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Ask The Experts: Consultants

Q: I have reviewed several resources regarding how a consultant typically sets rates. There are many variables to consider, including factoring in “down time” and determining profit levels. What guidance can you provide about setting consulting fees?

 
A:  Your question is a very good one and can be very difficult to answer since there are so many variables. Just like big businesses, the rates your charge for your products and services should be structured to cover all of your related business costs as well as an amount expected to compensate you, individually, for your time and effort. The corporate environment typically includes a “profit” factor in the development of their pricing strategy designed to compensate owners or shareholders for their investment in the enterprise in addition to the compensation for key employees. For the small business owner, the “profit” factor may already be included in that amount deemed as compensation or earnings for the specific owner.

Perhaps the most direct method to determining the rates you should charge for the services you provide is to estimate similar compensation that you might receive or have received in providing those same services as an employee. An apples-to-apples comparison must include both tangible and intangible benefits of operating as an independent contractor and as an employee. The intangible benefits of operating your own business include flexibility, autonomy, and a certain sense of control that is very important to many small business owners. The benefits of providing your services as an employee include some level of certainty, access to other resources, and some benefits such as vacation time, health insurance, etc., that may not be available to you as a sole proprietor.

Many of those benefits are indeed intangible, and therefore it can be difficult to apply a cost or price tag to those items, while other can be quantified. Vacation time for most employees can be 2-3 weeks paid time per year which represents about 5 percent of annual compensation. Health insurance benefits vary widely but can represent another 5-10 percent of annual compensation. Adding other benefits such as sick time, travel benefits, cell phone costs, and so forth can add another 5 percent of compensation for many employees. The comparison can vary widely but benefits such as those mentioned here can represent 15- 25 percent of compensation, per year.

A specific tangible cost that should always be considered is the effect of self-employment tax that will be incurred on all net earnings from self-employment. From a technical standpoint, the self-employment tax is the equivalent of FICA and Medicare tax that is paid on wages by both the employee and the employer. The key difference for our discussion is that the employee must pay 7.65 percent of wages for these taxes with the employer paying a matching 7.65 percent. The self-employed business owner, however, must pay both halves of this tax – a full 15.3 percent of net earnings – from self-employment. The additional 7.65 percent represents an additional cost to the small business owner and certainly should be considered in setting your rates.

Combining each of the above, a reasonable average to consider is a 20-30 percent “markup” or difference in rates when comparing an employee position to that of an independent contractor. For example, an employee providing services at an hourly rate of say, $50 per hour, might consider an hourly rate of $60 to $65 to provide an apples-to-apples comparison. Keep in mind that there are many other intangible costs that could be considered and ultimately, the market will dictate what you can charge for the services you provide, so the best advice would be to evaluate your specific situation, your clients, and your competition and then spend a bit of time to do the math to make sure the rates your charge will meet both your needs and the needs of your clients.