How To Realistically Set Your Fees

By Sue and Chuck DeFiore

Part 1

We all know there are 52 weeks in a year and 40 working hours in a week. Therefore, we can bill 2080 hours per year, right. Wrong. Too often this is the trap that many new service businesses fall into.

The first step in calculating your billable hours is to define a realistic working year. If you were employed elsewhere, you would expect or want at least two weeks vacation time, one week sick time, one week personal time and paid holidays. So, where does that leave us - 52 weeks minus four weeks leaves 48 weeks minus about 10 paid holidays, or a total of approximately 46 weeks per year.

OK, you say, that means I can still bill for 46 weeks times 40 hours per week or 1840 hours per year. If I charge $25 per hour that comes to $46,000. Not bad, that is more than I was making on my previous job. Wrong.

What you have just established is a realistic working year, not the number of billable hours. You still need to account for marketing time, administrative time, bookkeeping time, equipment maintenance, continuing education, etc. You also need to calculate in equivalent time for self-employment tax, local business taxes, etc. In many locales, this can add up to an additional 20% or so in time or money.

If we assume approximately one hour per day for marketing and one hour per day for administrative, etc., (and this is a very conservative estimate, then we need to subtract: 46 weeks times 5 days per week equals 230 days at 2 hours per day equals 460 hours, from 1840, for billable time left in a year of 1380 hours. Now subtract approximately 20% for the above taxes or 276 hours and that leaves you with 1104 billable hours in a year. And this may still be high, but at this point, you can see to earn that $46,000 per year you will need to charge $46,000 divided by 1104 hours or about $42 per hour.

There are many factors which need to be examined in setting your fees. We'll look at those items that need to be taken into account, such as business expenses, insurance, pensions and profit margin, in upcoming articles.

Part 2: Effect of Expenses

The last article examined how to calculate your realistic billable hours. If you remember, we arrived at approximately 1100 hours in a year. To earn our mythical $46,000 per year, you needed to bill at a rate of $42 per hour. Now we need to take into account the expenses of running a business and see where those put our hourly rate.

Most costs fall into three general categories: business and office expenses; salary and personal taxes; and, benefits and profit margin. In this article, we will concentrate on the first category, business and office expenses.

Everyday expenses are part of doing business, and these must be reflected in the prices you charge or you will not be in business for long. Expenses to consider are rent for office space. If you are home-based, you will still have an increase in utilities, such as gas and electric over your regular household bills. You will have telephone costs, postage, copying costs, stationery, office supplies, subscriptions and possibly, membership dues.

You will also need to make periodic upgrades to your office equipment and furniture. Items such as computer hardware and software; fax machine, copier, filing cabinets, telephone headsets, etc. All of these items add to the hourly rate you charge for your services. You must have a good estimate of what these costs total each year or you will end up cheating yourself. If you do cheat yourself, you are going to drastically increase your stress levels and lose much of the enjoyment of running your own business.

Let's plug some numbers into our costs and see how they affect our hourly rate.

Rent $600 per month x 12 = $7200

Utilities $100 per month x 12= 1200

Telephone $100 per month x 12 = 1200

Postage $100 per month x 12= 1200

Copying $50 per month x 12 = 600

Stationery $25 per month x 12 = 300

Supplies $50 per month x 12 = 600

Upgrades $150 per month x 12 = 1800

Furniture $50 per month x 12 = 600

Yearly Total = $15,300

The yearly total comes to $15,300, divide this by 1100 billable hours and you get approximately $14 per hour. Now add this to the original $42 per hour and you can see that you need to charge $56 per hour to cover your hoped for $46,000 per year income plus your expenses. If you are home-based, you can subtract the $7200 per year in rent or about $6.50 per hour from the $56 above.

I have made a number of assumptions in arriving at these figures, your costs may be more or less, but this will give you an idea of what to look for and how to calculate your expenses. If you have any questions, write to me or give me a call and I will go over your situation with you.

Remember, in order to be fair with yourself and your customers, your prices must reflect the true cost of doing business. Do not ever apologize for your prices. You need to charge enough for you to live on and enough to stay in business to service the clients that have come to depend upon you. If some of your customers can't understand this, change your customers, not your prices.

Part 3: Effect of Benefits

We have previously examined realistic billable hours and the effect of business expenses on your hourly rate. Now we'll look at the effect of benefits.

Once upon at time, when we were employed, we received a benefits package from our employer. This usually included health, life and disability insurance. Many firms also had available pension programs, profit sharing, dental and vision coverage. In addition, one-half of your social security was paid by your employer.

As self-employed individuals, we have to provide these benefits for ourselves. This means an additional boast to the hourly rate we've calculated so far. For the sake of argument, let's figure a standard benefits package consisting of health, life, disability, pension and profit sharing. Let's figure health insurance costs at $300 per month; life at $50 per month; disability at $150 per month; pension (a SEP-IRA) at $500 per month and about 10% for a profit margin.

If we total these up we get a yearly figure of $12,000. Now keep in mind, that most of these will be paid for in after tax dollars. So, we need to add approximately an additional 30% to this number, for a true total of about $15,600 per year. The 30% represents the amount of taxes you need to pay to end up with the net amount of money needed to pay for your benefits package. Keep in mind that I chose 30% as a completely arbitrary number. Your own tax situation may be higher or lower.

How does this effect our hourly rate, let's see. Last article we left off at $56 per hour. This represented a yearly salary of $42,000 plus annual business expenses of $15,000. If we take the $15,600 in benefit costs and divide by our billable hours of 1100 per year, we get approximately $14 per hour. This brings our total hourly rate to $70 per hour.

Now, we need to factor in our profit sharing percentage. Once again, I choose 10% as a representative number. Your targeted profit could be higher or lower. If you take your $70 per hour rate, multiply by 10%, you end up with $7 per hour. Your total hourly rate comes to $77 per hour.

This is the amount you need to charge to cover all we discussed so far.

Compare this to the approximately $20 per hour you would need to get paid by an employer to earn our hypothetical $42,000 per year. And yes, I know today many employers require a co-payment on their benefits package. I stated it this way for simplicity sake.

So, you need to charge almost 4 times what you would earn in salary to end up at the same place. Don't be discouraged, there are many people out there that are charging a lot more than this and getting all the business they can handle. Remember, these numbers are hypothetical, your situation may be much different.

Part 4: Effect Of Bad Debts

So far, we have covered the major factors involved in setting your fee structure. We have set a realistic number of billable hours, calculated the effect of expenses and taken into account the cost of a benefit package.

This has brought us to an hourly rate of $77. By charging $77 per hour, you will have an income of $46,000 per year, plus benefits.

What happens when you have a client that does not pay you for your services? What happens if a customer goes out of business before your invoice is paid? How will these events affect your own planning? Do you want to take a bad debt write off on your taxes? Do you want to try to include for these contingencies in your fee structure? Your answers to these questions will have a direct impact on how you operate your business.

Thankfully, unless you provide very poor service, most clients will eventually pay you. However, it may take you awhile to collect your money and you may have to settle for less than the originally billed amount. You have the option of adding late fees to your invoices, but keep in mind, the more time you spend trying to collect a past due invoice, the less time you have to devote to paying customers. Also, if you need to engage an attorney or collection agency, you will in all likelihood, not see the full amount of your invoice because of their fees.

One way in which you can protect yourself is to build into your fees an allowance for bad or uncollectable debts. If you estimate that 5% of your invoices will be either unpaid or underpaid, then add 5% to your hourly rate. For example, your hypothetical fee is now $77 per hour, 5% of that is $3.50, added together gives you a rate of $80.50 per hour. If we round this off to $80, you would have approximately $3300 per year cushion.

Allowing 5% for bad debts may seem high, however, keep in mind the present state of the economy and remember this figure can be adjusted as the economic conditions change. Today, it is not unusual for businesses to take longer to pay invoices then they did a couple of years ago. Most businesses expect to pay late fees for overdue invoices, however determining how much to charge and whether or not you are meeting the various legalities involved can be time consuming. It may be easier to add a percentage to your overall fees to offset bad debt. In a sense, you are spreading the economic risk over all your clients. For a small business this may be the safest and less time consuming course of action.

If your client base is large enough, a certain percentage of your customers will go out of business, leaving you with unpaid and uncollectable invoices. There is little chance you will collect any money in a bankruptcy hearing. To protect yourself, you can charge partial fees as your work progresses. This way you are assured of having received at least some of your money. Not all businesses are set up to take advantage of this option.

Remember, you are not in business to give away your services. Your goal is to provide yourself and/or your family with a reasonable income. Uncollected invoices are part of doing business, you owe it to yourself to consider this before you get stuck.

Part 5: How To Raise Your Fees

There comes a time when it is inevitable that you must raise your fees in order to maintain both your profit margin and income level. You will find that the greatest resistance to this comes from your oldest clients.

There appears to be a direct correlation between the length of time a client is with you and the amount of outrage they show to your rate increase. This article will discuss the types of clients and how they usually react.

Keep in mind, no matter how you raise fees, how you approach telling clients or amount of lead time you give them, you will lose some clients. This is a given. I have found over the years that a very high percentage of clients lost are those that I'm not crazy about working with anyway. It's worked out, for me anyway, that these former clients who complained the most about your fee increase, were responsible for 85-90% of the aggravation I encountered.

Clients are attracted to you for a variety of reasons. We would all like to think that it is because of our brilliant promotional pieces, our award winning designs, outstanding service, etc. The reality is that many clients are using your services strictly because of price. I refer to these clients as price loyal. They are loyal to whomever has the lowest price. This type of client is not particularly sensitive to quality of work or level of service you provide. They go strictly with the lowest price and if you have the opportunity to examine how they run their business, your see it operates on this principle. For me anyway, this type of client is no loss.

There is a second type of price conscious client that is concerned with the quality and type of service being provided to them. You may lose this type of client with a price increase, but you'll find that they will be very apologetic about it. These clients truly can not afford the higher rates. They are usually a dream to work with, and I hate to lose them. In this situation, I will try a number of ways to keep them.

Your newer clients usually react in a more neutral manner to a rate increase. They haven't been with you long enough to get a true baseline on your fee structures. You stand a very good chance of keeping these clients if the reasons for the rate increase are explained to them and not just dropped on them.

I find that I lose about 5-6% of my clients when I raise my fees. Usually, I suffer no income loss because my higher rates absorb their loss. Remember, the bottom line is you are selling your time, you must make the most efficient and profitable use of it. If your rates stay around market level, you should have little or no trouble finding new clients.

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