You did it! You branched out and started your own digital agency. No more working for the man – you’re the boss now, and one of the first things you’re going to need to figure out is how much you charge your clients for the services you offer.
In this article, I discuss the all-important question of how to calculate your agency’s charge-out rate. Even if you’re not new to agency life, you might find this article helpful. Afterall, charging incorrectly is a common mistake in all business types, but especially service-based businesses where markup and operating expenses aren’t as straightforward.
In this article:
- Charging on value vs charging on time
- Determining your hourly rate
- Missing numbers
- How to use this information to save you money
Charging on value vs charging on time
A common question I’m asked by owners of service-based businesses is how they should price hourly rates. Do you just invent a number out of thin air?
Well, kind of. The best companies I know price the customer.
Let’s say you make websites – sometimes they house basic information about a service, sometimes they’re publications in their own right, and some are e-commerce stores. The value of the sites you create varies widely depending on their use by the client and the client’s customers.
So while it may only take 10 to 15 hours to put together in Shopify, an e-commerce site is your client’s livelihood, underpinning the value of their business and their client’s experience of their brand. Every element of conversion-rate optimisation and design could mean tens of thousands of dollars of sales to their business. So, 10 hours at $150 per hour is really selling yourself short.
That’s why you should always charge on value, not by the time it takes to complete a project. But of course, this isn’t always reasonable.
Some clients want the old school way of pricing a job based on time input. Equally, there are some projects which warrant charging by the hour, rather than a fixed price. This also helps in defining scope, so that you can let clients know when their “hours” are used.
So, if you’re in a situation that doesn’t provide flexibility to price on value, you’re left with a conundrum.
If you’ve set your hourly rates for your agency based on gut feel, you run the risk of not being competitive in the market (priced too high) – or worse, going broke (not making enough money to sustain the business nor fulfill your personal profit goals) .
How do you determine your hourly rate?
Let’s start with some fundamentals.
Calculating your charge-out rate is basically pricing your services on a cost plus model. That is, what is the profit margin I need to make on the costs of my employees, factoring all of the other fixed overhead costs of running a business?
As a rule of thumb, your revenue-generating employees should be bringing in two to three times their salary cost. At a fundamental level, this implies that your gross profit margin, calculated as your revenue less the costs of your direct wages, should be between 50% to 70%.
Using this multiplier, we can reverse engineer the charge-out rate based on the number of hours worked each year and the expected number of billable hours.
Check out this neat calculator we built.
The figures required to calculate your employee’s hourly rate are:
- Annual salary
- The target return on investment (ROI) you need from your staff (we recommend between 2x and 3x times)
- Annual leave
- Target utilisation/productivity rate
- Any provisions for ‘stuff ups’- folks going over budget on time, or things taking longer than they should 🙂
You can calculate the number of productive hours by assuming they’re billable around 80% of the time. But if you know this is way off, take that into consideration.
How to use this information to save you money
Having an hourly charge-out rate is a super valuable metric – even if you don’t charge by the hour. It’s helpful because it sets a benchmark for how much you need to be leveraging your staff, and it sets a precedent to work out how many hours you should spend on a project.
If your clients want to pay a rate below your hourly rate, walk away, because it means you’ll be losing money.
From an internal perspective, knowing and setting your hourly rates sets a quantifiable measure of how much time and potential revenue you are wasting on non-productive things – such as the dreaded meetings that fill up all our calendars.
Quick tip: Quantify how much internal meetings are costing you in opportunity cost. When you work out the amount of cash your internal meetings are truly costing, I guarantee that you will think twice before sending out that calendar invitation…
In summary, if you’re not sure how to determine your hourly rate, calculate your employee leverage and quantify it using our nifty calculator.
If you’d like a copy, get in touch and we’ll send it over.