Don't Be Fooled: Calculate the Real Cost of Employees and Consultants

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REAL EMPLOYEE COST CALCULATOR

This calculator is based on the cost accounting methodology detailed in the article below.


Use the calculator below to compare the real costs of contractors vs. employees, based on their salaries and hourly rates.


Adjust hourly rates or annual compensation figures below to compute and compare real costs








* Real costs are roughly based on DCAA Cost Accounting Standards

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Cost multiplier (cumulative):
Fringe: Overhead: G&A:
Comparison above of employee and consultant costs
is based on the sample expenses specified below.
To more accurately compare the costs of employees and consultants in your organization,
adjust the values below to reflect your company's actual expenses.








Don't Be Fooled: How to Calculate Employee Costs vs. Consultant Costs

A typical flawed analysis

Andre’s gotten funding for his company and is looking to staff his development team. He needs top software engineering talent and he needs it fast. Andre was ready to bring on Roger, a freelance consultant who came highly recommended, but backed off upon learning that Roger’s rate was $70/hour. That seemed way too expensive After all, Andre reasoned, that’s equivalent to an annual salary of over $145K, based on a typical 2,080 work hours per year. In contrast, Andre is sure he can hire a great developer as an employee for $100K or less. So Andre decides to look for an employee to hire instead and save money.

Unfortunately, like all too many hiring managers, Andre’s financial analysis was overly simplistic and highly flawed as a result. The reality is that the costs per employee calculations when hiring are vastly different (and often greater) than those involved in bringing on a consultant, and the differences go way beyond annual salaries and hourly rates. Andre doesn’t realize it, but there’s a good chance he actually would have saved money by hiring the consultant.

It’s truly astounding how few business owners properly account for the real cost of their labor. In a product company, these errors can eat away at your bottom line. And in a services business, these errors can even result in spending more to provide a service than you’re charging for it.

But of course, this is not a new problem. Accordingly, tried and true methods do exist for more accurately calculating the real costs of your labor, enabling you to perform a sound financial analysis and make a more educated decision when faced with the “employee vs. consultant” dilemma. Here’s what you need to know:

It’s not so simple

Let’s assume that Andre finds an employee, Pete, for $95K/year. Evaluating costs on an hourly basis, Andre believes that Roger will cost him $70/hour, whereas Pete (using the standard 2,080 work hours per year) will only cost him around $45/hour.

That’s a significant savings.

Or is it?

Unfortunately for Andre, it’s not so simple when you take employee overhead costs into account. Let’s see why.

Most readers of this article will be quick to recognize that Andre has failed to factor in benefits. True. But even when it comes to benefits, things are not so simple. You may be factoring in health and dental insurance, 401K contributions, and other perks, but are you factoring in the cost of the employee’s annual vacation when calculating the cost of the hours that she is productively working for you?

Here’s a fairly typical list of the company-paid benefits that are directly attributable to each employee:

  • Insurance (medical, dental, life)
  • Annual Bonus / 401K Contribution
  • Payroll taxes (company paid portion)

So as a first step, let’s begin our cost per employee formula by factoring in these costs to better estimate Pete’s real cost to Andre’s company:

     $95,000   Pete's Base Salary
      15,000   Pete's Insurance (medical, dental, life) - company paid portion
       2,500   Pete's Annual Bonus / Company 401K Contribution
       8,000   Payroll taxes (company paid portion)
    ========   ===============================================================
    $120,500   Better approximation of total annual cost (salary + benefits)

OK, that’s closer to accurate, but still a long way from representing Pete’s full cost to Andre’s company. Benefits are frankly only the tip of the iceberg when it comes to figuring out how much an employee is really costing your company.

Cost of employee benefits? You’re paying for more than benefits

Running a business can be exhilarating. It can be challenging. And it can be expensive. There’s the cost of office space. Phone systems. Computer equipment. Administrative staff. Payroll services. And on and on and on. And each of your employees benefits from all this infrastructure “for free”.

And while you don’t charge your employees for any of this infrastructure, they most certainly do benefit from it. That being the case, to the extent that each employee uses this infrastructure, a corresponding portion of the cost is really attributable to him or her.

Using a consultant salary calculator that also calculates the cost of an employees overhead makes for better business decisions.

Here’s a fairly typical list of company-paid infrastructure costs (often referred to as indirect costs):

  • Accounting fees
  • Advertising
  • Bank service charges and fees
  • Books
  • Check orders
  • Computer hardware
  • Computer software licenses
  • Computer software subscriptions and maintenance
  • Conferences and trade shows
  • Corporate graphics and web design
  • Corporate taxes (property, etc.)
  • Credit card processing fees
  • Delivery and postage
  • Digital certificates
  • Dues and subscriptions
  • Equipment
  • Filing fees
  • Furniture
  • Hosting services
  • Insurance (liability, workers comp, etc.)
  • Interview expenses
  • Legal fees
  • Meals and entertainment
  • Meeting expenses
  • Office supplies
  • Overhead staff (executive, administrative)
  • Printing services
  • Recruiting (advertising and fees)
  • Rent
  • Repair services
  • Training
  • Travel
  • Voice and data communications

While this is a long list of overhead indeed, it’s important to mention that it’s not even necessarily complete. Many companies will have their own peculiar sets of indirect costs that don’t fall within any of the categories listed above. Collectively, it’s these many indirect costs that can cause a company to inadvertently “lose money” on hiring its employees.

Factoring it all in

OK, so how does one distribute these costs across each of the company’s employees to better approximate their real cost?

An overly simplistic way of doing this calculation would be to just add up all indirect costs, divide by the number of employees, and then add that portion of the total to each employee’s annual compensation.

While this may seem perfectly reasonable at first blush (and it is certainly much better than not factoring in these costs at all!), one quickly realizes that it is still way over-simplifying the problem.

Consider this, for example: Not every employee uses the same portion of the corporate infrastructure. As an extreme example, the company janitor occupies a much smaller portion of the administrative staff’s time than the CTO does. So attributing equal portions of the cost of the administrative staff to the janitor and the CTO wouldn’t seem to make a whole lot of sense. Even in less drastic cases, the same holds true. A Senior Systems Architect is likely to be using more of the company’s infrastructure than an entry level programmer.

The question then becomes how to intelligently distribute the company’s indirect costs across all employees. The generally accepted practice is to use salary as an approximation of seniority, which in turns serves as an approximation of the portion of corporate infrastructure and resources used.

Here's a very simple example that helps demonstrate the point:

    Annual Salaries:
       Sue      $75,000
       Bob      $50,000
       Ted      $25,000
     =====     ========
     Total     $150,000
    
    Allocation of Indirect Expenses:
       Sue      50% ($75,000 / $150,000)
       Bob      33% ($50,000 / $150,000)
       Ted      17% ($25,000 / $150,000)

But even this is still over-simplified.

Consider the fact that some employee’s salaries (COO, CFO, administrative staff, etc.) are actually part of the infrastructure costs. As you go further down this path, it becomes apparent that costs need to be “pooled” into different categories in order to properly distribute them. The basic idea is that indirect costs are pooled into three primary categories:

  1. Fringe benefits. Items such as health care, retirement contributions, paid time off, workman’s compensation, and so on.

  2. Overhead. Business expenses not attributable to a specific project. Examples include rent, computer equipment, office supplies, voice and data communication charges, hosting services, and so on.

  3. General & Administrative (G&A). Expenses attributable to running your business in general such as salaries for corporate executives and adminstrative personnel, legal fees, accounting fees, and so on.

The resulting calculations rapidly become quite sophisticated. For example, these Cost Accounting Standards from the Defense Contract Audit Agency provide a glimpse into the resulting complexity. Using cost per employee formulas such as these, an “indirect rate” corresponding to each of the above three categories is calculated. These are then applied cumulatively to an employee’s salary to derive his or her actual cost to the company.

According to a recent Deltek report, the most common values for these rates were roughly as follows: Fringe 35%, Overhead 25%, G&A 18%.

Applying these rates cumulatively yields a cost multiplier of 1.99; i.e., (1 + 0.35) x (1 + 0.25) x (1 + 0.18). This means that each employee is typically costing the company roughly twice (1.99 times) their base salary.

These multipliers can vary widely, though, across different companies, or even within the same company from year-to-year. In the Government contracting domain, the 1.99 figure is roughly the median, with cost multiplier values most typically being in the range of 1.5 to 2.5.

Returning to our true cost of an employee example, Pete’s real hourly cost to Andre’s company isn’t $45/hour; we now see that it’s probably much closer to $90 per hour ($45 x 1.99). On an annualized basis, this means that Pete doesn’t cost the company $95K; rather, Pete roughly costs the company around $190K/year ($95K x 1.99)! Suddenly, this no longer seems like such a bargain.

Consultant salary calculator: The real cost of consultants

But wait, you’ll say, don’t we have to provide a consultant with some corporate infrastructure too? So isn’t Roger the consultant also really costing us more than his hourly rate?

Yes, indeed he is. An excellent point.

However, the amount of infrastructure that a consultant uses is significantly less than that of an employee (not to mention the fact that the consultant doesn’t receive any benefits from the company). As a result, the actual cost of a consultant is affected by G&A (General & Administrative) costs only; Fringe (i.e., benefits) and Overhead are irrelevant to the cost of a consultant.

So, in our example, we can more accurately estimate Roger’s real cost to Andre’s company as being around $83/hour (i.e., $70 x 1.18, based on the typical G&A rate of 18% quoted earlier). This would equate to an annualized cost of roughly $170K (again using the standard figure of 2,080 work hours per year).

An apples-to-apples comparison

Now that we’ve properly accounted for the true costs of Pete the employee and Roger the consultant, we can make more of an apples-to-apples financial comparison between their costs:

What Andre thought:
Andre thought that Pete the employee was only costing his company around $45/hour, whereas Roger the consultant would cost his company $70/hour.

The reality:
Pete the employee is really costing Andre’s company around $90/hour, whereas Roger the consultant would only cost his company around $83/hour.

And thus, we prove the old adage that things are not always as they seem.

Other things to consider

Here are a couple of other key points to consider:

  1. Potential financial risks. There are additional potential financial risks with an employee that are less likely in the case of a consultant. A prime example is the fact that companies tend to make hire/fire decisions much more rapidly with consultants than with employees. It is not uncommon for under-performing employees to be kept on the payroll for multiple months, throughout various stages of probation, to minimize the potential for an employee-filed lawsuit. The resulting cost to the company can be quite substantial. In contrast, companies tend to dismiss consultants with minimal if any notice when in any way dissatisfied with their performance.

  2. Recruiting fees affect the cost of all employees. One obvious savings with consultants is the avoidance of often hefty recruiting fees. What may be less obvious, though, is that each recruiting fee paid drives up the real cost of all employees. Since recruiting costs are including in overhead expenses, every recruiting expense that your company incurs increases your overhead costs, which in turn raises your overhead rate multiplier, which in turns drives up the effective cost of each and every one of your employees (i.e., since the overhead multiplier is used in calculating every employee’s real cost, the higher that multiplier is, the higher each employee’s real cost ends up being).

Concluding remarks

When making the in-house employee vs. consultant cost-based hiring decision, it’s critically important to properly account for all the hidden costs per employee and costs per consultant involved in order to make a sound business decision.

Every company and situation is different so there’s no “one size fits all” answer here. But an awareness of the factors and issues discussed in this article will help arm you to make the best financial decision for you and your team.

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Comments

Pavel Novikov
Great article! I'm reading your blog for a long time and wonder how your point of view corresponds to mine one. More or less the same article I wrote in Russian a few month ago. I really wonder how many companies does not understand how the mechanism of infrastructure costs actually works. Thank you for great article and I wish you to be heard by community of heads of IT companies.
Jibril GUEYE
Great Article! Something EVERY FTE (full time employee) hiring managers should read!
Graham Swan
Very informative breakdown of the true costs of employees vs. contractors. Been having this conversation with many friends lately and it seems people have difficulty seeing the seemingly hidden costs in actually taking care of your employees. Thanks for the post, Hyam.
Taylor Ryen
This is a 10,000 foot view of the issue. It's far more complex than just the numbers. Keep in mind there are often ramp up times/learning curve with consultants (and employees alike), familiarity with the company's previous obstacles and solutions, and communication/workflow issues that often come with someone who hasn't learned the nature of how their team or projects function over the years. This article also mentions nothing of the fact that often the reason consultants are more expensive is because you're not providing any benefits.
H. Singer
Thanks for the feedback Taylor. I didn't mean to imply that this was a completely thorough treatment of the topic and you are therefore correct that there are additional issues and factors that couldn't be addressed in the confines of a single blog post. Also, I think you meant to say "the reason that consultants are *less* expensive is because you're not providing any benefits".
Stud
Do you have one for the executives ?
cjspurg
In software engineering especially I think you
BMG4ME
Very informative article although as an employee of a company I hope my company doesn't read this :-)
Critical Eye
Wow, there's a fundamental problem with this analysis. You're using 2080 working hours a year - 52 weeks at 40 hours a week. In reality, almost all businesses have 10-12 holidays a year, the so-called "Federal Holidays". Typically, contractors don't get paid for those days, unless they actually work; employees do. In addition, almost all employees have at least two weeks of paid vacation; contractors figure that into their rates, since they're only paid for hours worked. Right off the bat you're paying employees for almost a month that they're not working! For employees, figure 2080 hours - 80 holiday hours - 80 vacation hours, or 1920 working hours a year; for consultants, you're probably buying 2080 hours - 80 holiday hours - 40 unpaid personal days = 1960 hours a year. Your baseline cost for the $95K employee is now $50/hours; your cost for the $70/hour consultant is $137,200 per year. This comes from my experience doing cost analysis for government bids; you'll go broke assuming 2080 hours of revenue and billing 1920!
Rodrigo Alves
Great article! I have to add that in countries like Brazil, with strong labor regulations for both the employer and employee, this difference tends to be much bigger. In the normal form of hiring someone in Brazil, the company always spends almost twice the employee's compensation, every month.
Christopher Sanders
Good point. Everyone is always worried about what employees cost but no one is nit picking the gazillion dollars executives make regardless of performance and company success.
Mark Buzan
Excellent article! I wish I had this several years ago as a consultant. On question however...how do you counter the argument that with an employee, you get them for more hours per week than with a consultant who may only bill for a few hours or days per week...or even for a shorter period of time?
George Hollingsworth
I know I'm a little late to the discussion, but I have to point out something important. I have seen more often than not consultants utilize overhead resources. If you factor those costs, the consultant and employee cost difference changes dramatically.
Countac Mentcom
Consultants are generally more experienced than full-time staff. They've been around the block as opposed to being 'inbred'. Top notch consultants, have seen more code bases and generally can adapt much faster than any full-timer. The consultant also has as much incentive if not more that a permanent staff to write maintainable code cleanly because it will affect his reputation for his/her next gig. Permanent employees might write the code poorly because they have incentive to "create work" for later to ensure their job creating inbreeding. Consultants strive to work themselves out of a job to move to bigger and better things. In some companies, this culture is so prolific it only becomes obvious when outside consultants are brought in. Having a mix of consultants keep the permanent employees honest. There are only 4 SDLC processes in any company, waterfall, agile, waterfall/agile mix, chaos.
Kevin Cunningham
I have worked on both sides in the engineering industry and I can tell you that 70/hr is not a realistic billing rate for experienced professionals, that is more of a clerical staff billing rate at a consulting firm. The consulting firm that I worked at had a multiplier that ranged from 2.2 to 3.0. That means that they billed their clients 2.2 to 3.0 times what the actually paid their employee. So, if I use the figures from this example, a consultant that takes home 45/hr is actually billed to the client at 99-135/hr, depending on the multiplier. If the factor used to calculate employer expenses to hire an employee is 1.99, and you hire them at 45/hr, then the actual cost to the company is about 90/hr - thus why consultants aren't always the most attractive to organizations. You also have to take into account senior/executive level staff that touch nearly every project that comes through the door at consulting firms. It is very common for their billing rates to be 200-300/hr so that also drives up the cost of hiring consultants vs not. The only time it would really make sense to hire a consultant from a cost savings standpoint is when they don't work for a consulting firm.
TAMIKO BLACKFORD
Interesting analysis . I loved the points ! Does someone know if my assistant can find a template WA DSHS 14-078 document to fill out ?
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