Setting pricing and rates for a service business can be tricky. It is a complex area and there are no general rules about what the “right” price is. Some industries are very labour dependent, other less so. The charge-out rate for a service is impacted by many factors; let’s look at some of the most important ones.
One of the reasons pricing is difficult is because good pricing has to meet a number of opposing objectives:
- it has to offer a level of value that means the customer is happy to pay
- it has to be enough that you are making a healthy profit
- it has to be competitive or match the value given in your sector
Avoid the temptation to discount prices
It’s not uncommon for newer companies to set their prices at a lower rate to facilitate bringing in business and start taking market share. However, if you take this approach, you may inadvertently be causing yourself huge issues (not too far) down the line – for example, low profitability, a lack of cash flow, or the inability to invest in growth.
If you have employees being paid a typical salary, but you’ve set your prices artificially low, will you even be able to make money on these rates? Another issue comes once you feel established enough to increase your prices. What will happen when you go to your existing customers and tell them that you are increasing your prices by 30%, 50%, or even 100%?
If there are no other changes in terms of what the client is receiving, how happy will they be to suddenly see their invoices increasing? They aren’t interested in your overheads or profitability, they will be looking at the situation from the value they feel they are receiving. In such instances, value articulation is crucial; you will need to demonstrate how the increase in pricing will be delivering improved benefits to your client. Examples might be how the technology you use brings better efficiency or how more qualified staff make your service more effective.
Common errors in calculating the cost of delivering services
How do you calculate the cost of providing a service so that you can set your pricing? Some business owners do it with a very basic calculation that takes the cost of a person’s salary, divides it by 52 (weeks in the year) and then divide that by 40 (typical hours per week worked) to establish how much an employee costs.
Let’s say for argument’s sake that you have an employee on €50,000. This would make their hourly cost 50,000 ÷ 52 ÷ 40 = €24. Some may assume therefore that as long as they are charging the customer more than €24 they are making a profit.
But this is faulty logic. For one thing, no employee works 40 hours a week, every week of the year, on chargeable work. The reality is that there will be between six to eight weeks a year that your employee is not working on chargeable tasks because of:
- Sick leave
- Paid holiday time (the legal minimum is 8%)
- Bank holidays
- Study leave
There is also the time an employee is at work but not specifically engaged in chargeable work. They may be in team meetings, answering emails, on training courses, or doing general admin.
A formula for calculating the cost of delivering services
The ratio of total work vs client work is something you need to be aware of and in control of. It’s called utilisation, and firms that are highly profitable will tend to have highly utilised employees. You do this by making people accountable for their time at work; in its simplest form this may take the form of timesheets, and there are lots of great cloud solutions for this which make tracking time a straightforward task.
So, what is a realistic level of utilisation for an employee? Let’s take our previous example of an employee on €50,000. We know that there are 8 weeks of the year they are on holiday or otherwise not at work. We know that when they are at work, they will have to do other tasks which are not chargeable to the client – a rule of thumb is somewhere between 2/5 or 1/3 of time will not be chargeable. Now we can recalculate that hourly rate to something more realistic:
50,000 ÷ 44 ÷ 24 = €47
That’s more or less double the incorrect assumption we calculated above. But before you rush off to update your pricelist, remember that we are still a way off from calculating your charge-out rate. If you were to just charge €47, you would only cover the cost of your employee. You haven’t left any margin for your overheads or your profit. Overheads will include rent on your premises, oversight (manager salaries), vehicles, software, insurance, training, etc.
All those expenses need to be covered in your charge-out rate because they are the cost of doing business. It wouldn’t be unusual for these costs to be roughly equal to labour costs, and that would bring the hourly rate up to €94. This will allow us to break even, but we’re still not making a profit.
The chargeable hours + overheads + profit ratio
Now you can see that a charge-out rate must account for the following: the chargeable hours of an employee + the overheads for the company + the profit margin we are aiming for. There are a couple of rules of thumb used that may help you calculate this:
33/33/33: in the service industry, it’s typical for each area to represent one-third of the price. One-third labour + one-third overheads + one-third profit. It’s a calculation that’s been used for a long time and works very well for many types of service business.
40/40/20: this is the second most common calculation. This could work if you aren’t looking to make so much profit or don’t need as much cash to reinvest in the business or pay back loans, etc.
Setting your rate while staying competitive
What is an acceptable hourly rate will depend on your industry and competition. For digital agencies, for example, €120 per hour is not untypical, but if you try to get clients to pay €240 per hour you are probably going to meet considerable resistance. Yet an experienced manager in this sector could be earning €100,000, so in theory needs to be generating €300,000 in billable work every year (that’s a charge-out rate of €284 per hour). Just how feasible is this? If we look at other sectors such as commercial law or big consultancy, people wouldn’t be entirely surprised to be billed €500 per hour.
The other thing that sectors such as legal have perfected is the art of charging for all their time. Many service businesses will average out time and accept a certain amount of account management as just the price of doing business. But if you’ve ever had a bill from a legal professional, you’ll have seen that every single thing is accounted for, down to a five-minute phone call. They bill for their time and they don’t apologise for it.
There’s a lesson to be learned there for many of us. Many service companies such as creative agencies, trainers, IT consultants, or graphic designers don’t have anything near that sophistication of record-keeping or the confidence to charge for their value in that way. Sometimes, of course, it simply comes down to having the confidence to name your price and stick to your guns.
Knowing your value: a case study
I have an example that highlights this issue exactly. We had a client in the tech services area that was charging €75 per hour. When we ran our calculations (using both the 33/33/33 and 40/40/20 rules), we calculated that this hourly rate was simply too low. The company’s qualified employees were earning €45,000 to €55,000 a year and the sums, for us, simply weren’t working. When we suggested raising the hourly fee to €100 to account for the real cost of doing business, the client was apprehensive about losing work. So, our next step was to look at the value this client was bringing, and as it turned out they were providing lots of benefits to their customers – such as GDPR expertise and enhanced security. This encouraged our client to bring in the price increase, but they communicated their value proposition to their customer base while doing so. The result was that only two out of a hundred customers complained about the increase and their bottom line was transformed overnight.
In conclusion, to calculate your pricing correctly you need to start with the right figures, manage your employees’ time well, know your utilisation rate, establish your value and learn to articulate it, and finally keep excellent records!