The Psychology of Charging Clients by the Hour

*This post has been resurrected from my orphaned blog rulesoptional.com. It was written for entrepreneurs, but there are some important insights in here for business in general.

If your workspace is rectangular in any way, you are a failure. We’re all friends here so let’s just be brutally honest. Ninety degree angles are feng shui code for a life devoid of all happiness. Parallel surfaces are a direct path to a devastating erosion of the soul. We hold these truths to be self-evident. Duh. We design our lifestyles to our complete satisfaction and shun dependence upon the pedestrian geographical constraints observed by lesser mortals.

I call shenanigans. That’s right… Shenanigans! Cubicles are not the enemy. Offices are not the enemy. Commutes are an enemy, but not The Enemy. Trading away the hours of your life for linearly related remuneration is the enemy. If you’re working by the hour, you’re limiting yourself. This post is about shifting from hourly billing to a value based approach. If you’re already convinced that hourly billing is evil stupid, feel free to skip down to the heading with the asterisk.

The rest of this post is for entrepreneurs and related variations. If you’re an employee, the concepts don’t directly apply unless you’re willing to essentially create your own position within an existing organization. That’s definitely possible, and I encourage it, but this post isn’t tailored specifically for that purpose.

The good news is that for once, changing everything is merely a matter of making a decision. By the end of this, you’ll have everything you need to increase (perhaps exponentially) your income and profit without changing anything but your mindset. Don’t let the fact that it’s free and easy prevent you from doing it. In fact, if that’s a problem for you, let me know and I’ll send you a bill. Also, if you’re not making any money, multiplying zero will yield you an improvement of zero. However, it’s not necessarily even that harsh; you may be able to get jobs that you wouldn’t have previously by shifting your thinking as recommended herein.

Despite everything, some of you won’t be convinced. That’s society messing with your head. Stop it. First, a few words for those who need more than proclamation…

The Freelance / Contractor Problem

First of all, as I’ve written before, stop calling yourself a freelancer or contractor. Freelance is a concept, not a title. What’s worse, the concept is fatally flawed. I don’t think ‘contractor’ is different enough to talk about the distinction.

The thrust of this post is to get you to stop thinking like a freelancer and start thinking like a business. ‘Freelance’ implies that you are an employee without a job. We can argue whether or not that’s fair, but you’re going to have to buy me drinks first. Fairness doesn’t matter anyway. Freelancers generally act as if they are employees without jobs. Working by the hour is the structural foundation.

This is a good time to invoke Marshall McLuhan. Question: If “the medium is the message”, what message does the freelance medium convey? Answer: It conveys the practitioner willingly submits to act as a subservient wage-slave. Further, it communicates this externally to the client and imprints it in the mind of the practitioner. Freelancing as an “extension of man” in this case only extends the limits placed upon employees to non-employees. That’s a dirty trick if I’ve ever seen one.

I really can’t think of anything good to say about freelancing. The standard claim is that you get to be your own boss. It actually means that you get a new boss on every project. An underlying concept here is that you need to think like an advisor who’s hired because someone else needs you. While this may not seem financially accurate, you need to absolutely convince yourself that you do not need them. That’s an issue that could fill volumes alone, but it really does inform the rest of what I’m talking about from a more psychological, less practical, level.

For employees aspiring to upgrade to something more, the promise of freelancing is merely the promise of more of the same, but with more administrative paperwork. That’s hardly an improvement, I’d recommend skipping it if at all possible.

The Plague: The Bass-Ackwards Fee Calculation

For an example of exactly what NOT to do, you can check out the Hourly Rate Calculator by FREELANCE SWITCH. It’s seductively efficient in that it figures out the hourly rate you should charge by adding your estimated expenses to the profit you want to make for the year and dividing that by the amount of available hours. Yes, it’s ridiculously useful for the purpose it was designed. Unfortunately, industrial age thinking shouldn’t form the basis of software any of us use. This end-around calculation strategy is horrible for a few reasons:

• Ignores the market pressures of available work and competition.
• Estimations are problematic at best. This applies to hours and expenses.
• Unexpected expenses are impossible to plan for by definition. This strategy results in an unexpected expenses cutting directly into a preset profit margin.
• Blocking out time a full year in advance assumes a magical balance between multiple clients’ deadlines, project timelines, overages, illnesses, et cetera to achieve the desired level of hours. Good luck with that!
• Planning to operate at high levels of time utilization results in a complete elimination of schedule flexibility. Have you ever tried to defragment your hard drive when it’s full? The blocks don’t have anywhere to go. And it’s worse with a time schedule because you can’t use empty blocks in the past.
• LIMITS PROFIT POTENTIAL! Way to go business wiz! Even if everything goes exactly according to plan, this pricing strategy results in the plan being the best case scenario. The numbers can get worse for any number of reasons, but they can’t get better… unless you invent more time or increase rates with new clients to make up for past shortcomings. For those familiar with trading or gambling psychology, you may recognize this from a related cognitive bias or two. In short, humans instinctively gravitate toward this strategy despite its inferior performance in the long run.
• Along with the main theme of everything in this post, it creates an inherent disconnect between value to the client and the calculated rate.

The Medieval Surgery Tactic that Actually Kills

Time-Tracking Software. Remember how one of the worst things about having a job is having a manager? Remember that the worst kinds of managers are micromanagers?

Well, for a monthly fee, you can purchase software that allows you to micromanage yourself! What a deal! Okay, maybe you can even get this service for free. Lucky you.

The Immorality of Billing by the Hour

Let’s just make this simple… Billing by the hour is a conflict of interest. It is in the client’s best interest to get as much value as possible for the money they spend. It is in our best interest to maximize profit for the work we perform. Billing by the hour constructs a de facto barrier between price, value, and profit.

The only way to increase the client’s value in this system would be a qualitative measure of the work performed within each hour. Since an hour is quantitative by definition, its use for this purpose is patently absurd.

pros⋅ti⋅tute
[pros-ti-toot, -tyoot] noun, verb, -tut⋅ed, -tut⋅ing.
–noun

1. a woman who engages in sexual intercourse for money; whore; harlot.
2. man who engages in sexual acts for money.
3. a person who willingly uses his or her talent or ability in a base and unworthy way, usually for money.

The only way for us to increase our profit margin is to decrease the qualitative input per hour. The only way to increase nominal profit is to increase the number of hours billed. Even if these billed hours are billed honestly, there is incentive to find, discover, or invent tasks that are of relatively low value. It is easy to rationalize them as providing some benefit to the client or the project, but each hour does not yield the same value as the pricing structure would indicate.

Examples

• Scope Creep – Expanding the goals of the project
• Feature Creep – Expanding the features needed to achieve the goals
• Slow-playing (intentional or unintentional) – Working at different intensities during different periods of time.
• Estimation – Is 7.5 hours billed as 8? Is 1 hour and 15 minutes billed as 1.5 hours? We could play the infinite reduction game forever, but at some point there’s a breaking point between accuracy and the absurdity of tracking smaller increments.

Even if you manage to convince yourself that every billed hour is completely justified (the psychological biases are too strong for you to even bother trying to convince me) , you’re not doing yourself any favors. You’re compromising yourself on a more basic level. You’re imposing stultifying time regulations on yourself. We have a term for this… masochism.

The key to the above definition for a prostitute is “in a base and unworthy way“. I suppose that an inherent conflict of interest qualifies billing by the hour as “base”. I’ll let you decide whether it’s “unworthy” as well.

The Myth of Industry Standard

This construct is the reason I felt the need to write this article. I get it. Most industries do have “industry standard” practices and billing practices are almost always part of this. Some clients are used to dealing with certain industries in certain ways.

One thing to keep in mind is that resistance along these lines is often an issue with a human resource department, billing department, or accounting department. It is very important to understand that these departments only exist to support the core business. It is easy for people inside organizations to lose this perspective. If you are working on anything related to the core business, it will be possible for them to adapt. If you run into an absolute wall of inflexible resistance, I would make the educated guess that you shouldn’t be working with that particular organization.
The more important consideration is that the industry standard rules are the rules the average players play by. The elite recognize their own value and communicate that value. This relates back to the mental distinction between freelancer types and businesses. The inability to become exceptional while following industry standard practices involving hourly billing will become clearer when we discuss the math of things.

The Math Is Simple and It’s Bad

For capitalism to function, the person holding the cash must be able to answer the following question: Is the value of the service greater than or equal to the purchase price? Any reasonable expectation of creating maximum value for both parties requires an easy path to this question’s answer. The variables become too abstract for clients when hours enter into the equation. I promise that this abstraction lowers your profit potential… and that is in the best case. In the worst case, you will simply lose deals. The rub: often the others offered to do the same thing you would have done for a lot more money.

The moment you willingly participate in any conversation about hourly rates, you have lost. As soon as a client hears an hourly number, their mind immediately shifts to the hourly rates of things they’re familiar with. If their first job out of college paid them $11/hour, bias creeps in. If they pay their attorney $150/hour bias creeps in. This relative quantification is a death knell. It ranks you in relative position to everyone they’ve dealt with on an hourly basis. There is no way to predictably win this game. Perhaps you provide a lower number than your competitors. Sure, maybe you’ll seem like a better relative deal, but it’s more likely that you’ll seem low quality. Perhaps you’ll provide a higher number than your competitors. Sure, you’ll avoid the low quality perception, but it’s more likely that you’ll seem overpriced.

“Wait a second Andrew? How can you suggest that I’ll lose if I price something lower than everyone AND higher than everyone? Is there a Goldilocks sweet spot that you’re going to talk about next?”

Nope. It’s not a mistake. There is no way to predictably win this game. The game is rigged. The game is rigged because there is a disconnect when you try to answer the fundamental question of capitalism using the abstract representation of hours as value. It’s a lose-lose proposition. Good luck with that!

It’s simple math; With rates based on hours, the only way to increase income and profit is to work more hours. Since the number of hours at your disposal is limited, your income and profit are limited.

My final note on the math may be its most damning. Billing by the hour guarantees that money will be left on the table in every project (that’s honestly estimated/billed). Because of the capitalist question discussed above, any acceptance based on an hourly abstraction would have been more powerful if the discussion was conducted in pure cost and value terms.

To be fair, there is one exception… If your hourly rate is higher than the value you’re capable of delivering. But if that’s the case, well…

Friction Points and Temptations to Avoid

There are a few exceptions that I don’t want to dwell on in this post, but are worth mentioning and discussing.

What About My Employees? The entire economic system declines rapidly if employees are removed from the mix. There are compelling and valid reasons to be an employee. Short-term risk exposure is one thing that comes to mind. The unrecognized genius of employees is that they have effectively outsourced management. This has negatives as well, but it’s actually kind of brilliant. It’s definitely a good strategy for some.

Supply and Demand. I mentioned this briefly before, but I think it needs to be highlighted again. Hourly pricing strategies are generally biased to discount the importance of supply and demand in relation to the market and competition.

When you’re creating a demand, there is no curve. The reversal to the previous point is that creating and/or demonstrating a need in a company negates the need to pay attention to supply and demand.

“Am I getting billed for this”? When billing by the hour, clients are forced to make a cost-benefit analysis every time they think about you. In a sense, it’s very prostitute-esque. This results in potential work getting delayed or ignored because you never get a chance to intervene in the sales process happening in their brain. This may sound insignificant, but it’s devastatingly powerful and will impact your business.

Pricing by project. Another way to think about this might be when the practitioner makes an estimate of time a project will take, does a bunch of calculations, and slaps a price tag on it. This may be pitched to the client along with a list of deliverables. It’s then generally understood that the work will be done for a fixed price with the practitioner taking on risks of overages. This is essentially an hourly billing scenario masquerading as something else with the added negative of increased risk exposure. Pricing by project itself isn’t a bad concept, but the figure should be calculated with the methods below rather than the time-based methods discussed above.

The outsourcing loophole. Whether we’re talking about outsourcing piecework to the design office next door, or a programmer on the other side of the planet, this can break down when dealing with anyone you’re hiring (including employees). There are a lot of reasons for this, but one of the main ones is that more up-front investment is required to execute the methods below. This results in an efficiency nightmare that increases geometrically as the project or job in question gets smaller. I’m sure you can imagine this so I’m not going to flesh it all out now.

*The Required Paradigm Shift

While this is most directly applicable to things like web development companies, consultants, and designers… it has far-reaching implications. The same approach can be adapted to products and services.. even prepackaged services.

So far, I’ve basically been discussing the negatives in terms of time. Now I’m going to switch things up on you without a ton of explanation and hope you stick with me. We’re not really talking about time and billing by the hours. What we’re really talking about is the relationship between inputs and outputs. Time is simply the most obvious input to discuss.

Here is the paradigm shift (in terms of pricing): Disconnect all relationships between inputs and outputs in your mind. From this moment forward, only think about inputs.

This is important, so let me rephrase it another zillion ways…

• Inputs are not related to outputs.
• The amount of work you perform has absolutely no bearing on its value.
• How hard you work has no relationship to output value.
• How long you work has no relationship to value.
• Output is the only thing that has value.
• Value is easy to put a price tag on.

(Things like “rush jobs” are in a different category. Artificially compressed timeframes with serious deadlines imply an increased value to the client. Mandated speed is different than nominal hours.)

Any attempt to pass input costs to clients is arrogance. Reverse calculating your rates based on your wants is a de facto personal charge passed along to the client. Your needs are important, but they are only important to you, and are not connected to the value you deliver in any way. I hope I make myself clear on this point. It should never be ignored that your success should be important to your clients. If they don’t want you to win, don’t work with them or fire them.

The reversal to the preceding paragraph is that if you charge based on value, your margin should be high enough that wants and needs never comes into question… and that is the ultimate point.

Clarification: Inputs such as raw materials and hired labor may be billed directly to clients, but this is a separate conversation completely.

Back to the Question of Capitalism

As I said above, this is the important question to answer: Is the value of the service greater than or equal to the purchase price? Any reasonable expectation of creating maximum value for both parties requires an easy path to this question’s answer.

Here is the actionable principle in its simplest form: Once you determine the value of something you’re offering, the only question is the balance between what the client is willing to pay and what you are willing to accept to deliver that value.

Example: If the value (to the client) of a marketing initiative is agreed to be $500,000 over 2 years, what is the dollar figure agreeable to both parties for you to deliver that value? The only real question is what that number is between 0 and 500,000. If you agree to $100,000, there are questions of terms, interest, et cetera. However, these are more math and budget questions than conceptual questions.

If you can reliably deliver the client $500,000 worth of value, they will not begrudge you for making $2,731 per hour after the fact. For one thing, you no longer talk about inputs, so it shouldn’t even come up.

On the other hand, go to a client and attempt to negotiate a contract for $2,731 per hour. I dare you! Please… By all means… Film it and share! First, try to do this with a straight face. If you do, you will be the only one in the room not laughing. Deadlines notwithstanding, clients DO NOT CARE how much time it takes you to complete a project, but they get weird when talking about hourly rates… especially when they’re large (the rates, not the clients). It’s not logical, it just is. This doesn’t seem to change a whole lot between average folks and mult-millionaires. I haven’t had the conversation with any billionaires… yet.

Loose Ends and a Note for the Aspiring Rockstars

Answering the question of value is not always easy. It varies widely by industry and market. There isn’t a shortcut to solving for X in this case. It will likely take some level of expertise in your field. In lieu of expertise, there’s always research.

I will admit that implementing these things requires a degree of confidence. Often, confidence comes easily with examples. In this case, it might help to think about all of those sensational celebrity news stories that talk about how much Oprah and Bill Gates make per hour. Those numbers are in no way connected to quantitative inputs in comparison to coal miners or deep sea fisherman. Oprah and Bill Gates get paid on the value they deliver.

For an dose of validation directed at consulting specifically, Value-Based Fees by Alan Weissis a great resource. It greatly clarified my thinking on the topic and informs much of what I’ve written here.

Aspiring Rockstars! If you’re charging by the hour, you have no idea what it’s like to be a rockstar. Act like a rockstar, not a barista who happens to also be in a band.

Requirements

As I mentioned way back up at the top, the requirements for this are very small. You have to take the paradigm shift seriously, then you have to apply it. If you do, Congratulations! You are thinking like a business, not an employee.