At one time or another I have used each of these methods. Those sometimes painful experiences are the basis for my recommendation.
I can think of 6 Ways to set hourly rates.
The 6 Ways
Work backwards from a typical fixed fee project What the Market will bear Calculation of breakeven plus profit markup
Before looking at the PROs / CONs of the 6 Ways, let’s briefly consider the uses of hourly rates.
The uses of hourly rates
Hourly rates have more uses than the obvious one of charging per hour for your work. These are the three main uses.
Charging clients for your time Determining the hours available to complete a fixed fee project Setting a price for a service
Charging clients for your time
Every project is an opportunity to use hourly rates. I had several repeat clients that preferred the simplicity of this method. Most clients prefer some sort of fixed fee arrangement. Even those clients usually prefer hourly rates for additional services.
I know of firms that never use hourly rates. Often the reason is that they don’t want to track time. There are inherent limitations to this approach. First, you are forced to guess a fee when a one-off service is requested. Second, you have no way of knowing which projects are profitable. Or why. Third, you only have ‘gut feel’ to warn you that a project is not going well. Finally, you have only your income statement to tell you how you are doing, but not why.
So knowing your breakeven hourly rates and your billing rates help you bill clients appropriately. They also help you manage your work based on facts.
Determining the hours available to complete a fixed fee project
When you have a fixed fee project, you can’t realistically think that you have all the time in the world to complete it. When I haven’t watched the progress of a project, it has always gone over budget. Once half the fee is spent and you aren’t in the Construction Documents phase yet, you cannot prevent a loss without cutting the quality of the service - a lot.
With hourly rates, you can simply calculate the hours available per phase by dividing the net fee by the rate.
Setting a price for a service
Let’s say you want to charge a fixed fee for a pre-design estimate of the construction cost of a proposed project. Using hourly rates and an estimate of the hours needed and perhaps a contingency, you can arrive at a fee in an hour, or less if you have done this before.
As you will see in the following PROs / CONs of the 6 Ways, your choice of method will have ramifications. By choosing a method based in reality you will know more about how efficiently you are organized, and what is holding you back from better organization.
The PROs / CONs of the 6 Ways
In reverse order of the initial list above.
CALCULATION OF BREAKEVEN PLUS PROFIT MARKUP
The only method that gives results based in reality Provides guidance for the “What the Market will bear” way Shows you what your profitable hourly rates are Also shows you how to be more efficient
The calculations are hard to find ()
Architekwiki has a tool that makes the analysis and calculation simple.
Learn more about the Financial Model Workbook here.
WHAT THE MARKET WILL BEAR
I routinely raised rates at least once a year. Often the amount of the increase had nothing to do with data of any kind. I never did get pushback so I never found out what the “market will bear”.
Has to improve profitability
Doesn’t tell you whether you are as efficient as you should be, and may encourage inefficiency.
WORK BACKWARDS FROM A TYPICAL FIXED FEE PROJECT
By taking a project that had a ‘good’ fee and that was completed in a timely manner, you have data to establish reasonable hourly rates. I looked at this way after completing a couple of fixed fee projects. The exercise was worth the effort, but wasn’t a full solution.
Takes a fair amount of work and analysis. Difficult to make valid assumptions about overhead allocation. Profitability might be a guess. Unlikely, despite the effort, to be completely accurate.
If you have a colleague who will share their rates, or access to information like this, then you are better off than using the Guessing method. I decided to raise rates once when I learned what another firm was charging.
Might not be an improvement. Low chance that the other firm(s) have similar overhead factor and utilization rate. Especially true if the other(s) are larger than you.
DICTATED BY OTHERS
Sometimes you don’t get to set the hourly rates. I had a governmental client that would only pay the rates set by a state agency. When I suggested that the rates were at least 25 years out of date, it was suggested that other firms had figured out how to live with the rates.
Almost guaranteed to lose money unless you turn a blind eye to ethics. Introduces an element of special data manipulation to adjust reported hours into billable hours. Getting your consultants on board with the method is not guaranteed, so there could be more special methods needed.
Guessing is just that. You pick a number that appeals to you for the top or bottom rate and adjust up or down to fill in the other levels. My first hourly rates were done just this way. Several years later I learned just how much I was losing per hour using these rates.
Very low chance that your rates will perform as hoped.
Use a fact-based method of determining your rates.
Finding your fact-based rates tells you a lot about how profitable you can be, which is valuable information.
Knowing how you might be limiting your profitability is more important than almost anything else, except how to get work in the first place.
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