I’ve been self-employed for most of my career. Sometimes I talk to other people who are interested in leaving a full-time job to do some kind of contracting or service business. By far, the most common newbie mistake that we all seem to make is in pricing ourselves.

Take this useful blog post that breaks down employee income vs freelancer income in the US. It estimates that you need $140k revenue as a freelancer in the US to have the equivalent of $100k employee compensation. I remember finding calculations like that really useful when I first started a business. However, some people will look at the result and think, “Gee, I have to make 1.4x as much if I’m self employed. Can I really do that?”

No, no, no. That thinking is backwards.

How to price yourself

Let’s make up an example. Suppose you’re a full-time-employed software engineer grossing that $100k p.a., and you’re thinking of switching to contracting.

When you’re self-employed, you have to think like a business because that’s literally how you’re making your living. So you have to add up all your costs and figure out how you’re going to recover them. Spreadsheets get a bad rap (for some good reasons), but they’re actually really useful for this stuff (and a lot of other calculations you’ll do as a business owner).

The first cost to add to the tally is that $100k. If that sounds weird, it’s what’s called “opportunity cost”. You could have made $100k by staying employed; not making that is effectively a cost you have to justify when planning your business. Mark that cost down, along with any other employment benefits you actually use. If your employer offers on-site lunches, add what it costs you to get lunch each workday of the year. If your employer offers employee discounts on its fitness software, but you don’t use that software anyway, don’t add that benefit as an opportunity cost.

Other costs depend on what you’re doing and where you live. Employee-provided health insurance isn’t as big a thing in Australia as in the US. On the other hand, compulsory superannuation payments (similar to the US 401(k)) are a big deal. I have my own company, and my major non-salary costs are insurance, accounting/filing, legal (for contract reviews, etc.), debt collection and various online service costs. If you’re counting something durable (like a desk) divide the cost by the estimated number of years you expect to use the thing.

Anyway, so far this is basically what was in Caleb’s blog post, so to keep things simple, I’ll assume the same $100k nominal salary and $140k equivalent business cost. (Scale everything to match your own circumstances, of course.) Now you need to figure out how to recover that cost. There are about 255 Australian working days in a year, so if you could contract them all out, you’d charge $550 a day (plus sales tax). In reality, you won’t be able to bill the entire year. I’ve taken a higher-risk approach and averaged about 60-70% in the past 6 years of my current stint of self employment. Accenture’s annual financial reports say they get about 90% “utilization” from their contractors, which I assume means they bill 90% of the total workdays. Let’s assume you’re moderate and bill 75% of work days. That means you recover $140k of costs in 75% of 255 days (or 191 days) by billing about $730 a day (plus sales tax).

The mistake

People new to contracting often react to numbers like that and think, “WTF?! That’s huge!” That’s just one example calculation, but it’s normal for service prices to be around double or more what you might naïvely guess from equivalent full-time employee rates. However, that day rate came from a simple calculation of how much you need to charge to get the equivalent of a $100k salary. It’s the same thing. Thinking otherwise is the critical mistake.

New contractors are often still unsure. Won’t they sound greedy asking for that much? If your clients have any clue, they’re doing pretty much the same calculation. “I could pay Gentle Blog Reader $730 a day for just as long as I want, or I could pay ~$140k for a full-timer who I won’t even really need every day.” A $100k salary isn’t actually $100k from the employer’s point of view, either. Basing prices on nominal base salaries just doesn’t make sense. Even if you’re selling B2C, your cluey competitors won’t be charging less, at least not sustainably.

Why it matters

That specific example was for contracting, but it’s a basic rule of business economics: unless you’re trying some super-risky growth hacking (and we know how Pets.com turned out), you need to figure out your costs and set your price high enough to cover them.

Some people still feel uncomfortable with the price they need to set, and they rationalise dropping the price. Perhaps they think something like, “I’m a really nice person, and if I charge only $400 a day my clients will be even happier.” The problem is that you won’t get the same clients. Cluey clients who would pay $100k a year base salary for an employee won’t pay $400 a day for a contractor to do the same job. Instead, in practice, you might get a few good clients who just didn’t have the budget for $730 a day, but you will get a whole bunch of really bad clients. Think about it. If a stranger offered you a fancy-looking diamond ring for $50, would you pay? Or would you rather buy another ring for a normal price?

Let me stress that I’m just taking the numbers from Caleb’s post and that everything is relative. Use your own numbers instead. In most parts of the world, $400 a day might be a fantastic rate. However, if you’re a senior fintech developer in Silicon Valley, charging $400 a day will just make you a magnet for terrible clients. Most of the good ones will know something isn’t adding up, and they’ll be scared away.

What do I mean by bad clients? Browse through the Clients from Hell blog for a bit. It ranges from a lot of basic annoyance like clients who are never satisfied, or who make unreasonable demands, or who waste your time, all the way to clients who are outright abusive, or who get you to do work to spec before arguing they shouldn’t have to pay because “I don’t want it”. Some clients simply don’t pay at all.

If you don’t value your own product enough, don’t be shocked if you have customers who don’t value it enough, either.

It gets worse, though. Good clients tend to work with other good clients. If you’re always available when you say you will be, would you work with people who waste your time? If you treat others with respect, would you work with people who are unreasonable and abusive? On average, your good clients will tend to refer you to other good clients. The reverse is true of bad clients, if they’re even grateful enough to refer you to anyone at all. Therefore, if you charge a good price, your business will tend to grow as you build a reputation. If you undercharge, you’ll find yourself in a downward spiral where you’re not only losing money, but finding it harder and harder to get proper pay at all.

All of this is just a matter of averages, and if you’re lucky you’ll still get good clients even if you undercharge, and if you’re unlucky you’ll still get bad clients even if you charge the right price. However, if your revenue is already weak, each bad client will really hurt. Hoping to beat the averages isn’t a good plan.

“But no one pays that much!”

Suppose you’re an experienced full-time engineer and you decide to try going independent. You’ll probably find that your calculated rate seems high compared to what you see on a freelancing website. That’s because it’s hard to build up a reputation on freelancing websites. Freelancing websites are most useful for casual buyers who primarily want a low price.

I think a lot of smart engineers assume career networking is hard and requires super high levels of extroversion, so they have to rely on freelancing websites for work. The bad news is that you need to build up a good reputation to get good pay. The good news is that most people can do it as long as they have skills that are in demand. Networking isn’t about going to so-called “networking events” (they’re actually mostly terrible for networking). Networking tips would make a whole new blog post, but the key is to find good clients in their natural habitats, and to do the things that make them keep coming back and maybe even refer you to other good clients.

In any case, don’t let freelancing websites or anything else set your price below the equivalent of what you could get from a full-time salary. In fact, you might even get better than your current salary, which is why this is “Pricing 101”. Undercharging, however, will kill your self-employment career.