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Calculating Your Internal Hourly Rate

The difference between a business and a hobby is that a business is set up to earn money. If you aren’t earning a profit, however small, then you do not have a business, you have an expensive hobby. Which is not necessarily a bad thing! Hobbies are great. But if you want to run a business, you need to be making a profit. Remember that profit is what you bring in minus what you spend to run your business and do the work.

Many business owners pull their prices out of thin air, based on what their competitors are charging or what “feels” right at the moment. (This usually translates to, “Whatever price I think will get me the project.”) But not you. You are going to start with numbers: Your living expenses, cost of doing business, and goals for how much you want to profit. I know, I know, numbers aren’t super sexy. But they're also not prone to change based on your feelings, mood, self-esteem, or other subjective things.

So the first thing we’re going to do is calculate your internal hourly rate. The internal hourly rate is how much you need to land in your business bank account for you to make as much money as you want to make. The internal hourly rate is what you are making per hour after taxes, expenses, time spent on admin and marketing work, etc. You can think about your internal hourly rate as what you need to be bringing in to make it worth your time to not go work somewhere else.

This isn’t a quick activity. It’s at least an afternoon's worth of work to go through, assuming you’ve tracked these expenses for a while. If you need to, go through and pull as many bills and receipts from the last 3-6 months now and at least make a ballpark estimate. Then make a plan to track more carefully and revisit next quarter. I promise it is totally worth it to feel confident that you are (or will be) making enough money.

Start by listing your monthly cost of doing business. These are your regular, recurring general business expenses that are not associated with a specific project. (Those should be billed to the client based on each project.) If you pay something once a year, then just divide that up into 12 and use the amount for your monthly cost of doing business. If it's a little different from month to month – take an average. If you're not tracking these expenses, you need to be! I know it's not fun or glamorous, but you've got to take the guesswork out of your business finances. You may find when you start actually tracking these numbers that you’re not bringing in very much money.

Some costs of doing business items might include the cost of renting a studio or office, any software or materials you use to actually create your work, website hosting and domain costs, accounting software, business registration fees, insurance, and general marketing and promotion.

If you are in the first 1-3 years of doing business, you likely will not have something in all of these categories, but as soon as you add a recurring expense, write it down and revisit your internal rate calculations at least once a year.

If your goal is to leave your day job and earn a full-time living from your business (whatever that means for you), you must figure out your monthly cost of living to determine how much you need to charge for your work. Even if your business provides partial or discretionary income, you need to know how much to bring in. Cost of living includes things like rent or mortgage, transportation, groceries, food, entertainment, fitness, all those different things. Again, for annual or semi-annual expenses figure out what the monthly portion is, and take an average for irregular expenses. Track! All! These! Numbers!

Decide how much of your cost of living you want to pay for through your business. Some people want to pay for everything. Others may have a partner or parent who can provide insurance and additional income so they don't have to earn quite as much from their freelancing. Maybe this is a side gig for you and you just want to make some extra money to pay down your student loans or save up for a vacation.

Take your cost of doing business and add it to the part of your cost of living that you want to pay for with your business. This is your target monthly income.

Next, decide, or at least estimate, how many hours you want to work per month, which is going to be a personal choice. Again, for some people, this is going to be their full-time job, so they're going to work 30 to 40 hours a week, which is 120-160 hours per month. Others may want to fit it in around school or family responsibilities, or you just want to spend less time working, which I completely support!

Finally, take your total target monthly income and divide it by the number of hours you want to work per month. And that is your internal hourly rate.

As the name suggests, this is an internal rate, not what you actually charge your clients. If you use your internal hourly rate with clients, you will have an ugly surprise at the end of the year (or month) when you’re making half as much (or less) per hour worked as you thought you were. To find out why to keep listening…