How To Set The Right Hourly Rate As a Freelancer

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Methods of Billing

While an hourly rate is not the only way to charge, you still have to know your numbers. After all, you’re providing the service personally and there are only so many hours you’re able to dedicate in a day. Even if you go with fixed-price projects, your effective rate should not fall below your regular hourly rate. Otherwise, you’ll make more money by billing hourly.

Value-based pricing is difficult in the beginning until you build up your brand and are known to solve a specific problem that has a computable cost or gain associated with it. You evaluate the risk you’re assuming and price the work at a percentage of the cost or gain. Business people expect returns on their investment and they know the riskier the bet, the less they’re willing to pay. The safer it is, the less they’re expecting to earn.

Most clients want to reduce risk, so they’re willing to pay extra.

I could write a whole book on value-based pricing, so we'll leave that for another post. For now, we want to understand what numbers can sustain your one-person business.

As a side note, we’re not taking into account any potential educational and software products you could leverage to earn even more income. Rather, we’re focusing only on the exchange of services. This is where everything starts, but doesn’t need to be where it ends.

Freelance Hourly Rate

Alright, let's calculate the equivalent hourly rate for the Senior Software Engineer from our example. We'll assume a $150,000 gross annual pay (before personal income taxes) to keep things simple. How much is it per hour?

If you took 40 hours per week and multiplied by 48 weeks to find the total amount of hours worked for the salary, then you’re right since you don’t spend all 52 weeks in a year (vacation, holidays, and sick days). Dividing by the number of hours, we get $78.125/h.

This isn't the final hourly rate because if you stopped here, you’ll be going out of business very soon. You can almost forget about billing the full 40 hours unless you’re ready to dedicate extra for business work that doesn’t earn you money.

At a full-time job, you work 40 hours a week, and after that, you can fully disconnect and focus on something else.

As a freelancer, by following the same pattern, you'll only bill a maximum of 75% of those hours and you need to make the same money as if you worked 40 hours at your job, so this alone increases your rate to $104.17/h (take $78.125 and divide by 0.75).

However, we're just getting started.

Just because you're running a business, you have additional expenses. Without going into specific taxes at a regional level, United States has Medicare and Social Security that are usually split with the employer. As self-employed, you have to cover both sides.

Medicare tax is 1.45% each and Social Security is 6.2% each, so you’re liable for the amount that your employer would normally pay. Though as a business, you're also able to deduct business expenses from your earnings, which will lower your tax bill, so let's just use a round 7% on top of the $150,000 that you need to bill in a year.

If your country or region has extra costs like this that are % of earnings (such as unemployment taxes), make sure you add them, too. It's best to consult with an accountant to make this calculation correctly.

Speaking of, you now need help from an accountant to either do your books or help you with tax filings. If you’re making a good amount of money, I would highly encourage you to delegate this work to someone else who knows what they’re doing. IRS penalties are quite hefty and audits take time to complete, which you'll need to cover out of pocket.

This puts the yearly billable income at $179,500 ($10,500 for Medicare and Social Security + up to $9,000 for unemployment taxes + up to $10,000 for accounting and compliance work).

Next up are the hidden benefits that you’re receiving from your employer: health insurance, retirement account matching, food and amenities at the office, but also office expenses. You now have to cover all of that on your own.

This could easily add up to an additional $15,000 every year, which puts our gross equivalent income at around $195,000. Dividing this by the number of available billable hours gives us $135.42/h.

In other words, our Senior Software Engineer needs to charge $135.42/h as a freelancer to earn the equivalent of a $150,000 annual salary. If we had stopped at only adjusting for the difference in billable hours, our engineer would have ended up charging only $104.17/h, which is 23% less, meaning a pretty big pay cut that would have popped out of nowhere without even realizing it until the end of the year.

Going through this calculation once helps us come up with a coefficient to calculate the other hourly rates easier (staying afloat and future target). In this example, we end up adding 73.34% on top of the employee hourly rate (EHR = $78.125) to get the right freelance hourly rate (FHR = $135.42). This is the formula we’re going to use:

• FHR = EHR * 1.7334 (multiplier to cover additional expenses and taxes).

• EHR = Annual Salary / Work Hours Per Year

• Work Hours Per Year = 48 weeks/year * 40 hours/week (1,920 hours/year)

Now that we have an easy way to calculate the freelance hourly rate, you just replace your annual salary and you’ll end up with your number.

This is how you calculate your hourly rate net of processing or platform fees, but since you'll bill through Upwork or Stripe, they take a cut from the top (let's use 10% by Upwork), so your FHR is the 90% leftover amount. Dividing by 0.9, it goes up to $150.47/h, which the employee in our example can just round down to $150/h flat.

This rate billed at 30 hours every week will ensure that after all business expenses, you end up with the $150,000 salary.

Even if you billed outside of Upwork, I would still recommend to keep $150/h because you can use the 10% (minus payment processing fees) for a Payment Protection Fund (think of it as a guarantee in case a client disappears without paying or a chargeback; this happened to me in the past).

Staying Afloat Figure

Now what will your “stay afloat” number look like? This is quite easy:

• Calculate your yearly overhead (all recurring expenses either per month or per year, but make sure they're annualized): let’s say you did that and they add up to $36,000/year

• Calculate your variable expenses: we’ll assume they add up to $24,000/year

• Calculate the income taxes you have to pay: assuming 30%, so $25,700/year

In other words, your "stay afloat" salary is $85,700, which is $44.64/h and your FHR is $77.37. Taking into account the Upwork fee (or Payment Protection fund), this pushes it up to $85.97/h, so a nice, round $86/h.

So if this was my bottom line, I would stay afloat as long as I charge the minimum or I will turn a good profit if I charge anything more than that.

If your “stay afloat“ rate is higher than the equivalent for your full-time job, then there’s definitely something wrong and you need to fix that first.

Future Goals

The next calculation is for your future target, your goal. You can either take your hourly rate and multiply it by a coefficient you want (maybe you want to double it, in which case the calculation is easy), or you can start by describing your ideal monthly expenses on a day-to-day basis and then come up with the hourly rate based on that.

Let’s look at a quick example:

• Overhead: $120,000/year

• Variable expenses: $80,000/year

• Taxes: $86,000/year

Annual salary is $286,000/year, so $148.96/h. The FHR is $258.20, so you’d need to charge $287/h to include your Payment Protection Fund. At this point, I don’t think anyone would mind if you rounded it up to $300/h.

Funny enough, I average between $200 and $300 an hour right now, which seemed impossible only a few years back.

That’s all for today. See you next week!