You have your business idea, you are excited to get started, now, the tricky question: how much to charge per hour for your services? Let’s explore some pricing models for service businesses. A service-oriented business is one in which you are primarily selling time as opposed to products. Typical service businesses are tutoring, landscaping, painting, bookkeeping, etc.

Let’s first take a look at a pricing model where we don’t have any specific expenses associated with each particular job:

Breaking this down, first we need to determine what is your desired pre-tax annual income (profit) for your business. For the purposes of our example, let’s take $60,000. Next, we need to add the business’ fixed annual expenses, i.e. software subscriptions, bank fees, rent, tools, etc. Let’s say that those come out to $2,000 per year. We can continue by figuring out how many hours you anticipate to work in the year. For our purposes let’s say 30 hours a week for 48 weeks during the year. Putting this all together we get:

Now, you may be wondering where the two times multiple comes in. This multiple accounts for the hours which you work but cannot bill. For example, you have billing, marketing, client development, travel, collections, and many other tasks which are essential to the success of your business, but for which you cannot bill clients for your time. This model considers that you will only be able to bill (and collect) half the hours you devote your business which is a fair estimate.

This model works just as well if your business is a side hustle to which you can only devote a small number of hours per week. Just adjust everything to take into account your limited numbers of hours and desired income based on those hours. That being said, if your business is a side hustle, a good rule of thumb is that your targeted hourly rate (pre-expenses) should be at least three times that which you are receiving at your day job. This means that your effective our hourly rate (the rate for all your hours worked, not only those which you bill) is 1.5 times your day job’s hourly rate. Having this type of multiple is important as it will incentivize you to put in the extra time to your business when it requires it.

In addition to the general hourly rate pricing model, some businesses have job-specific expenses which could be substantial. For example, if you are painting houses, you likely need to buy paint and brushes for each job. With respect to those job-specific variable expenses, there are two main approaches: you charge the expenses directly to your client with a markup or you integrate the expenses into your hourly rate.

The greater the variability of the job-specific expenses and the greater the involvement of your client in the selection of the items to be expensed, i.e. the specific paint purchased or the grass seed to be planted, the more you are incentivized to adopt and expenses-added model over an integrated hourly rate.

With respect to the expenses-added model, it is very important to add a markup on those expenses. Such markup covers your time to choose and acquire the items which are being expensed as well as the fact that you may be fronting the money. Typical expense-added markups range between 15% and 25%. When in doubt, start with a 25% mark-up.

Be extremely cautious fronting costs and expenses for your clients as this exposes yourself to actually losing money on jobs if your clients don’t pay you. A good way to deal with this risk is to request a non-refundable deposit before starting the job which covers at least the job’s specific expenses and ideally 25% of the hours going into the project. As mentioned in Money, Money, Money: Managing your Business’ Accounts Receivable, it is a serious red flag if your client is not prepared to give you a deposit as this is often indicative of a future collection problem.

With respect to the expenses-included hourly rate, take the time to accurately estimate your job-specific expenses and be conservative in this regard.

Here is a simple model for a job specific hourly rate factoring in the expenses associated with a specific job:

For example, let’s assume that a painter requires $200 of paint and $20 of brushes for a 20-hour job. Using our general hourly rate that we calculated above ($86.11/h), we get:

This formula has an implicit markup of 100% on the estimated variable expenses. The reason why this markup is considerably higher than the one I recommended in the expenses-added model is that you have the additional variables of needing to estimate the number of billed hours as well as the actual job-specific expenses. The more you are estimating, the more you are incentivized to insure against underestimates, hence the higher markup rate .

Naturally, with the expenses-included hourly rate, you will likely have a different hourly rate for each job to its specific expenses. That being said, if your goal is to have a consistent hourly rate for all of your jobs, either use the expenses-added model or the general hourly rate and factor in all of your anticipated job-specific expenses for the year in the “fixed business expenses” category.

The last point to discuss is fixed-priced contracts. In order to determine your price for a fixed-price contract, simply estimate the number of billable hours on the project, the job-specific expenses, and then add a contingency fee of 25% to factor in the additional time and materials required. This gives us the following formula:

Coming back to our painter example, for the anticipated 20-hour job, we get the following:

Now, having gone through this whole exercise of calculating your hourly rate, you need to determine the rates which your competitors charge to render a similar service. Although not determinative, if your competitors are charging a higher rate than what you calculated, you can likely charge more than your calculated rate.

On the other hand, if your competitors are charging a lower hourly rate than your calculated rate, you are now setting yourself up for a challenge by charging your calculated rate. Naturally, you could lower your hourly rate, but this will impact your earning potential from your business. That being said, if the market requires that you significantly reduce your hourly rate, take the time to assess the viability of your business at the lower rate. If you are uncomfortable lowering your hourly rate so much, consider another angle to the business to justify a higher hourly rate. Otherwise, reassess whether you want to be operating that business or whether you just want to keep it as a hobby. Because, at some point, if you are not charging a significant enough hourly rate, just won’t be prepared to keep on working for your business anymore. Best of luck!