Fees or Famine: Fee Structures for the Well-Fed BusinessPosted: October 28, 2011
If your time or expertise are things for which you bill clients, the difference between fiscal feasting and financial famine depends on a profitable billing rate and a cash-flowing payment schedule. Even if you’ve been in business awhile, take an objective look at your pricing to make sure there are no holes in your net.
Defining an appropriate billable rate can seem mystical. Aim too high, and you’ll never reach capacity; price too low, and the market might not take you seriously; miss the mark, and you won’t ever build a profitable business.
If you work in an industry with established and visible fees, do a little research. Call your colleagues or what some call competitors. Some peers are secretive about their pricing practices. Others are happy to help friendly competitors. Be honest about the reason for your call, and let them decide how much they want to share. This respectful approach may begin a long, mutually-valuable relationship.
You can also research pricing on the internet. Go to www.google.com and type into the search field an industry buzz word like refrigeration or event management to find competitors in other cities and see how they present themselves. Call if pricing isn’t online; information might be more free-flowing from someone serving a different market. You also can search online for trade associations and published industry data that will provide insight about fee structures, costs, and other jump-starting information.
If you’re charting completely new pricing territory, or just want an objective process for checking your historic approach, you can follow a four-step process: 1) determine your costs; 2) determine a profit margin; 3) test the market’s response; 4) adjust.
Know your Nut
Determine how much you need to bring into your business each month to break even. There will be no more worthy investment of your time than gathering this information, and while you’re at it, setting up a system for maintaining accurate spending information hereafter. Outsource this to a bookkeeping pro if necessary; the impact of choices you can make by having this information current and ready will more than offset the cost of paying someone to do what you may not have the skills or discipline to maintain. You’ll see decision-making opportunities using this information as you progress through the four steps.
This breakeven number, the “nut” you may hear referenced in entrepreneurial circles, tells you what you need to earn just to keep the doors open. When compiling numbers to identify your nut, remember to include seemingly incidental categories like office supplies, TAXES, and insurance – it all adds up. And add a number for your salary that is the sum of all your personal expenses. Even if yours is a sole proprietorship, organizing your personal expenses collectively as a single line item will add an important layer of discipline and clarity to your financial reporting.
A typical lurking danger in businesses with fluctuating cash flow is the temptation to pay yourself more in the lucrative months and delay timely payment of personal obligations when times are lean. “Bonuses” are to be paid once a year, and only if you and your accountant see sufficient cash reserves and cash flow to extract more than your personal nut from the business. Many business owners agree with the idea of a salary but see these periodic shortfalls as a barrier to extracting a fixed amount each month. This is where that cash reserve account becomes critical. Indeed, a shortfall this month will need to be caught up – just when is determined by how much cash you have in reserves to cover the shortfall.
Ideally, you’ll have at least three to six months of nuts stored away – even more if your business has a lengthy sales cycle or experience tells you the longest period of time your business has run without any income. If you’re not in a position to secure a line of credit for reserves, start setting aside extra income from the higher income months immediately. This usurps conventional financial wisdom that there’s no point in saving until you’ve liquidated all debt, but a cash reserve account is top priority for every business – especially the multi-hat-wearing sole proprietor.
It is through this management of income and expenses that you ultimately will be able to build a sustainable business and personal wealth. And without it, no fee structure will save you.
Once you know your monthly nut, multiply this number by 12 and divide by 52 to get a weekly nut that is easier to build on. Now, divide this by the number of billable hours you are willing and capable of working each week. There are only 168 hours in anyone’s week, so be realistic about your personal requirements as well as those of your business. This whole game will be lost if you don’t calculate based on what you can actually work (and sell) in a week. You want the ratio between billable and non-billable hours to favor billables, but plan too for administrative and sales work that may be required to prepare for and service paying work. The resulting number is the base rate below which you can’t afford to do business.
Here’s an example for the first step; remember your personal expenses and taxes already are included in the monthly nut number.
$5000 monthly nut x 12 months = $60,000 annual nut
$60,000 annual nut/52 weeks = $1,154 weekly nut
$1,154 weekly nut/30 billable hours a week = $39 base rate
Price for Profit
Now that you know what it actually costs and how many hours you have to bill to sustain the business, you can add on top of this with a margin that begins to return profit to your business and you. Again, there are industry standards – advertising agencies shoot for a profit margin in the 20% range; 30% is a standard for many professional service providers. Check with those trade organizations and peers for a realistic number or start with 30%. If $39 is your base rate, add $12 for a billable rate of $51. You can round the number up a bit to make math easier and quote a rate of $55 per hour.
Test the Market
Use your formula to calculate the profitable rate and bravely present this to your prospects. If you close every contract, your fee may be too low. If you don’t close any contracts over a reasonable period of time, (check trade sources for the typical length of a sales cycle) you can suspect that your fee may be higher than the market is willing to pay for the service you provide. Especially when you are just beginning your business, it’s okay to revise your pricing to reflect the market’s view about value.
Value is defined uniquely by each customer, but with careful attention to prospects’ response, you can begin to see where the most contracts are closed. There also may be times when it’s beneficial to reduce your price. Your profit margin offers wiggle room. For example, you might be working under capacity for the period of time the contract requires your service and a reduced rate will help you meet your monthly nut. Or that cash reserve account would allow you to confidently contract work for which you’re appropriately talented and billing your full market rate.
If you find during testing that no one is agreeing to your pricing terms, you may need to recalibrate. If you can’t at least bill your base rate, you may need to lower your expense base to what the market will support. Or if this isn’t possible, and frankly if you’re not able to work to begin generating some degree of profit margin, it is better to find out early in the business, not after five years of barely getting by.
Provided you meet your sales quotas and bill the hours you calculated in the base rate, you will sustain the business and end the year with a 30% return that may go to build your cash reserves, to build your personal net worth, or to reinvest in the business.
Homework: Follow the directions in this post to assure that your own fees are fabulous. Comment below to tell us about any changes you’re making!