When you set the rates for your services, how much did you think about it? How did you come up with that figure? In this episode, we discuss how to set a rate for your services that allows you to achieve your goals and plan for the future.
In the area of pricing, there are two types of companies: price takers and price makers.
If you have ever studied accounting, you probably know that revenue - expenses = profit. This is a commonly taught formula and is the basis for the income statement (also called a profit and loss statement). Unfortunately, this method also encourages us to think of profit last. This is a misguided strategy which causes many small business owners to stay broke or never achieve their dream of full-time, self-employment.
There is a better way. Rather than settling for whatever profit is left over, we need to determine how much we want to make and develop a plan to get there.
If your company is a price taker, you should be thinking about your expenses as your bottom link. Your formula looks like this:
Revenue - Desired Profit = Expenses
Since price takers have little control over what they charge, they must work hard to keep their expenses in check or else profit will disappear. By staying in the mindset that expenses must be paid with what is left over after you get paid, your business will become more profitable immediately.
Hopefully, you have created differentiation in your business to become a price maker, even if most of your competition are price takers. Your formula looks like this:
Desired Profit + Expenses = Revenue
In this case, you will use profit and your expenses to determine how much you will charge for your services.
It's important to understand how your expenses behave as your revenue increases. There are four different types of cost behavior:
Knowing how your costs behave allows you to plan better as your sales increase. It also allows you to more accurately set your hourly rate.
Have you ever asked yourself this question? Maybe you've thought about how much you would like to make to replace your income or pay off additional debt, but have you really developed a plan?
When setting your rate you must ask yourself two important questions:
Most business owners just work, work, work without a plan to stop. Other business owners have no plan for how many hours they need to bill out each month and therefore can't understand why they aren't hitting their goals. Answering the questions above will create a lot of clarity in your life and your business.
Let's say you want to take home $5,000 per month and have 25 billable hours per week. That's approximately 100 billable hours per month.
$5,000 / 100 hours = $50 per billable hour for profit
This does not mean that you will bill $50 per hour. This $50 is just to pay yourself. You must add expenses and other items to get your full billable rate.
if you want to bring home $5,000 per month, you need to make more than that to pay your taxes. To calculate the total amount of profit needed to take home the amount you want and pay your taxes:
Desired Take Home Pay / (1 - Effective Tax Rate) = Total Desired Profit
Your effective tax rate is the percentage of your income you pay in taxes, both federal and state. Typically, you can get this off a summary or comparative report on last year's tax return. Add your federal and state effective tax rates together to determine your total effective tax rate. Typically for a small business owner, the effective tax rate is 20 to 35%.
Let's use our $5,000 per month tax home pay and an effective tax rate of 30%. Let's plug these numbers into our formula:
$5,000 / (1 - .30) = $5,000 / .70 = $7,145 rounded
If you want to take home $5,000 per month, you will need $7,145 in profit. By building your hourly rate with your taxes included, you should never be short to pay your taxes again.
If we divide this amount by our 100 monthly billable hours, we need $71.45 to cover profit and taxes.
Most of your expenses are probably fixed costs, which makes this much easier. Calculate your average total monthly expenses. To do this, look at all of your expenses each month and add them together. Don't forget to budget for your annual expenses as well. You can also look at your total annual expenses and divide by 12 to get your average monthly expenses.
There are two ways to deal with variable expenses. You can either directly bill client-based variable expenses to your clients (like software fees or mileage) or you can calculate the average annual amount and add this to your fixed expenses.
Let's say your average monthly expenses are $3,000. If you bill 100 hours per month, you must add $30 per hour to the $71.45 we calculated for profit.
So far, we have an hourly rate of $101.45 but we need to add one more thing to get our final rate.
All small business owners need to set money aside for upgrades, education, and new equipment. Imagine what you could do with $10,000 per year to improve your business. Does that seem impossible? It's a lot easier than you think.
$10,000 / 12 months = $833 per month
$833 per month / 100 billable hours = $8.33 per billable hour
That's right. If you want to save an additional $10,000 per year for upgrades, expansion, and education and you bill 100 hours per month, adding $8.33 per billable hour will get you to your goal. If you only want $5,000 for growth, it's a little over $4 per billable hour. It sounds much more reasonable now, huh?
$71.45 + $30.00 + $8.33 = $109.78 or $110.00 per billable hour.
This would be your hourly rate based on the numbers we used. This would allow you to take home $50 per billable hour, set aside $21.45 per billable hour for taxes, pay your monthly expenses, and set aside $10,000 per year for growth and education.
Do you think this is something you could do? Frankly, it's something you can't afford to not do.
When we do this calculation with new businesses, we often hear, "But I can't possibly charge that much!"
Before you go there make sure that is really the case and it's not just your fear. Often, we undervalue our services. Jeff tells an awesome story about how a fellow author increased her sales by raising her prices.
If you do find that your rate is too high, there are ways to still achieve your goals:
Make sure you know what you are worth and what others are charging. You might be surprised that you are charging far too little which may be hurting your sales. Don't set your rate low in the beginning. It's hard to raise your rates later.
(The 1st question has saved us hundreds of hours of wasted time)
(The 1st question has saved us hundreds of hours of wasted time)