How do hourly pricing models work?
Do you run a business that charges clients by the hour? Whether you’re an accountant, lawyer, designer, or consultant and you’re ready to expand – or hope to one day – there are a few things to consider to make sure your growth strategy is profitable.
Let’s start with the basics…
How does the billable hour pricing model work?
“Billable hours pricing” is a method used by many different services with one thing in common – customers pay by the hour. Businesses that use this model estimate the maximum number of hours in a year that they can generate revenue, and use that number to set hourly rates. Here’s an example:
Dr. John Watson owns a private investigation firm and is the sole investigator. He plans to work a typical 40-hour workweek and take two weeks off for vacation.
40 (hours per week) x 1 (employee) x 50 (workweeks in a year) = 2,000 billable hours
But Dr. Watson is not a robot and has to plan time during the workweek to eat, travel to clients, and handle administrative work in the office. He estimates this will take about 1,000 hours.
2,000 (billable hours) – 1,000 (non-billable hours) = 1,000 maximum billable hours for the year
Watson has already determined that his business’s operating expenses (marketing, administrative, office lease, etc.) will be quite low since he is well-known and works from home. He uses that figure to set his break-even rate.
$20,000 (total expenses) / 1,000 (maximum billable hours) = $20 per hour
If Watson charges just $20/hour, he’ll be able to cover all of his expenses. Anything higher than this number will go straight to the bottom line, which is why he’s decided to charge $60/hour.
So what you’re saying is I should just bill more hours, right?
Unfortunately, it’s not so elementary. Looking at the last equation above, you’ll see that lowering expenses, increasing the number of billable hours, or increasing rates could all send profits skyward. But if you’re a sole proprietor and many of your expenses are fixed, what are you to do?
Grow my team?!
If Dr. Watson hired a junior investigator at $30,000/year…
$30,000 (salary) / 2,000 billable hours = $15/hour nominal cost
could he simply re-bill her at $30/hour? Keep in mind that you have to account for federal holidays, employment tax, vacation and sick time, in-office work, and training for new staff. When all is said and done, the true cost of an employee is actually double their “nominal cost,” which means he’d have to re-bill his junior P.I. at much than $30/hour to make a profit. Expanding your staff could be the answer, you just have to be sure the numbers work out.
So, hire several more people all at once?
This could also be a solution, but with more employees comes more clients to maintain employee turnover, and a need for more office space and support staff. Hiring subcontractors, versus full-time employees, does offset some of those issues, but subs typically charge higher rates since no one is covering their vacation time and health insurance.
Can’t I just increase my prices?
If Dr. Watson increases his hourly rate from $60 to $70, this $10 increase would yield $10K more in pure profit. But he risks driving away loyal clients or attracting a different type of clientele that come with challenges he hasn’t faced before. Increasing your rates is a viable solution, as long as your customers are prepared and see a good reason for it.
As you can see, growing a billable-hours business can be done in a number of ways, but you’ll have to use your powers of observation to determine which method makes the most sense for your business.
