Determination of a minimum hourly rate
Regardless of how you plan to charge for your work—i.e. on a project basis (fixed-fee), or an hourly basis—you still need to figure out the minimum amount you need to be earning per charged hour.
Available hours — We began by computing the number of hours per year each of our staff will work, on average, taking into account public holidays (12 days, in Germany), vacation (30 days, in Germany) and weekends (104 days, on Earth). So in Germany, that’s 219 working days per year, or 1,752 available working hours.
Chargeable hours — It’s important to recognize that not all of a person’s available time will end up being chargeable. People will sometimes be supporting bids, sometimes working on overestimated projects, sometimes idle, sometimes off sick, etc. In our case, we assumed a chargeability figure of about 70% (which turns out to be pretty consistent with the service industry as a whole). With that, we’re down to about 1,226 chargeable hours per year, per person.
Minimal hourly rate — To compute a minimum hourly rate, we need to divide the minimum revenue we need to make per person, by those 1,226 chargeable hours. The total minimum revenue equals our employment costs (salary, benefits, social security, etc.), all overhead expenses (office rent, support staff, marketing, accounting, legal, etc.), plus the minimum profit we want to make.
Example — In a hypothetical scenario in which a company’s staff costs, on average, $75,000 per year per person, with overheads equivalent to say 20% of employment costs, and wanting to make a 15% profit, the minimum hourly rate would be roughly $85/hour. (That wasn’t the particular number in Makalu’s case ten years ago, but might seem a reasonable starting point today.)
Making adjustments according to supply and demand
Over time, as we produced good work (and through some lucky breaks), we found ourselves with consistently more demands on our time than we had availability (and we note, however, that doesn’t necessarily imply a higher level of chargeability per person.)
As is natural in free markets, prices adjust in order to balance supply and demand, and so we began to slowly increase our hourly rate, in order to alleviate the excess demand. (Some companies would have just ramped up their staff count. In Makalu, however, we place far greater importance on maintaining our ability to produce great work, and that means only hiring great people. We simply couldn’t find legions of great people; we’ve been lucky to find one per year!)
An interesting (though obvious, after-the-fact) consequence of increasing our hourly rate, is that the customers that were left tended to be exactly the type of customers we’ve always wanted to work for — they appreciate, value and demand high quality, and are doing interesting things!
Of course, I sometimes wonder whether we should have started out with higher rates to begin with. In hindsight, though, I don’t regret starting with lower rates, because at least I know that the price we do charge is based on something non-arbitrary. I know how we got here, and that knowledge frequently proves useful.
But what about the others?
Occasionally, I hear stories of companies working in our domain charging astronomical rates (considerably higher than what we charge), and told in a way to suggest that such rates are a sort of “industry standard,” which all serious firms are charging. My instinctive reaction is usually, “Gosh, we must be really underselling ourselves. Have I completely missed the mark?”
But then I remember that it’s human nature to sometimes overstate the truth. There may well be companies out there charging that much (due to their own demand), but I’ve got a couple pieces of evidence against the notion that we’ve somehow missed the boat.
I’ve once seen an invoice from one of our high-profile competitors, and the charged average hourly rate was actually lower than ours.
One of our best customers (and an industry icon) generally tells us their project budgets up front. When I divide their budgets by how long I believe it’ll take us to do the work, I almost always end up with an hourly rate very close to what we charge.
Once again, I think it can be wise to sometimes just ignore what you hear about others, and have confidence in your own experience and objectivity.
Hourly or project? Effort or value?
How should you charge for your work, on an hourly or project (fixed-fee) basis? And if you charge by project, should it be based on effort estimate, or based on the value you believe your work has to your client. These seem to be eternally debated questions, and I don’t have answers that would likely apply to everyone.
Although we occasionally take on the rare fixed-fee project, here at Makalu, we almost always insist on charging for our work by the hour.
Fixed-fee projects tend to put the client and provider on opposite sides of the table, with orthogonal motivations. The client’s motivation is to achieve as much as possible within the fixed price, while the provider’s motivation is to complete the project as quickly as possible, maximizing profit and minimizing risks (and as a possible consequence, minimizing innovation).
Fixed-fee projects also tend to demand that detailed requirements are agreed up front, the production of which often waste time and money, as final products rarely reflect original specifications. And such projects also suffer in the close monitoring of requirements, and the production, negotiation and agreement of contract modifications when the inevitable scope changes occur as the project evolves.
Charging hourly, on the other hand, works to align the client and provider interests, and allows for the agile, iterative approach to project development that’s becoming ever more accepted as the best path to efficiently meeting objectives, while maintaining a balance of value and cost.
When Makalu gets a project request, twelve years of experience allows me to make a reasonable rough estimate of the required effort, which I can multiply by our standard hourly rate to immediately provide the customer with a ballpark estimate. It won’t be perfect, but at least we can quickly establish whether the project is financially feasible.
If it is, and based on that rough estimate, we’ll begin working on an hourly basis (invoicing our time periodically; say monthly). This allows us to manage cost and scope, together with the customer, and generally has resulted (for us) in the development of successful products, with little of the friction typically found in fixed-price engagements. And that makes us happy!
For some potential customers, a natural reaction is, “We won’t go into a project if we don’t know precisely what we’re going to get for our money.” Such a reaction is understandable, but, unfortunately, there’s an enormous history of failed projects in our industry supporting the notion that fixed-price usually isn’t the best way to go.
For others (particularly in countries like Spain), their reaction is, “We’d never enter an open-ended hourly project, since you could cheat us by charging time you didn’t really spend.” Those are precisely the kind of customers Makalu doesn’t want to work with. Nothing good can come from working with a company that doesn’t have the foresight to see that cheating isn’t a sustainable strategy for a company like Makalu.
We want to have successful projects, and don’t want to spend our time in the wasteful paper-pushing and unproductive arguments that too often characterize fixed-price engagements. For those reasons, we took the decision to (generally) avoid customers who require fixed-priced engagements. Since taking that decision, our projects have gone absolutely great, and, just as importantly, the customers who we since work with have tended to be dream customers who share our passion for quality.
But what about value pricing?
We recently bid on the redesign of the 37signals blog, “Signal vs Noise,” and in the process entered an interesting twitter exchange with Oliver Reichenstein (@iA) of Information Architects. His argument seemed to be (and there’s room for misinterpretation in exchanges of 140 characters) that the 37signals budget of $8,500 was far too cheap, compared to the value of a well-designed blog (to that particular company), and that their offer was disrespectful of the creative industry.
This would have been one of the rare fixed-priced projects in which Makalu would have been happy to participate. First, $8.5k would have almost certainly covered the amount of time we’d need to do the work. Secondly, we’ve been reading 37signals’s blog for years, and know they are reasonable people. If we were doing good work, and the scope increased or they wanted a particularly large number of iterations, we’re confident they would have worked with us. Finally, that project is going to bring whoever does it a lot of visibility, and (perhaps even more importantly) they will have the opportunity to develop a relationship with Jason, David and the other influential people at 37signals. There’s a lot of value in that.
But on the other hand, Oliver does make a valid point. In the “Build an Audience” chapter of 37signals’s new REWORK book, they imply a value of “hundreds of thousands, or millions” of dollar in having built an audience of close to 100,000 readers of their blog. So it’s easily arguable that a great redesign of such a blog has a value to 37signals far in excess of $8,500.
Even if I still don’t fully agree with his conclusions, Oliver’s arguments at least caused me to spend some time rethink pricing (and that’s a good thing to do from time to time). Should design be priced differently than development, for instance? I supposed if all I did was design logos, charging hourly wouldn’t be a smart strategy. But what about a business in which the work usually spans the whole spectrum from strategy to tactics, design to development, and even operations?
Although I continue to keep an open mind on the subject, for now, I’ll stick with our tried-and-true hourly and effort-based pricing. It may occasionally result in (subjectively) unbalanced value to our customers, but I can live that. It’s a model that seems equitable, and has proven to work for Makalu, allowing us to create great products, for amazing customers, remain profitable, and be happy in the process.
And, as my colleague Alex pointed out, it also happens to be the model of a firm we tremendously admire, IDEO, which (at least on this point) puts us in good company.