The cost of doing business: an explanation of bill rates
From time to time, I'm asked by a relatively inexperienced developer how I decide on a bill rate.
As a rule, I point them to a post I made to email@example.com in May of 2002 addressing that very task, among others. A discussion of process takes up the first half of the post, and will look familiar to those who've read my December 2006 article about avoiding presentation edge cases.
The intended audience for this article are new Web development freelancers and clients for Web-related services (both mine and others'), by way of writing once what I can otherwise expect to write repeatedly.
Those here from Google seeking information on the cost of operating a small business in their own field of interest should tailor their search to the industry and market in which they operate. This article best suits Web services freelancers (and their clients) who operate in the American Midwest.
Since I am no less unqualified to offer professional advice about accounting than I am qualified to offer professional advice about sitebuilding, I recommend that you get the last word from a certified/chartered accountant with respect to setting an appropriate bill rate.
It's tempting when inexperienced to charge what you need to live on, when in fact you need to take into account a bunch of other costs. In this instance these costs are described with the independent lone developer in mind.
- Rent: how much does it cost for you to maintain your workspace? If nothing else, set this amount in terms of
office_rent :: dwelling_rentas
office_space :: dwelling_living_space.If you own the dwelling, remember to include the cost of homeowner's insurance, upkeep, and property taxes in addition to your mortgage payment. If you are a renter, likewise with renter's insurance and likely rent increases.
- Utilities and services: What is the cost of electricity, heat, telephone, garbage, and Internet access? Some or all of these liabilities are affected by the manner in which you conduct your business.
- Equipment: How much does the depreciation (or wear and tear) of your office equipment, rig, and software cost?
- Insurance: If you have private health insurance, how much is it costing you? If you are a member of a household and your spouse pays the benefits, it doesn't matter. That cost is still affecting you.
- Holidays: Unless you are an absolute workaholic and childless to boot, this justifies a 4% increase in rate for most in North America, an 8.3% (1/12) increase in Europe. Or, you can just eat the money. If you have school-age children, the number is more uncertain, as you may be forced to take time away from work to nurture them back from illness.
- Federal and local income taxes: In the U.S. the IRS wants its pound of flesh, which will likely amount to an average of 20% for those making a decent living. State tax rates for the current filing year can be found at http://www.taxadmin.org/fta/rate/ind_inc.html. Some jurisdictions (such as Texas) also require that sales tax be charged on Web services delivered by an intrastate vendor.
- Payroll taxes: For a U.S. resident or citizen, these amount to 15.3% of gross income, up to $84,900 per annum (as of May 2002). 2.9% of all income is in fact taxable in this fashion. There are also other local taxes that may be assessed.
- Professional services: The cost of paying your attorney, accountant, printer, answering service, professional subscriptions, &c. each year finally needs to be taken into account.
So, let's suppose that in a year I spend:
|Line item||Estimated cost|
|Cost of workspace alone (tiny corner of one-bedroom apartment)||$450|
|Software, hardware, and supplies||3,300|
|Utilities, internet, cell phone||1,500|
Despite having all of these costs, I've yet to drive a mile in my car, or eat so much as a single biscuit all year. Nor have I paid rent on the 85% of my living space that is set aside for personal use. If I expect to bill 1200 hours for the entire year, that means that I need to bill $9.17 per hour just to meet these costs alone.
Once I factor in taxes (20% federal, 15.3% payroll, 7.5% state for a total burden of 42.8%) and 4% for holiday time, I discover that 46.8% of my revenue can't be applied directly to operating costs, capital, savings, food, or discretionary income. In order to clear the $9.17, I need actually to charge 188% of that amount, yielding (thus far) a rate of $17.23 per hour.
This number increases further if there's a bond in need of maintenance, or there are premiums being paid for errors & omissions insurance.
That $17.23 per hour is how much I have to charge just to keep my business running smoothly from month to month. In this scenario I haven't spent a dime on marketing except for business cards and tri-fold brochures. Perhaps I've designed cheap presentation folders and letterheads. (And oh crap, I forgot to consider the cost of paper, which if you use a lot of it starts to add up.)
When the aforesaid services aren't being contracted
...They need to be taken into account anyway.
If an operator's not contracting those services, it means that he's undercapitalized — and those funds will ultimately go toward contracting those services, sooner rather than later.
Where the 1200 hour figure comes from
Based on several years' experience, 1200 hours is at the upper limit of what I can expect to actually bill without spending more than 55 hours a week on billables, paperwork, training, business development, and networking — all activites that are vital to the health of my business.
A brief note about tax deductibility of home office expenses
It is this author's understanding that attempting to deduct one's home office expenses tends to earn undesired attention from the tax collector, in the United States at least.
Defining cost of living
Now, let's look at what I (single, 32, no children, living in exurban Kansas, does not own a vehicle, smokes but does not drink, lives a phenomenally spartan lifestyle), might spend in a year to meet personal overhead:
|Line item||Estimated cost|
|Net cost of living:||$14,000|
Assuming the same numbers applied above, the need to meet these bare expenses imposes a minimum increase of $21.93 per hour to my bill rate, yielding a final bill rate of $39.16 per hour.
The consequences of that bill rate are:
- No conferences
- Plain wardrobe
- Challenged to give Christmas gifts
- Client service is unspectacular
- Vulnerable to delinquent clients with extensive legal representation
- Debts get poor service
- Financially unable to start a family
- ...And forget living in a market that has lots of work at hand
Since I want to provide good client service and keep my spirits high, I'm likely to bill considerably more than $40. per hour to practically all of my clients so that I'm not forced to settle for the outcomes listed above.
Correlation between bill rates and client hassles
It has also been my experience that the less I charge, the more invoices are haggled and corners are cut by my clients. I imagine that when an operator can deliver at a high level of quality and bills a rate that apprehends that quality, clients are more likely to stand out of the operator's way and let him do his job, so as to keep project costs down in the long run.
It seems most likely to me that good operators tend to bill what they need to live well. Given that I've just posed a bill rate of more than $40. per hour for living poorly, it should be no surprise that genuinely good contractors in almost any business - especially those with far higher overhead such as construction and mechanical trades - charge a great deal more than that.
In the end, I suspect that effective bill rates are primarily a reflection of a client's trust in their vendor's ability and professionalism.