Setting pricing and rates for a service business can be tricky. It’s a complex area, and there are no general rules about what the ‘right’ price is. Some industries are very labour-dependent; others are less so. The charge-out rate for a service is impacted by many factors. In this blog, I 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 objectives at once (and getting any one of them wrong has consequences):
- 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 start bringing in revenue and taking market share. However, if you take this approach, you may inadvertently be causing yourself huge issues down the line – for example, low profitability, a lack of cash flow, or an 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 nothing has changed in terms of what they are receiving, that conversation is going to be a difficult one. Clients aren’t interested in your overheads or profitability – they will be looking at the situation purely 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. That might be the technology you use, the qualifications of your staff, the results you deliver, or the risks you help your clients avoid. Without that narrative, a price increase looks arbitrary.
Before we look at how to set the right price, it helps to understand where most businesses go wrong in calculating what it actually costs them to deliver their service.
Why the basic cost calculation doesn’t work
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 divides that by 40 (typical hours per week worked) to establish how much an employee costs per hour.
Let’s say that you have an employee on €50,000. This would make their hourly cost calculation 50,000 ÷ 52 ÷ 40 = €24. The assumption that follows – that an hourly rate above €24 must be profitable – is where things go wrong.
This basic calculation ignores two things that significantly reduce the number of hours an employee can actually bill in any given year. The first is absence. No employee works a full 40 hours a week, every week of the year, on chargeable work. In reality, there will be between six and eight weeks a year that your employee is not working on chargeable tasks because of:
- sick leave
- absences
- paid holiday time (the legal minimum is 8%)
- bank holidays
- study leave
The second is non-chargeable time. Even when an employee is at their desk, a significant portion of their time will be taken up with non-chargeable tasks like team meetings, emails, admin, and training. A reasonable rule of thumb is that around one-third of working hours fall into this category, leaving approximately 26 chargeable hours out of a 40-hour week.
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 achieve 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 platforms for this which make tracking time a straightforward task.
A formula for calculating the real cost of delivering services
Using 44 weeks and 26 chargeable hours, the hourly cost calculation looks like this:
50,000 ÷ 44 ÷ 24 = €47
That’s nearly 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 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 well for businesses that need to grow, reinvest, or maintain a cash buffer. If you are building something, this is the model to aim for.
40/40/20: this is the second most common calculation. Labour and overheads are each at 40%, and profit is at 20%. This is more appropriate where overhead costs are lower, competitive pressure limits what the market will bear, or where the business is in a more mature and stable phase with less need for significant reinvestment.
Neither ratio is universally right – the appropriate model depends on your cost structure and ambitions. What both make clear, however, is that a charge-out rate that only covers labour is not a sustainable business.
Setting your rate while staying competitive
Knowing your costs gets you to a floor – the minimum you need to charge. What the market will actually bear is a separate question, and the answer varies considerably by sector. In digital agencies, for example, €120 per hour is not untypical. Yet an experienced manager in that sector could be earning €100,000, which means they need to generate around €300,000 in billable work annually (a charge-out rate of €284 per hour).
The gap between what the market expects to pay and what the business actually needs to charge is where a lot of service companies quietly haemorrhage money. In sectors like commercial law or management consultancy, rates of €500 per hour are not uncommon, and clients accept them. The difference is not always the complexity of the work; it is often the confidence with which the rate is presented and the rigour with which time is recorded and billed.
Sectors such as legal have perfected 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 noticed 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. (If you’re here looking for a simple way to track time, tasks, and expenses on projects, take a look at our blog about Xero Projects.)
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 operate very differently. They absorb account management time, round down invoices, and avoid difficult conversations about scope. The result is that they consistently under-bill for the value they are actually delivering. Sometimes it simply comes down to having the confidence to name your price and stick to your guns.
Case study: what happens when you get the pricing right
I have a real 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 around €50,000 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. Our next step, therefore, was to look at the value this client was bringing, and as it turned out, they were providing lots of additional benefit to their customers (such as GDPR expertise and enhanced security).
This knowledge 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.
Pricing correctly is not just about covering costs. It’s about genuinely understanding what you are worth – and being able to explain it clearly. Get that right, and the pricing conversation becomes much less daunting.
