Calculating Contracting Rates
I have been a contract software developer for 2-3 years. I am self-employed and currently have no other sources of income — investments and/or other products and services.
Considering that, you might think that I have given much care in calculating the rates I charge my clients. But that has not been the case. My rates have evolved based on how I measure my skill against other developers I know, how much they are charging, a gradual increase over time, and a vague intuition of what I feel is fair considering the client and context of each project.
I’ve always been very impressed when I read about or speak to another (and usually much more experienced) contractor that knows exactly what their rate is, why it is what it is, reasons it may vary, and how they would adjust for those reasons. Well, I’ve finally stopped procrastinating and sat down to figure all these things out for myself.
What follows is just my first stab at a method for figuring out the above for myself. Please, assume I am no more (and probably a lot less) versed in matters of personal finance than yourself. I expect there are holes in my logic and understanding. Hopefully, sharing will help others improve their thinking about these matters, and they will also help me improve my own in return.
I must mention that this post is almost entirely inspired and informed by conversations with my friends and fellow contractors in the Quote in Progress Telegram group. A special shout-out to @marcantoinefon for starting the group and constantly being so generous with his wisdom and time!
As we proceed, we’ll answer the below questions to generate some variables. Those variables will be used to calculate our rates, and to reflect on our financial status in general.
- How much do you want to earn?
- What are your living expenses?
- What are your business expenses?
- How much will you have left to save and invest?
- How much are you willing to work?
- What are your hourly, daily, and weekly rates?
- Target Annual Revenue (TAR)
- Living Expenses (LE)
- Business Expenses (BE)
- Self-Employment Tax (ST)
- Investable Amount (IA)
- Investable Percentage (IP)
- Work Weeks (WW)
- Work Days (WD)
- Work Hours (WH)
How much do you want to earn?
This is simply how much we’d like to earn in a year. It can reflect what you need to earn (a bare minimum), what you currently earn, or what you aspire to earn. Most of the subsequent calculations are dependent on it.
I’m going to be somewhat aspirational. You go with a figure that makes the most sense for your current curiosity and situation.
I’m aspiring for the sturdy benchmark of $100,000/year. So…
Target Annual Revenue (TAR) = $100,000
What are your living expenses?
You’ll need at least a rough estimate of your yearly living expenses. I find it’s easiest to work out my monthly living expenses first. If you are a keen budgeter, this should be easy. Otherwise, you can use Numbeo to find average expenses for residents of your city.
I call Portland, OR home. However, many of my expenses are generally kept much lower than the average Portlander. As I’m being aspirational, some of the following expenses (e.g. housing) are going to reflect a quality I would like to be able to afford instead of what I generally do afford.
- Housing: $1,500
- Utilities (Electricity, Heating/Cooling, Water, Garbage): $145
- Internet/Mobile: $65
- Groceries: $300
- Restaurants/Cafes: $300
- Clothing/Accessories: $50
- Transportation: $100
- Gym: $100
- Leisure: $100
Living Expenses (LE) = $2,660/month = $31,920/year
What are your business expenses?
In the US, self-employed individuals can include all “ordinary and necessary” expenses that they incur to operate their business.
An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary. - IRS
So… are my headphones a business expense? I never work without them, and it seems the same for many (maybe most) other software engineers. Headphones, especially those with noise cancellation, greatly improve my ability to focus for extended periods of time. More focus equals more productivity. That would appear to meet the IRS criteria for “ordinary” and “necessary”.
I was also initially uncertain about health insurance counting as a business expense. Based on my understanding of the IRS documentaion, it is.
In fact, I’m currently uninsured because of what has felt like prohibitively high healthcare premiums. Now, I am heartened to remedy that vulnerability, knowing I can deduct the expense.
“Devices” is a special expense. Before you proceed, you need to do a bit of extra math to calculate it. For each device (e.g. laptop, phone, headphones) you use for work, calculate the following:
Device Cost / Avg. Device Lifespan (in years) = Annual Device Expense
Now, sum the annual expenses you get for all your devices. That is your “Devices” expense.
Note: I first break everything down to a monthly cost (even if I pay annually), and then I recalculate the yearly total. That might seem like extra work to you, but it’s easier for me to think about things that way.
- Devices: $45
- Health Insurance: $300
- Office/Coworking: $300
- Web Hosting: $20
- Time Tracking & Invoicing App: $15
- Task Management App: $10
- Design Apps: $25
Business Expenses (BE) = $715/month = $8,580/year
What is your self-employment tax?
Ok, I’m sorry. I snuck this extra question in here. This will actually get added back into business expenses, and you’re going to need to update that amount once you answer the question — at least, if you are a US citizen. I don’t know how it works in other countries.
I have separated this out from the initial business expense calculation because it will limit confusion. If you are a programmer that is familiar with the differences between reading synchronous and asynchronous programs, you’ll recognize my point.
For a detailed explanation of the following calculation, read this article.
The way these taxes are structured, the burden is shared equally between the employee and the employer.
Given that you are self-employed, there is no employer with whom you can split the burden. - Mike Piper
Self-employment tax (in the US) is calculated as 15.3% of your net income (revenue minus expenses). You’ll also need to adjust for the fact that that half the tax is itself deductible. Read the article linked above, for more on that. So, finally…
Magical Adjustment (MA) = 92.35% = 0.9235 Tax Percentage (TP) = 15.3% = 0.153
Self-employment Tax (ST) = (TAR - BE) x MA x TP = ($100,000 - $8,580) x 0.9235 x 0.153 = $12,917/year
Now, you need to update your business expenses to include that amount…
BE (updated) = BE (initial) + ST = $8,580/year + $12,917/year = $21,497/year
God damn, that hypothetically hurts!
How much will you have to save and/or invest?
It was only after I finished my first draft of this post that I realized I had included Living Expenses, but never used it for any subsequent calculation.
Instead of edit it out, I decided to leave it in and also add this section. Together, they will help us assess our TAR before going any further. Now that we know all of our expenses — living and business — we will check how much it leaves us to save and invest.
Investable Amount (IA) = TAR - (LE + BE) = $100,000 - ($31,920 + $21,497) = $46,583/year
Further, we can consider the above as a percentage of our TAR:
Investable Percentage (IP) = IA / TAR = $46,583 / $100,000 = ~47%
I’ve seen common recommendations for saving/investing to range 15-30% of one’s income. So I’d be very happy with the above. I’m not going to analyze it any further because I need to learn more about this stuff myself. Let’s just say that I’m quite overdue when it comes to planning for my long-term financial future.
If you find your calculation to yield low on (or below) the above mentioned range, then perhaps you’d want to reconsider your TAR.
How much are you willing to work?
I love writing software. I love learning about computers and information system. A day rarely goes by that I don’t spend time doing one (often both) of those things. Although client projects pay the bills, they aren’t always the best source of engaging and educational work.
There are 52 weeks in a year. For every three weeks I work on client projects, I want one week to focus on my projects, learning something new, or simply to take a break.
I’m willing to commit four days a week when working on client projects. I can realistically expect to spend 6 hours each work day on “billable” tasks.
Work Weeks (WW) = 52 x (3/4) = 39 Work Days (WD) = WW x 4 = 156 Work Hours (WH) = WD x 6 = 936
What is your hourly rate, daily rate, and weekly rate?
Now, that we’ve got all the variables worked out, let’s do some quick math to arrive at our rates:
Weekly Rate = TAR / WW = $2,565 Daily Rate = TAR / WD = $641 Hourly Rate = TAR / WH = $107
Note: I would round each of these to a figure divisible by five (or ten). It’ll make it easier for both you and the client to do quick math about, and there’s simply a pleasing quality to a nice round number.
Additional thoughts on estimating contracts
Depending on how we decide our initial variable of TAR, the above rates could be seen as a minimum, a starting point, or a goal. In any case, there is much more nuance to quoting projects than spitting out a number and waiting for an answer.
Let’s address some of these nuances and consider some strategies for navigating them.
Set some parameters for deciding between which rate to use.
For me, the hardest part about contracting is estimating how much time a project will require. Even if the project is similar to previous projects and I’m very familiar with the chosen tools, there are still many unknown variables that can effect the time it will require.
Those unknowns come in the form of the client’s personality and experience, the current state of the project and team, the necessary workflow, the required level and frequency of communication, et cetera.
Later on, we’ll discuss how we can protect ourselves against those unknowns. For now, let’s assume we have a decent estimation for how much of our time a project will require.
Now, how do we decide between quoting a project with our weekly, daily, or hourly rate? Here’s what I’ve currently settled on, based on recommendations and my own intuition:
- ≤ 12 hours — hourly rate
- > 12 hours, < 1.5 weeks — daily rate
- > 1.5 weeks — weekly rate
Give yourself some padding.
Remember all those “unknowns” I mentioned above? Well, this is where we’ll manage them.
That estimate we made of how much time a project would take us to complete was a floor. It’s the ideal amount of time required — given that the right combination of celestial bodies align, the gods are pleased, you don’t walk under any ladders, break any mirrors, or cross any black cats, and miraculously everything goes as smoothly as possible from the start…
Yep, that has never happened to me either. Nor do I hear of it happening to colleagues. So, until it does begin happening (and proves itself a trend), we’re going to give ourselves some protection for those extra meetings, additional features, delayed design assets, debugging sessions, and everything in between.
Set a range that you will choose a padding factor from. The number you choose will depend on your experience with similar projects, the clarity of the requirements, the reliability of your collaborators, your history with the client, and so on.
Padding Range = 25-50%
So, you’d take your initial estimate and simply multiple by the padding factor you chose from within the range. I’ll leave it to you to decide on rounding up/down.
Name the price that you’ll enter “grind mode” for.
If you do good work, communicate well, and don’t get lazy about networking, all the hours and days you’ve allotted for work will get filled up. Times will come when you have to be disciplined about turning away new contracts, in order to avoid finding yourself overextended.
However, set yourself a “grind factor” — another multiplier that you can tack on to a quote if the client is insistent about getting you involved in the project, doesn’t want to wait for your schedule to open up, and is willing to pay a premium for you to take on the extra load.
Grind Factor = 50%
Note: Don’t throw this option around lightly. It’s important that you stay honest about how much extra “juice” you can squeeze out of yourself, and for how long, without your previously established commitments and personal health suffering.
Looking towards “value-based pricing”
I’ve read some about the power of value-based pricing. Honestly, the sales speak and persuasive voodoo I've seen touted in those articles and email courses left me dubious (if not totally repelled ).
I get it. I see the wisdom and power of the principle. Yes, our time has a limit, and if we stick to quoting based on our time, then so to will we limit our earnings. Additionally, as your skill and efficiency improve, so to will the “value” you bring to a project — and not just in the form of expediency. There are plenty more points to be made for value-based pricing.
I think I’m just not quite there yet. Perhaps, after I improve my precision and confidence at estimations projects and assessing the business value I can guarantee a client would yield from my services.
What I’ve learned writing all of this down
Ok. That’s all folks! At least, for now. Taking the time to think about all this stuff, and try my best to formulate those thoughts into a system that makes sense to me has been highly educational and confidence boosting.
I’ve historically been lazy about considering my business finances. I’ve held a vague notion that it just wasn’t as intellectually interesting as staying focused on building my technical skills and knowledge. But that changed when I started thinking about it as system I could define. I ended up having a lot of fun writing this post!
I’m especially excited to hear what other contractors have to say after reading it. Where can I improve my understanding and methods? How does your approach differ?
You can email me with your feedback, questions, and comments. Or, even better, post them in the Quote in Progress Telegram group. I wouldn’t have began thinking about this stuff if it wasn’t for those folks.
I should also note that, upon the completion of this post, I have yet to implement these new rates and strategies. I truly worked all this out for myself as I wrote this post. The last quote I made was for ~100 hours of work at $85/hour , but I think there is still time for negotiating that to daily/weekly rate.
Maybe I should also add some discussion on the rationale and benefits of quoting for different spans of time. But, for now, I’m just going to put this out there for a while.