The most common question I get when speaking to new, and even experienced, freelancers is “What should I charge?”

How should I set my rate?
Hourly or Fixed?
How much will I make this year?

I have a formula I use to raise or lower my rate, as well as some key strategies you can use to set up a good game plan. The key is to be intentional and strategic.

This talk was given at International Freelancers Day 2011.

We just finished our business retreat and I am pontificating our one year goals. Last year was a huge year for us as we transitioned from two professional technicians to budding entrepreneurs. A little time in the woods, some long walks on the coast and we come out of seclusion with a strong vision and some big goals. All right, let’s do this:

In 2008, we are going to gross a million dollars and still have a life.

Now, if I laid that statement at the feet of most contractors, some might say “that’s cool” and offer a generic smile while others would certainly laugh at me. After all, we are a pretty long (long, long) way from making a million this year.

I can hear the voice now. I knew that guy in high school. There is nooo waaaaay he can make a million dollars. And the voice is right. There is no way that we could pull that off. But what they don’t know, and maybe you don’t know, is that we are not afraid to change. We will change and grow and become the leaders and team it takes to achieve the goals we are setting.

The first step, as esteemed personal growth and change expert Steve Pavlina would coach you to do, is to clearly define the intention and announce it off the top of the hills (mountains, if you got ‘em).

Using Fear to Pick your Goal

The fact is that most of us are filled with fear every time we approach something new. There is nothing wrong with that. It is the normal, healthy response of a sane human being. Personally, it has been a great companion in the adventure that is my life. Like a road map.

I’ve found my fear to be pretty useful in a weird business context. Peter hates this, but the way I pick goals for our company (being the CEO I get the prerogative) is to keep pushing the bar mentally until I feel myself getting unconformable, then nervous then afraid. That when I stop and mark the goal. I’ve always felt that a goal that does not make you stretch is not a goal at all, it’s a task. Should all goals make you stretch? Yes, I personally think so. What are you just a little afraid of? We are afraid of a million. So we decided to demystify it.

I’ve been afraid of a lot of things. I was afraid of going independent and crashing and burning. I was afraid of owning a home and having a $3400/month mortgage. I was afraid of living with Julie. I was afraid to travel through the Middle East. I was afraid of college. I was afraid to surf 15-foot waves. I’m afraid to speak in public. I’m totally scared about being a good father. And yet, all of these are the highlights of my life.

Announce the Goal

To a Million and Beyond.

I start by announcing it to myself. Since I became independent, I’ve been saying that some day I will gross a million, then earn a million. And from a financial perspective, our crew has not missed a goal by more than a few thousand dollars in five years. We have a habit of setting financial goals that scare us and then achieving success. That habit and our history gives me confidence. We are ready for this challenge.

If we are going to pull this off, we are going to need a bunch of positive affirmations. To be clear though, making a million for me isn’t about the actual dollars, it’s about the lives we touch. Peter & I believe we can gross a million, because we believe we can build a team that can gross a million. Today, we support 6 families with our business and provide periodic money for a few others. That fact makes me feel completely alive. The idea that we could support 15 families fills me with fire. I don’t know about the details of how we will gross that million, but I do know how we will build the team to do it.

So I started by IMing a few people around midnight. I think Tea’s answer was my favorite:

Shane: so we are going to make a million next year
Shane: just letting you know
Tea: lol thanks
Tea: i can sleep now aha

She then shared her goals (she can share them herself, ahem – ahem, i she wants). I can’t wait to be part of helping them come true. She’s got the two cutest kids (Jules just turned 2) and I honestly believe Perth will give her the key to their city some day.

You got to tell everyone, especially your team. Anyone who thinks they will make a million all by themselves is in for a tough ride. After all, if we gross a million, who do you think will get most of it (hint: not Shane and Peter).

I’ve been reading Robert’s book ‘Flying Solo‘ and though I’m half way through it and am pretty jazzed on the book, the title turns me off. No one truly flies solo. It is thanks to the support of our friends, family, mentors, business team, industry compatriots and more that we succeed.

Why do you announce?

I proclaim our goal for two reason.

First, I keep noticing that whatever I really focus on and mention out loud over and over and over tends to eventually come true. I think it has something to do with our level of awareness of opportunities. I remember when I first bought Deucer, my Ford Focus (aren’t you all impressed?). The next day I was driving around thinking, “Jeez, how many people went out yesterday and bought a red Focus? This is ridiculous, I’ve never seen so many of them in my life.”

Between you and me, do you really think the number of red Ford Focuses on the road actually changed? Or did my awareness level change?

It’s the same thing with opportunities. I remember impulsively looking for a wedding ring for Julie (it started impulsively) for a full 9 months and getting frustrated that everything I found in my price range ($400) looked really chintzy. I wanted something really special. We had been living together almost 5 years and we were engaged to be engaged. So I started to tell everyone who would listen about it, asking for ideas. One evening, Mom was teasing me about the eternal hunt and I sarcastically asked if she had any 1 carat diamonds lying around which she could use to just put me out of my misery.

[long pause]

Turns our she did. So Julie got great, great, great grandma’s old diamond (pretty neat). Guess sometimes you just got to ask. But if I hadn’t been so focused on it, I would never have ended up with one of the most beautiful wedding rings to give my wife. We designed the setting ourselves. Now I doubt someone will just hand our crew a million, but you bet your ass I’ll be out there asking anyone and everyone if they want our cookie.

The second reason. When things get tough, it’s easy to compromise with yourself. I don’t really feel like making that sales call (my personal demon), I’ll just do it tomorrow. Or perhaps come August we’ll have only grossed $370k, and the urge to ease up and just shoot for $600k rears it’s ugly head. That would still be a world class year for us. I find it’s a lot harder to look into people’s eyes and tell them you gave up. There is no dishonor in failure. It’s how you learn.

But if you are going to stand in front of the people you lead and trust, and build their hopes, then you have to keep going until the last minute. Thats why I am telling everyone. Accountability.

And so next February, when the whole crew gets together for the annual retreat (looking like El Salvador this year), we will put our heads together and figure out as a team, how we can come together to gross a million and still have a life.

Scare Yourself: Big Goals with Small Steps

I hear way too often, set something realistic. In some ways that is correct. After all, both success and failure are learned habits. Your small goals should always be realistic. But, if you don’t have a big goal that drives you to your knees and forces you to grow and change, then you are stealing from yourself and the world. People follow leaders and leaders are those who are willing to leave their comfort zone to achieve something greater than themselves. We are looking for leaders. I will follow a man on his knees fighting to make a difference any day. Pick a huge goal, something that scares you (like a million gross scares us) and then fill the vacuum with small steps. Each of those steps should be finite and attainable. Have tons of them, because checking things off your list feels good.

Our steps:

Back to school for S&P: on December 3rd we’re signing up through Berkeley for a Software Project Management course which should hopefully provide us some insights into the issues we face as we move our core team into the double digits.

Fill the Gaps: We turn away about 50% of the projects that come to us. Some because they’re not good projects. Other because we just don’t have the resources (it absolutely killed me to tell GM we couldn’t work on their prototype for their new onboard computer, just because we didn’t have the availability). So, if you are killer at design, flash, flex, php, witango, click the join us link and send a link to your portfolio along with a bit about yourself and why we will love you. We may have a project with your name on it.

PM system: Continue to tune our current PM system while searching for an ideal fit for our business style or building one ourselves to satisfy our need for flexibility.

So What is it Going to be?

I’m throwing you all a bit of a challenge.

Join us and scare yourself just a little. Take a leap of faith. Pick a goal you think might be possible, just maybe, but not necessarily probable. Write it down. Put it up on your fridge. On your computer screen saver. And on a comment below. Then start working on how you will personally need to change for that improbability to become likely.

We want to cheer you on. While scary is good, the right group of people make it possible.

Unlike most of the freelancers I meet, I started my freelance career charging by the hour. The CTO of the company, now one of my best friends, carefully watched my deliverables and my bills to make sure they matched his expectations. Knowing this was my first gig, he explained to me that the company was buying my expertise.

He encouraged me to charge, and charge well, when I knew what I was doing and was kicking butt. He also insisted that I learn on my own dollar and not penalize my client for any lack of productivity. Basically, even though we had agreed upon an hourly rate, he made it very clear he was paying for the end product, not all the time I may have been spending.

There are fundamentally two payment structures used by freelancers in today’s market:

Hourly is the exchange of a productive hour of expert work for an hourly rate. For $xx per hour, I will provide you the technical expertise you need to develop the API for this prototype.

Fixed price is the exchange of a pre-defined amount of work for a specific total dollar value. For $xx,xxx I will provide your company a new brand including colors, typeface, logo, business cards, store sign and letterhead.

Both approaches are common and each has their appropriate place and time. What fascinates me is the intense emotion that we often see (even among ourselves) regarding which to choose. So what are the pro’s and cons, how do you choose and how do you price yourself once you do?

Hourly

You are charging a specific dollar amount for each hour of solid progress towards a deliverable. Your client knows you are an expert on the subject. They have agreed to pay your rate for support on their endeavor.

Misconceptions

Before we get any further, let me address some of the misconceptions I commonly hear.

Charging by the hour means there is no accountability on the freelancer’s part, nor planning or a general budget. A good project manager always has a target budget and the goal to keep within it. If you expect any repeat business, you are just as liable for the end budget as the project manager. You need to be in constant communication working with them to manage expectations so that they can do their job well.

Honestly, if you were to pick only one goal, it should be to help make your client’s project manager a hero. The better they look, the happier they are with you and the more they will use your services and refer you in the future.

Charging by the hour means you expense each and every minute you work. The client is paying for progress on a solution to their problem. They are not paying for you. You do not bill the time it takes you to invoice them. You do not bill time you spent researching the web for ideas. You do not bill for each and every meeting. Often, you do not bill for the egregious direction you took which lost 4 hours of progress on the new module.

These are the costs of being in business. You need to make sure that you build the cost of doing business into your rate. Be careful or you can end up working for pennies on the dollar.

Hourly is unfair to the client. This is completely false. Take the following three points into consideration:

1) Over 90% of our projects are completed well under budget.

2) If the ultimate liability for the cost of the project is not in our court, we do not have to pad our rate to cover for the unexpected.

3) Managing feature creep in a fixed rate project makes us guard the sanctity of the spec and resist change. If they are getting a better rate, more flexibility and perhaps even a lower price, then it is often to the client’s advantage to have us charge hourly. Virtually all of our hourly projects have been a win for our clients.

Many contractors fear that with an hourly budget, they will be fighting the urge to bill more. Many clients are afraid to get gouged. The risk is certainly there. Let me ask you – are you in business to rip someone off? If you intend to make this a career and run a successful company, you need to remember that all that matters is your reputation. Success = happy client. If you keep that in mind when you write your invoice and balance both sets of expectations, then everyone tends to be happy.

Pro’s of Charging Hourly

• Get paid for most of the work you do / Lower financial risk on your part
• Client is more aware of the correlation between their requests / changes and the cost
• Less resistance on both sides to technical and direction changes
• Less resistance from you on timeline changes
• Less likely you get burned

Con’s of Charging Hourly

• Income level is unclear
• Tougher to plan forward
• Increased possibility for budget miscommunications
• Leverage of past work has less impact on your profitability

Selecting a Rate

Your hourly rate should be based upon the quality of your work, the industry you are in, and your cost of living. Make sure you take into account the fact that you will never bill all your time. Freelance Switch has a great rate calculator to help you determine what your rate should be based upon industry, environmental and personal factors. For more on pricing yourself, check out are you working for free?

When to Charge Hourly

• Developing a clear spec is not possible: vague deliverables such as prototypes
• Working in a volatile environment, such as developing on Facebook whose API is in constant flux
• Retainers for clients that want to lock down your availability
• Clients that have a history of making a lot of changes and need flexibility

Fixed Bid

You are charging a set amount of money for a clearly defined set of services. The key to a successful fixed bid is the clarity and accuracy of the specifications document, called a spec in the industry. The more clear you are with a spec, the higher the odds that you’ll make a profit.

Misconceptions

You don’t need to track your time on a fixed bid. A fixed bid is built upon an hourly rate applied to your spec sheet. You write out an exact list of deliverables: this piece of code, that piece of design. Then you make a guestimate on how long each piece will take. Once that’s done, many contractors go along their merry way and complete the project without ever asking themselves one critical question: how well did I guess? Or even worse, they don’t know their hourly rate at all.

The only way to know your level of success or failure is if you track your time and compare it to your estimates. With that information you can learn, grow and improve towards a more profitable business. Our first few fixed bids ended with us working a $12/hr in one case and paying the client $15,000 to build their application in another. I am serious when I keep repeating that tracking your time is not optional.

A fixed bid makes for easier client relationships. Clients want their problems solved as efficiently and economically as possible. If you bid accurately and the client actually knows what they want (and doesn’t change anything), then fixed bids go very smoothly. Often that is not the case, and nothing generates more frustration than feeling like you are being taken advantage of.

With a bid gone wrong, both you and the customer feel that sense of apprehension. Freelancers need to be more than technicians. They need to understand how to work with people and get the spec that actually solves the issue. Frankly, most of us should be spending 2 – 3 times longer on our bids than we do.

Be extremely careful with technologies you are not totally familiar with – we’ve been burned to the tune of $10k+ a few times when exploring new terrain. Our fault, but it hurts. If you are using subcontractors to fill some holes, make sure they are part of the bidding process and you are not guessing. Just like you are being held accountable to your estimate, they should be as well. Guessing is bad. The more data you have, hence tracking you time, the more accurately you can estimate the true cost of a bid. The more accurate your bid, the less conflict you will need to work through during the project.

Fixed is fixed. After getting the fixed bid as accurate as possible, you then need to control for feature creep. Feature creep is the never ending series of requests for one little idea after another to get added in. A few minor changes are acceptable, but many clients will keep pushing until you push back.

That act of having to constantly push back can be quite stressful on the relationship and needs to be handled early and artfully. The key here is the power of the word “Which,” a word deserving of its own blog post.

“Which way would you prefer: to have the new feature you just explained or this feature that was in the spec? Your budget only allows for one.” If they say both, ask for more money. If they refuse, put on your biggest smile and while gently chuckling say, “Are you asking me to work for free?”

The art of negotiation continues through the entire project. While many contractors don’t mind working for free while trying to build their reputation, this cannot last forever. Once you get to the point where you are rejecting work, the idea of working for free for anyone leaves a sour taste in your mouth and can ruin a relationship. We are talking from experience.

Pro’s Of Charging a Fixed Price

• Income clearly defined
• Working from a highly detailed spec
• Easier to manage your resources
• Simpler to ask for money up front
• Increase profitability through the use of assets (code libraries etc…)

Con’s Of Charging a Fixed Price

• You take on all financial risk
• Timeline and technical changes are not usually in your favor
• More likely you get burned

Setting your Price

Get the following together: 1) your spec, 2) your estimated time to completion, 3) the list of assets you plan to capitalize upon and if you work with subcontractors, 4) your team’s cost and availability. All these will need to be taken into account. Don’t forget to include project management, meetings, quality assurance and testing, deployment, customer service and any other services that you may be responsible for, but have not detailed out in your spec and time to completion.

Once you have a true number of hours, figure out your reserve or buffer. The purpose of this is to cover you in the case of the inevitable changes and surprises that happen during projects. Sometimes things take longer than planned. A brilliant solution turns out to be wrong. You know how it goes. I tend to add a buffer around 30% of the project time, higher for extremely complex projects, to the total hours. Take your total and multiple it by your hourly billable rate. Check the number over and ask yourself if it seems reasonable.

I’ve often found our estimates to be pretty accurate. If the client freaks out, carefully explain it to them. There are good reasons to lower your price, but understand that almost every time we’ve done that, we’ve ended up losing money.

Good reasons to lower your price might include gaining a high profile client, market exposure, or gaining a new asset you can reuse. I often ask myself: Is this client and project going to help us get closer to the goals in our business plan (you have a business plan, right?)? If the answer is a resounding “yes”, then I am more willing to negotiate.

When to Charge Fixed Price

• The project is easily defined and a clear spec is available
• The project requirements are stable and not subject to much change
• When you have a lot of assets (code library etc) that can be applied to increase profitability
• When you are highly confident you can drive a good profit based upon your spec

Picking the right one for your project

The one true difference between a fixed price and an hourly project is which party accepts ultimate liability for the budget. It all boils down to that. There is one question I ask every time we approach a new project: how confident am I that we can drive a good profit? If I am not confident, I will insist on hourly and that the client take on the risk. If I am confident, then I will work with a fixed price.

Whether it is an hourly or a fixed price gig, we have a spec we are working from. We track our time. We warn the clients about changes and how they will affect budget. We keep a careful eye on the problem we are trying to solve. The fact is, the difference between the two when run by a seasoned business owner is minimal.

I’d love to hear in the comments what criteria you use when you decide which way to go!

I’d like to thank Brandon, Tea, Eric, and D.L. for their discussion on the topic.

You could be. In fact, you probably are, and there is nothing wrong with that, as long as it is intentional. I’m down with investing my time, but I’d rather surf or nuzzle my wife than work for free. I’m sure you can all relate.

Let me share how this article came to be. I was about to write a carefully crafted argument on how tracking your time directly affects your income. Then I realized the dialog I just finished with my friend on IM says it better than any argument I might make. I asked for permission to post our chat, she reviewed, sealed, stamped and delivered.

So, to set the stage, we were gabbing along about life drama and all and suddenly, mid conversation, she pulled a little IM judo and slipped in some business:

Friend: is $2800 US too cheap for something like xxxxxxxxx.com?

Shane: all from scratch?

Friend: yep

Shane: how long did it take you start to finish

Friend: full time? I don’t know.

Shane: do you clock?

Friend: no

Shane: hmm … start clocking, it will help you define your rate

Friend: I usually work on a couple of different things at once

thought: aren’t women amazing. I tend to trip when I think. still, thats not a good enough excuse

Shane: I understand. When, I first started clocking, I realized I sometimes worked for less than $12/hr. Start clocking.

Friend: but, I tend to work on packages / fixed bid projects

Shane: I know how you feel. I felt that same way. I found that clocking turned my whole business around. It might be awkward but figure it out. Trust me, you need to, or you end up working for free

thought: hmmm maybe I should shut up and ask her for a few fixed bids …

Friend: LOL – is that a hint?

Shane: I can’t tell you if the work you did was too cheap unless I know truly how long it took, nor can you

Friend: well, it took about a month, but that was in bursts of time

Shane: so if you had to guess? how many real hours, design, code, planning, meetings, QA, the whole thing

Friend: probably about… 100-120, thats a rough guess

Shane: you do the math

Friend: do you think that it would be unreasonable to charge $3500?

Shane: seriously, you need to do the math

The conversation went on for a while. The point. If you don’t know how much time a project takes, how do you know what to charge? I don’t mean how much time you spent coding or designing. I mean the whole package. Once you have begun clocking, figure out your true hourly rate. Once you have that, you will either be pleased or, if you were like me, absolutely horrified. It’s sad when the kid at the local in-and-out burger has a higher hourly rate than you do.

How to Set Your Rate

Once the nausea passed, I realized I absolutely couldn’t keep doing the same thing. In my quest for guidance I was offered very valuable advice: work it out backwards. Instead of asking what will the market offer, I asked myself how much money do I really need to live, and what do I need to save to make progress towards my life goals. These formed i) my baseline target and then ii) my I-don’t-know-how-I’m-going-to-do-this-but-it-would-be-amazing-if-I-made-this goal. Just to let you know. Since the day I did that, I’ve overshot every it-would-be-amazing goal to date.

1. I start with what I’d like to take home after taxes when it’s all said and done. I figured that out by reviewing our family expenses and then setting a goal for savings. For a long time early on my goal was a true take home of $5000/month.
2. Then I figure out what profit represents pre-tax. Since that is about a 25% taxrate in California, we are talking $6250/month.
3. Next I look at my expense basis (or guess) and tack that on to figure out my gross. I had few expenses early on - for the sake of easy math, let’s say for now $750/month (computer, software…), which brings us to $7000/month.
4. With my gross revenue dollar figured, it’s then a matter of division. Figure out how many hours are you willing to put into your business and then subtract how much of your time is non-billable. When I was truly a one-man shop, I found that my time was 60% billable. I did manage to improve it up to 75% once I became aware of how high my non-billable time was. So, if I was working 50 hours per week on average (some way higher, some lower), then my billable time was 37.5 hours at 4 weeks = 150 hours. 7000/month devided by 150 hours = $46.67/hr.
5. Once I had a rate to focus on, the next questions I had – what are my pivot points? Where can I improve the odds? With some experience and advice I began to work on tweaking my i) billable hours ratio ii) rate iii) taxes & expenses. I play with those consistently to this day. That’s what real business owners do.

Trust me, this is the most profitable little piece of math you’ll ever take the time to do. It pays really well to count your pennies and your minutes. For a nice little summary of other factors that you will eventually need to consider when setting your rate, check out Cyan’s post on FSw: nine factors to consider when determining your price.

Once you know what rate you need to make, then start asking yourself: what need is out there that I can fill and people will pay for? But that is a different article.