far more. Obviously, there's a lot of leeway in this figure. You may find you be able to go down to $60, $50 or even $40. For example, you may have minimal business expenses, defer socking away that retirement money, be willing to draw a much lower salary, or find and work more billable hours. Or you may find that your rate should be $90, even $100 or $150 per hour. Like I said, this exercise is very informative. Don't apologize for your prices, if they're fair. This is the cost of your business or service, and includes all your overhead. It's very different from being a contract employee, going in to someone's existing facility. OTHER STRATEGIES Once you know what you have to charge, you can also consider other strategies to base your prices on, which take into account factors like circumstance, bargaining strength, etc.: o Going Rates. What do your fellow professionals charge; what are prospects paying? Call them and ask, or have a friend call. Remember that it's hard to compete on price, because somebody else can ALWAYS beat your price, if they want to. What you can compete on is value: quality and expertise. Clients who choose based on lowest price tend to be difficult from start to finish. The savvy client will select their suppliers (you) based on expectations of quality timely service, delivered painlessly and reliably -- for a fair price. o "Until They Say Ouch!" Raise your rates periodically. In this interesting variation on the "going rate" method, the goal is to see just how much you can get. Keep raising your prices in talking with new prospects, until they fall off their chair in shock. Remember, you can always negotiate down, but almost never up, unless you're a fast talker. Leave conversational gambits to let you bargain down. o "A Piece of the Action." Base your fee on a percentage of sales or savings you create. (Get the deal in writing.) o "Paying for Priority." If someone needs immediate, drop- everything service, that often is worth 25% - 50% more. (Don't be greedy, though.) o "Knowing Where to Kick." This is the plumber's answer, justifying the large bill for a five-second kick that brought a recalcitrant appliance back into life -- and it can apply to consultants and anyone else with the right answer. You can't always charge for being the right expert at the right time. But the opportunity may arise. And finally, always remember that it's legitimate to have sets of prices, such as: o Large corporations versus start-ups and small businesses o Discounts for agencies, job shops, contract houses, etc. o For regular, on-going clients o Fixed prices for standard types of projects. o Sliding scale for individuals based on income, etc. o Non-profits and charities and worthy causes o Pro bono work for good causes o "Freebies" in return for marketing exposure. Remember, you're in control. You can set the price (although your client may challenge it). Negotiating makes all the difference. But without knowing what you have to charge, you can't go and out sell -- and 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 figuring!
Copyright © Daniel P. Dern