New to independent consulting, freelancing, or contract work? Learn to set your rate like a pro. Factor in what employers do when budgeting for personnel. Your rate should reflect the overhead you take on and the risks and responsibilities that shift from the employer to the contractor.
The Beauty of Setting Your Own Rates
Successful independent consultants don’t discuss their rates in public. Their rates are negotiated behind closed doors much like most big sales contracts. They don’t always have set rates, and even if they do, they can always change their rates. For example, between the beginning of my first year to the end of my second year consulting I increased my hourly rate by 50%. As a contractor, I can re-negotiate my rate with a client on an ongoing basis. This might seem unfair at first, but the client can always terminate the contract without reason and without paying severance, unlike with employees. What this means though is that contractors have more control over their rates than employees do over their salaries.
“You’ll never get rich consulting,” said a former colleague.
This is a common fear that most freelancers, gig workers, and independent consultants face when they ditch the 9-to-5 to go solo. It’s also a common misconception echoed in society. We're going to dispel this myth with how we set rates.
As the person typically responsible for either paying the bills, tracking the bills, or approving the bills, I’ve had the privilege of knowing how much moderately successful consultants get paid. I callout moderately successful, because highly successful consultants end up turning their solo practice into a company. In broad strokes, consultants’ rates usually come in the following ranges:
The rates here span engineering, marketing, product management, sales, business operations, and similar functions serving small to mid-sized companies in the software space. Additionally, these rates are tied to high cost of living, urban cities such as NYC and SF. Outside of tech and outside of urban cities, the rate should take a 10 to 30% rate reduction.
These are general guidelines to provide a frame of reference. However, what any individual consultant can charge boils down to how well they present their value, set their rates, and deliver on work.
A former colleague and VP of Sales once told me I should never go into sales, because I would suck at it. I’m not naturally competitive with others, and I usually am too much of my own harsh critic, which means I typically lowball myself. That’s why when I went into independent consulting I typically didn’t negotiate my rates. My rates were often take it or leave it.
This approach on first blush defies conventional wisdom, and seems outright stupid. However, there are three reasons that this approach can work well:
As a new consultant, getting good at pricing is an incredibly important skillset. It means the difference between scraping by versus making a good living. However, most advice on rate setting is garbage.
New consultants should focus on setting hourly rates, with potentially a first month’s retainer. All other pricing models are too complicated and requires more experience in order to do well. For example, when I first started out, I typically underestimated how many hours a particular task would take, but with 2-3 years of practice I can now either estimate within a small variation of the hours needed or know enough to say I can’t yet assess until I put in a few hours.
Secondly, unlike wages, consultants are paid through the typical accounts payable workflow instead of through HR. Employees are paid usually twice a month on the 15th and the 30th of each month. The longest time between time worked to payment received is at most two weeks.
Contractors, on the other hand, bill in arrears. I bill for the month of January in February because I only know how many hours I worked in January after the month is over. Additionally, bills are often paid net 30, meaning the accounting department will pay your invoice from Jan 1st on Jan 31st, 30 days later. That’s if their payment department is efficient. It’s not uncommon for some AP departments to pay net 45 days on average when terms are typically net 30 due to inefficient approval workflows. Therefore, from the time you’ve put in your first hour to the time you’re paid can be up to 60 to 75 days later. Requesting an upfront retainer that is applied towards the first month’s work can help with managing cashflow as you start out.
Personally, I typically forgo retainers because of the complexity of administration, personal lack of a cash need, and the healthy cash positions of my clients. It’s a recommendation to protect yourself as a contractor, but not a requirement.
For new consultants, the most common place to start when setting your hourly rate is to convert your annual salary to an hourly rate with one of the many conversion calculators that’s everywhere on the internet. This is appropriate if you’re going from an annual salaried to an hourly EMPLOYEE, but it’ll significantly underpay you as a consultant. Other recommendations take some sort of heuristic that isn’t particularly sound and not sufficiently defensible to get to a higher hourly rate.
In reality, there’s a very formulaic and logical way you can get to a healthy hourly rate. This method is based on how companies estimate costs associated with having employees, typically called “overhead”. Every year during year end, the finance department will be working to pull together next year’s budget, including all personnel related costs. In that budget, they’ll likely identify a rough multiplier to approximate all costs associated to personnel that are non-payroll. These costs range from employer taxes, health benefits, office rent and utilities, to employee perks; and are lumped into a broad category called “overhead”. Overhead for an employee can run anywhere from 50% to 250% of employees’ gross wages. This is just one component of the budgeting process, but we’ll utilize the concept of overhead in our methodology for setting hourly rates.
Here are the steps to finding your hourly rate from your annual salary:
In the comparison chart below which shows what a typical conversion looks like in comparison to a fully loaded conversion. Note that a direct conversion still makes sense if you remain an employee with the company. It's when people mistakenly apply a straight conversion when going from an employee to a contractor that becomes a problem.
The pay difference is stark. The main thesis behind this approach is that costs typically covered by employers are now the consultant’s responsibilities. Note that employees are further protected by many HR policies and regulations in the workplace that independent consultants are not privy to, which are not quantified here. Independent contractors take on disproportionate levels of risk in comparison to their fully employed counterparts. Their rates should appropriately reflect these risks.
However, with great risks can be great rewards. By taking on the employer’s risk, an independent consultant can price at much higher rates, and how profitable they are boils down to how well they manage their operations. Corporations suffer from layers of administration and management causing overhead costs to drag down the company’s margin and subsequently depressing employee pay. Small shops can operate leaner and faster, allowing them to thrive because of their small size. Whatever efficiency consultants can achieve becomes their take home pay. Essentially, the consultant is betting on themselves as opposed to betting on someone else.
To those who think you can’t get rich consulting, you should really think again.
We built a calculator! Convert your annual salary to an hourly rate as an independent contractor. Ensure you are getting the same take-home pay as you would if you were employed, by factoring in overhead, administrative work, benefits and more.
Reference:
1 https://www.irs.gov/affordable-care-act/form-w-2-reporting-of-employer-sponsored-health-coverage