Setting Rates for a Firm

Freelancers tend to work on projects that are subcontracted to them by design firms and agencies. Because of this, most freelancers have a single rate and their services are billed on a simple time-and-materials basis. In contrast, design firms tend to work for clients on a fixed-fee basis. This puts pressure on firms to use a very logical process for planning and pricing each project.

To calculate a fixed fee, design firms must first estimate the number of hours that will be involved, then apply a standard hourly rate to get a potential price for the project. Some firms

• A different rate for each staff member
• A different rate for each role on the team
• A different rate for each task
• A multiplier that is applied to base salaries

Here's some information about each one of these methods.

One rate for the entire firm

This calculation starts with an analysis of total payroll and overhead expenses, then moves on to an analysis of chargeable staff hours. Next, a target profit percentage must be determined. Finally, all of these components are put together to determine an hourly rate. It's often called a "blended" rate because the calculation is based on company-wide financial data. It represents a blend of all employee hours, all payroll costs, and all overhead expenses.

In calculating this labor rate, you don't need to worry about project materials-that is to say, special items or outside services that are purchased only for specific client assignments. Instead, these one-time costs should be budgeted project by project. The amount you're charged by the vendor will simply be marked up and invoiced to your client. The hourly rate that you use for labor needs to cover everything else, including your company's full payroll and all of your overhead expenses. These recurring costs must be covered if you're going to stay in business. The challenge is that they don't match up neatly to any single project. That's why they must be built into your hourly rate. This allows you to spread them proportionately across all client work.

Covering your business costs isn't the entire picture, though. If you charge just enough to cover costs, you'll only break even. As a businessperson, you want to do better than just break even-you want to produce a profit. To do this, a base profit margin also needs to be built into your hourly rate. (If you think carefully about profits, you'll realize that some of your annual profits also come from markups on project materials. However, in contrast to advertising agencies, most design firms do not broker large amounts of outside expenses. For the most part, design income is based on staff labor. Your business model is to generate fee billings for the creative services produced by you and your team.)

To calculate a blended rate for a design firm, follow these four steps:

1. Add up all of the expenses that need to be covered for you to stay in business.

Total payroll (both project labor and non-project labor)

+ all overhead expenses
= total costs to be covered

2. Out of the total amount of time covered by salaries, determine how many staff hours are actually available for client projects. For example, the annual salary for a full-time employee covers 2,080 hours (52 weeks x 40 hours). Salaries for five full-time employees would cover a total of 10,400 hours. However, once you've subtracted all non-billable time from the total, chances are that only 60 to 65 percent of the annual schedule is available for client projects. (Billable and non-billable hours for design firms were discussed in greater detail in the earlier article about financial management.)
Total staff hours (number of employees x annual schedule)
- vacation
- sick time
- holidays
- staff meetings
- administrative activities
- new business development
= total chargeable hours
3. Determine a target profit percentage to be built into your hourly rate. For most design firms, the net profit each year (before bonuses and taxes on business income) is in the neighborhood of 10 percent. This is the pre-incentive margin that appears near the end of the company's profit and loss statement. However, for planning purposes, you should not hesitate to be more aggressive about your target profit. Some creative firms are able to achieve a net profit as high as 15 or 20 percent, depending on the type of services being sold and the strength of the firm's reputation.
4. Put all of these components together to determine your hourly rate:
Total costs to be covered
÷ by total chargeable hours
= breakeven rate
+ target profit percentage
= hourly rate to use for project planning purposes

Because your labor expenses and overhead expenses change over time, it's a good idea to recalculate this rate once or twice a year to make sure that it's current.

Again, this is referred to as a blended rate. In the past, most design firms used this approach. The major benefit of using a single rate is that it makes project planning very easy. There's a downside, though. When you get into pricing conversations with corporate clients, it can be very difficult to explain why the same rate is used when interns are making photocopies and when the company's founders are developing global strategies. Although clients will love paying a low rate for the founders, they'll complain bitterly about being overcharged for everyone else.

A different rate for each person

This leads to a different approach. It involves calculating personal billing rates based on the salary level and work schedule of each person involved. The rates must also include a standard overhead factor and a target profit percentage.

To calculate the overhead factor, look at a 12-month profit and loss statement. Compare total payroll expense (both project labor and non-project labor) to overhead expenses. For most design firms, the overhead expenses will be equal to roughly 50 or 60 percent of total payroll expenses. This means that the overhead factor for our rate calculations will be roughly 1.5 or 1.6.

Individual salary

÷ by individual chargeable hours
= payroll per chargeable hour
x overhead factor for company
= breakeven rate
+ target profit percentage for company
= personal billing rate for project planning purposes

A personal rate reflects the skills and experience of each team member. The senior partner on a project will bill at a much higher rate than the junior associate. This approach puts pressure on the design firm to make the most appropriate use of each resource. It also puts pressure on senior staffers to delegate effectively. If they make their own photocopies or mount their own presentation materials, they'll find that they're burning through the project budget much too quickly.

Firms that calculate personal billing rates must take care to protect the confidential payroll information involved. Anyone who knows a person's billing rate and the formula that was used to calculate it can learn the underlying salary. In a firm where salaries vary widely, this can lead to gossip and discontent.

If you're responsible for planning a project and you know for certain which individuals will be involved, you can work up a very accurate estimate using their personal rates. However, if you work in a large firm and you're pitching a big project that won't start until next year, you can't know for certain who will be involved and who will be unavailable. Often, the best you can do is to determine the size of the team and the skill sets required. This leads to another pricing variation, which is to calculate fixed fees using hourly rates for general roles rather than individual people.

A different rate for each role on the team

The size of each project team is determined by the scope of work that must be accomplished. In general though, most projects require the involvement of a creative director, one or more designers, one or more production specialists, and a project manager. In a large firm, there will be several staff members in each of these categories. The standard billing rate used for each role will be an average of all the individuals in that category. This approach still allows you to produce very accurate estimates for projects, and it has the added benefit of protecting the confidentiality of payroll information. For these reasons, many leading firms have adopted hourly rates based on roles. In practice, it leads to a rate structure like the following:

• Principal (for co-owners and executives)
• Senior (for all senior staff members and team leaders)
• Staff (for all mid-level team members)
• Junior (for all entry-level employees and interns)

A different rate for each task

Sometimes, design firms are tempted to set rates based on recurring tasks that are involved in all projects, such as sketching, scanning, time spent in meetings, mounting presentation materials, et cetera. Task rates only work well in small firms where all team members receive roughly the same compensation. In large firms, they become a problem. If highly compensated individuals spend lots of time on tasks that bill at low rates, it will make the project budgets look good, but it will mask a deeper problem. From a business standpoint, highly paid individuals need to generate enough revenue to cover their salaries and justify their positions. There is an opportunity cost to the company every time that senior people stray from their highest and best use. If a high-level resource spends lots of time on low-level tasks, a billing shortfall is being created. When you compare the actual income generated to what could have been generated at senior rates, you'll see the revenue that was lost.

A multiplier that is applied to base salaries

This approach is not as common for design firms, but it's widely used in other professions such as accounting and law. It's based on the assumption that annual labor billings should be a certain multiple of annual labor expenses. For example, if an accounting firm is hiring a CPA, they might agree that he or she can receive an annual salary of $100,000 provided that he or she generates $500,000 in revenue for the firm.

The exact multiplier will vary from company to company, based on the type of service being provided. Here are some typical multipliers used by different professions:

So, how exactly do you use a standard multiplier to calculate a billing rate? Here are two examples:

Staff designer
Annual base salary of $50,000
÷ by target billable hours of 1,664 (80% of 2,080)
= equivalent hourly rate of $30
x industry multiplier of 3.5
= suggested billing rate $105
Company principal
Annual base salary of $150,000
÷ by target billable hours of 1,664 (80% of 2,080)
= equivalent hourly rate of $90
x industry multiplier of 3.5
= suggested billing rate $315

As you see, this can create a wide spread between junior and senior rates. In practice, most firms sculpt things a bit so that the variation in dollar amounts is smaller, but the company itself still achieves the desired multiplier overall:

If you decide to use this approach, be aware that there are variations on the calculation. Some design firms include base salaries plus payroll taxes and benefits. Also, the billable hours for each position are open to discussion. In any event, this is intended to be a quick rule-of-thumb calculation, so it's best to keep it as simple as possible.

Project planning

Once you've calculated a standard hourly rate, you're ready to use it to develop preliminary budgets for projects. A standard rate will allow you to work up a "suggested retail" price based on the number of hours that you believe will be required. However, before you communicate a price to the client, especially in the form of a fixed-fee contract, you need to make an important judgment call. Is this suggested price too high to be competitive on this particular project? If so, how can it be brought down? Conversely, is the suggested price too low to accurately reflect the project's importance? Always adjust your final price to reflect current market conditions and the value of the work to the client, as measured by the impact that it will have on their business.

The ultimate goal for design firms is to determine final prices based on value rather than simply the number of hours involved. However, to make smart pricing decisions, you must first go through a logical planning process. Develop a project planning worksheet, preferably in a spreadsheet program such as Excel. Using a worksheet forces you to clarify assumptions about the size of the team required, the steps that will be involved in producing the work, and what outside purchases will be necessary.

Methodology

One of the most important things about your internal planning worksheet is that it must accurately reflect your creative methodology. It has to be a realistic description of the way you actually work. Think about how you want projects to unfold. What phases, steps, and milestones are the most natural for you? Having a rational work process does not mean that you're ruling out the unexpected-there's still plenty of room for magic. Detailed planning is not a threat to the intuitive insights that emerge from the creative process itself. The goal here is to develop a model that will, in fact, enable you to do your very best work.

Your own creative methodology should be the framework for all planning as well as the outline for the proposal document that you will send eventually to the client (for additional discussion of the client document, see the earlier article about proposals). Many designers follow the example of the multidisciplinary firm Fitch and structure their projects in four consistent phases. A general framework like this can be flexible enough for planning and executing a wide variety of client assignments, from identity design to web development to the creation of new products.

Think carefully about your own preferred phases and steps, then prepare a written description and a visual overview in the form of a diagram or a flow chart. These will be very useful in explaining to clients how their projects will move forward. It's particularly helpful for clients who have never purchased creative services before and don't know what to expect. Many design firms also develop specialized terminology for unique project components or milestones. Presenting a compelling description of your process is a very powerful way to differentiate yourself from your competitors.

The underlying message of all this to a new client is that you're an expert. By giving their project to an expert instead of the lowest bidder, they will gain a much higher probability of success. Your process is a distillation of years of experience. You've been down this road before and you understand the critical issues. By emphasizing creative methodology, you also make it clear that design is, first and foremost, a problem-solving process. It's a highly customized professional service that is idea-driven and focused on innovation. For these reasons, pricing must reflect the process being employed. This counters the misconception held by some clients that design is a commodity buy, like placing an order with a service bureau. Many leading creative firms work on strategic projects that do not produce traditional types of design deliverables. Unit pricing based on the size or quantity of output does not match the consultative nature of the work being done in the profession today.