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How to Estimate your Hourly Rate (Part One)

Finding it hard to estimate your hourly rate as a freelancer? This simple guide will help you do just that.

…a man of action will always find employment – Sir Walter Scott, Ivanhoe

So you decided to get up on your horse and point your lance in the right direction, eh? I bet the second most troubling question you have is: “How much should I charge?” (The first is: “Where do I find clients?”)

Here’s the truth: You could be a freelancer or a business owner with multiple employees – either way this problem will remain a challenging one no matter what level you reach. It’s similar to finding the right camera placement. There’s the perfect way, and then there’s the way that’ll make you more money. If the two are not the same, which one will you choose?

So, don’t fret. Everyone has trouble arriving at an hourly rate. There’s a good side to this: You don’t have to base your rate on what others charge. You must have your own justification – otherwise, as we shall soon see, you’re asking for trouble. If you follow the herd of free lancers across the plain, you might end up fighting the wrong battles, marrying the wrong girl and buying expensive real estate in the wrong part of town.

Disclaimer: This article is written for understanding and information purposes only. It does not constitute or replace professional legal or financial advice. Do not take any action based on the words in this article. You are responsible for your own actions and finances.

This article will explain how to get to your hourly rate, one that will not let you down in the long term. You could be in any country, and the same rules would apply. There are expenses, benefits and circumstances unique to every region or business, and this makes it impossible to arrive at a precise formula. It also makes it imperative that you know the laws of your land. This means you need two solid weapons: Flexibility and sound financial advice.

In spite of all the constraints, I’ll try my best to get as specific as possible so the information has practical value to you. I won’t be covering business entities, because that’s a wildly complex domain.

BondTaxMan

How much accounting should you know?

A lot, really. The more time you spend in business, the more you’ll have to know about money. You’ll never stop learning. Why?

Firstly, sound accounting principles will allow you to reach your financial goals faster. Who wouldn’t want to retire years earlier than planned? Secondly, as I mentioned at the beginning, finding the ideal hourly rate is always going to be tricky. The more accounting you know, the better you’ll get at it.

This means: Accounting is a skill that you will learn, one way or another. The wise way is to befriend it and get used to it quickly, like brushing your teeth or sharpening your lance, till you can do it in your sleep (not that you should).

You must learn the basics and learn to use a spreadsheet like Excel or LibreOffice. You must learn the laws of your land, which includes knowledge of business structure, taxes, fees, investments, insurance, etc. The person who will help you throughout your working career (and possibly after it) is your accountant.

Are you worth anything at all?

If you’re in school, living off your parents, is your time worth anything? It is worth a whole lot to you, of course, but you’re not paying for having a good time when you’re young. Somebody else is, that’s for sure. Sometimes you hear filmmakers saying things like: “My movie only cost me $100 to make”, forgetting all the ‘free’ things somebody else paid for. If you’re in that camp, living off somebody else thinking the world owes you a favor, then please change your mind and attitude. If you don’t want to, stop reading.

The rest of us appreciate the freebies, and are eternally grateful. But as a freelancer we’re the kind of person the system wasn’t designed to help. They teach you how to get a job, but not how to create one. Every modern school system assumes there’s a job waiting for the student at the end of the rainbow. You buck the trend and you’re on your own. In a bad economy, the system fails you, and you’re on your own anyway.

Suddenly the real value (or lack of it) of your time hits you with brute force. You try to sell your time, just as if it were a bar of soap, to someone in return for cash. It’s damn hard. Nobody has taught you the value of your time in these terms. You don’t know where to begin. Should you ask for what the going rate in your area is, or should you just pick a random number that will pay this month’s bills? Either way, you feel you’re not in control, and it’s frustrating.

To get out of this rut, or any other rut, make a list:

  • Do you have any skills? Answer: Hopefully, you do.
  • Are your skills in demand? If not, then learn some first.
  • What are your goals in life? Can you find a quiet time to think and ponder? If not, make that time happen and screw the rest. If you’re having trouble, ask friends or family for help. No help? Ask strangers. No help? Go to a park and ask a tree.

 
When you have your goals jotted down, it’s time to find out how much they will cost.

The cycle of life

No philosophy here, just common sense. How does an average person spend money in his or her lifetime? It varies, of course, but I bet most of us follow this pattern:

Earnings vs Age

Notes:

  • 1 – When you’re in school, you don’t have a care in the world. You don’t know sickness or taxes, clients or layoffs. Somebody is paying for your time and life, but society does not expect you to return this amount. It is an investment made on you in the hope you’ll come good. Don’t forget, you’ll be expected to fall into the same pattern with your kids and aged parents when the time comes.
  • 2 – When you’re in college, the pressure starts. You must begin to show inviduality and enterprise. You need money in your pocket. In some societies you work part time. In others you borrow more ‘pocket money’.
  • 3 – When you’re out of college you’re expected to find a job or start a business. In either case, you must now start earning something, and what you earn must at the very least take care of yourself. Your expenses grow too – you might be renting your own place, buying a car, paying taxes, and so on.
  • 4 – This is the stage where you expect to earn more every subsequent year. You are not only earning for your own needs, but the needs of your family, your house, your parents. You will also have to earn extra for the future – in terms of health insurance, life insurance, paying off your mortgage or loans, preparing for your kids’ college expenses, and so on. You must try to see your entire life ahead of you to get this part right.
  • 5 – This is the age of retirement, where you’re no longer expected to provide for your kids or plan for the future. Your spending decreases. If you have planned your health and home expenses right, you will have enough money to continue your lifestyle until death – and then some for your funeral. If you have needy kids, they’ll expect an ‘inheritance’ as well.

 
You could be in any of the above stages. Recognize:

  • Which stage you’re in,
  • How you would go about preparing for the next stage, and
  • The realities of your unique situation.

 
For the purposes of simplicity, I’m going to assume you’re over 18 and not retired yet. This leaves out groups 1 and 5. If you’re in 2, now’s a great time to learn all this so you can come out swinging when it’s time. If you’re in 4, it’s never too late to start. Don’t worry, most freelancers skip 3 and start directly in 4. War has no warm-up period.

Do you have any loans?

In some countries, one is expected to pay for one’s higher education, mostly because a loan has been taken. If you’re lucky, somebody else is paying for you. Still, as a freelancer you have gear and software to buy. Expenses never cease, you just become aware of them.

Loans look complicated, but are easy to understand. You borrow money, and you have to pay it off little by little, usually with interest. In some instances, a loan, when fully paid, will be double (or more) the amount you took – whatever the lenders think is fair for the risk taken.

You are expected to give back a monthly or annual payment until the loan is entirely paid out. Loans taken to purchase something might include a down payment, which exists so they know you are in some position to pay them back.

If you have any loans at present, then start by drawing a table like this (use a spreadsheet like MS Excel):

Down Payment Loan Amount Interest per Year Term in Years How much you’ll end up paying Cost per month
1 2599 23,999 5% 3 30,381 772
2 5499 34,512 9% 4 54,216 1,015
3 0 1,398 23% 1 1,720 143
Total per month 1,930

I’ve given three loans just to show you how it works. If you think the table is complicated, just look at loan number 1 (first line).

Loan 1 has a down payment of 2,599. The loan amount is 23,999 (Did you just buy the most expensive camera?) at an interest of 5% annually, which you must pay off in three years. You’ll eventually end up paying about 5,000 more than you took. The average payment is 772 a month.

So far so good. The thing is, if you’re paying 772 a month for three years, then you’re losing that money. The same applies to the down payment. That money could have got you something had it stayed with you:

Loans Down Payment Interest/Yr You could have earned Lost Earnings from Down Payment
1 2599 10% 3,459
2 5499 10%  8,051
3 0 10%  –

Look at the first line. Let’s say you put 2,599 into a conservative mutual fund, where you get about 10% returns annually. At the end of three years, this amount will have been worth 3,459 – almost a 1,000 more than you put in.

Unfortunately, because you gave that money away to the lender, you have lost 3,459 instead of the 2,599 that you thought you lost.

In case you’re wondering, the formula I’ve used is:

Compound Interest

where:

  • Principle Value = original deposit.
  • r = rate of interest annually, divided by 100. E.g., if the interest is 5%, then r = 5/100 = 0.05.
  • n = number of years.

 
The same ‘loss’ applies to your monthly loan payments:

Loans Future Value of Monthly Payments and Down Payment FV per month Total Loss Incurred
1 35,703 992 1763
2 67,650 1409 2424
3 1,801 150 293
Total 105,153 2551 4481

If you invest 772 (monthly payment in loan 1) every month into a recurring deposit (what they call a Systematic Investment Plan, SIP) that offers 10% returns every year, you will have earned 35,703 (including the down payment) at the end of three years.

The formula I’ve used for recurring deposit is:

Recurring Deposit Formula

where:

  • Monthly payment is the monthly deposit you’re making. This must be a fixed value for the formula to work.
  • r = rate of interest monthly, divided by 100. E.g., if the interest is 5% annually, then r = 5/12/100 = 0.004.
  • n = number of months you have to make your payment.

 
If you’re using Excel, the formula is (=FV(…)).

As you can see quite clearly, if you’ve taken a loan, you must not only earn that money back, but also whatever that money would have earned in a conservative investment.

This kind of thinking must permeate through every financial decision you make. Holding on to money means it has the potential to earn for you. Spending it destroys not only the value spent, but also the potential for earning from it. You might be asking: So why spend at all?

Ever heard of the phrase: ‘You have to spend something to earn something”? This is the principle via which businesses operate. Spend you must, whether you’re in business or not. It’s the ‘earning’ part that makes it worthwhile.

If your line of work can’t guarantee you that, then you might as well put that money in conservative investments and sit tight.

In simple English: Your freelancing rates must pay for your goals in life. The more you ignore this, the harder it will get to meet your goals. Only take loans if you can make far more than would if that money was invested in a conservative mutual fund or some other investment plan. Read my article Rent or Buy? for an in-depth analysis on how to know when one should buy versus rent. Like everything else, your gear must not only pay for itself, but also make up for ‘lost earnings’ plus your income.

Inflation is your enemy

You government collects taxes. Inflation is a kind of tax that you pay to keep the whole charade going. Money devalues, no matter what.

E.g., let’s say you wanted a million bucks at the end of 30 years. Somehow, you slave and save to reach that goal, and finally, 30 years from now, you have a million, right?

Wrong. Every year your money devalues. It is written as a percentage. Let’s assume the average inflation yearly is 1.5% (they are different for each country, check you country’s actual inflation rates).

In this case, the million you have at the end of 30 years is only worth about 476,000 in today’s money. If you wanted to have enough money to buy what a million will buy today, then you need about 2 million.

Get the picture? Every long term accounting must take inflation into consideration. If you’re getting an annual rate of return of 10% yearly, and your country’s inflation is 2.5% (say), then you’re only getting about 7.5%.

No wonder people take jobs! They don’t have to worry about:

  • Accounting
  • Inflation (the system is designed to give you a raise every year)
  • Introspection
  • Finding business every day (it’s like finding a new job everyday!)
  • Insecurity without benefits
  • Thinking and worrying all the time
  • Hard work

 
But you’re a freelancer because it gives you the power to choose your own destiny, right? The process starts with planning your destiny, and then planning for it. That’s what we’ll look at in Part Two, and also complete our task of finding our hourly rate.