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The Real Cost Of An Employee Vs Cost Of A Contractor

Do you know how much your employees actually cost your company? What would cost you more, an in-house employee, or hiring a consultant? Is either of the options cheaper than the other?

It is surprising how few organizations properly account for the real costs of their employees. In a product company, these errors can eat away your bottom line. For an agency, these misinterpretations can even result in spending more to provide a service than you are charging for it.

In this blog, we will discuss how the costs of an employee are calculated and what more accurate methods you could use in your calculations. We will also compare the cost of having an in-house employee and hiring a consultant and outsourcing the job.

What Is The Cost Of Employee And How To Calculate It?

The cost of an employee is calculated as the sum of each employee’s gross wages, and other expenses that are paid per employee. Other expenses include payroll taxes, benefits, insurance, paid time off, meals, and equipment or supplies. These extra costs are collectively called overhead costs and include all the expenses you pay outside of labor costs and can be calculated either monthly or annually, depending on the type. Things like building costs, property taxes, and utilities too have to be added under overheads, divided as a per-employee expense.

Besides, as a business owner, you are required to pay taxes for the Federal Insurance Contributions Act (FICA), which covers Social Security and Medicare, and the Federal Unemployment Tax Act (FUTA), which funds workforce agencies. On top of that, there are unemployment taxes, which vary by state but can include state income taxes and unemployment insurance.

Taking all of the above into consideration, let us take a look at an example for a better understanding of real costs.

Let’s say an employee, Alex is paid $60 per hour. If Alex works 40 hours per week for 52 weeks, they will work for a total of 2,080 hours, which makes their labor cost $124,800 (pre-tax) per year. Let us assume that Alex has 15 days of paid leaves, they will actually work closer to 1,960 hours per year — making their actual hourly rate closer to $64.

Sticking with that $124,800, we can now use the labor cost formula to determine the amount of annual overhead costs an employer pays in addition to that employee’s hourly wage. This formula includes building costs, property taxes, utilities, payroll taxes, benefits, insurance, supplies, and equipment costs. Once the total overhead is added together, divide it by the number of employees, and add that figure to the employee’s annual labor cost.

In this particular case of Alex, their annual labor cost is $124,800. However, let’s say an employer spends 80K extra and has 10 employees, it makes it an additional $8,000 spent per employee throughout the year. Add $8,000 and $124,800 to get $132,800. Now, dividing $132,800 by the number of hours Alex will actually work in a year with paid leaves leads us to the true hourly rate of that employee. In this example, the total hourly cost of Alex is closer to $68 per hour.

Simple right? Well, yes. However, I would argue that this is an oversimplification and does not represent reality aptly.

The reality is that the actual costs per employee are significantly different and are often greater than usually estimated, and the differences go way beyond annual salaries and hourly rates.

This is primarily because all employees do not use all benefits equally and therefore, overheads cannot be just distributed equally amongst employees.

The Real Cost Of An Employee And The Factors That Contribute To It

Running a business is challenging and can be very exhilarating. Some of the additional costs are not that obvious. Each employee costs you the rent for that particular square footage in space, plus the furniture that the employee is utilising, office equipment that various employees are sharing, internet bandwidth, phone lines, electricity, organizational costs of payroll and keeping data, and so on. These factors add up. It is essential that you carefully consider all these additional costs when calculating how much your employees truly cost per hour.

Here is a list of infrastructure that you may typically pay for in your company:

REAL COST OF AN EMPLOYEE
Fig: List of infrastructure that you may typically pay

While this is a long list of overhead indeed, it is important to mention that it’s not even necessarily complete. Many companies will have their own peculiar sets of indirect costs that do not fall within any of the categories listed above. Collectively, these many indirect costs can add up significantly to shoot up your cost of labor.

Additionally, we further need to consider the fact that, some employee’s salaries such as the COO, CFO, administrative staff, etc. are usually part of the infrastructure costs. As you go further down this path, it becomes very apparent that costs need to be categorized and pooled into different categories in order to properly distribute and identify them. All indirect costs can be categorized into three main types:

  • Fringe Benefits: Costs such as health care, retirement contributions, paid time off, workman’s compensation, and so on.
  • Overhead: Business expenses that are not attributable to a specific project. Examples of these costs include rent, computer equipment, office supplies, voice and data communication charges, hosting services, and so on.
  • General & Administrative (G&A): Expenses attributable to running your business in general such as salaries for corporate executives and administrative personnel, legal fees, accounting fees, and so on.

According to the salary benchmarking report, the most frequent values for these rates are generally 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 your company roughly twice their base salary.

These multipliers obviously vary drastically amongst different companies and can change within the same country year to year. In the Government contracting domain, the 1.99 figure is approximately the median, with cost multiplier values ranging from 1.5 to 2.5.

Let us take a look at Alex’s example again. Being paid $60 per hour, Alex costs their company roughly $124,800 per year. Compensating for the aforementioned costs and using the multiplier of 1.99, we conclude that Alex ends up costing the company $248,00 each year making the hourly rate approximately $120. It is distinctly clear that the hidden costs involved in employing an individual can add up to take your expenditure and costs way beyond what you might initially estimate. Further, add the paid time off and your costs balloon up to $130 hourly. Things are indeed not always, as they seem to be.

Contrast this with Mark, an outside consultant. A consultant doesn’t receive any real benefits from the company hiring them. As a result, the actual cost of a consultant is affected by G&A costs only. Fringe and Overhead are irrelevant to the cost of a consultant and are eliminated. Starting with a similar hourly rate but with no paid time and only general administrative cost, making his effective rate to be $70. Here is a table outlining our learnings

Factors Calculation Employee Consultant
Employee hrs. worked per week - 40 40
Number of weeks worked - 52 52
Hourly Cost - $60 $60
Total Annual hours worked Hours worked per week*Number of weeks 2080 2080
Total cost Annual Hours* Hourly cost $124800 $124800
Effective Cost with overheads Total Cost* overhead factors $248352 $147264
Hourly rate with overheads Effective Cost/Hours worked $119.4 $70.8
Paid Leave time in hours - 160 00
Effective Hours in a year Total Annual Hours-vacation time hours 1920 2080
Effective hourly rate Effective Cost/ Effective Hours worked $129.35 $70.8

Table: Comparison of cost structure for Employee and Consultant

The table concludes the following points

👉 Actual cost of an employee is approximately 2X of gross cost
👉 Actual cost of the contractor is approximately 1.2X of gross cost
👉 At the same hourly rate, a contractor would cost around 60% lesser

To calculate the cost of labour for your company consider each and every aspect of your expenditure. This includes the rent you are paying for your office space, accounting and legal fees, corporate insurance, corporate taxes, marketing materials, training, books and publications, subscriptions, and subcontractor costs if any. All these small costs become a significant part of the total individual cost.

Conclusion

All we have done is rather than comparing just the salary of an employee and the consulting fee of a consultant, we have taken a closer look at what an individual actually costs to an organization. Now that you are armed with calculations that reflect the cost of an employee and consultant much more accurately, you are in the perfect position to choose what is best for your organization monetarily.

Of course, there are positions that need an in-house person and hence, every hiring decision cannot be based on just cost. Every company and situation is different so there is no general answer for all organizations here. Nevertheless, an awareness of the factors and issues that influence the cost discussed in this article will help arm you to make the best financial decision for you and your team.

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Ayush Jain

CEO and Founder of Mindbowser, Chapter Director of StartupGrind Pune

Ayush is the CEO of Mindbowser Global Inc, a top-notch agency providing software development services to renowned companies like Dell, Pepsi as well as to a lot of growing startups. Ayush is also the director of the StartupGrind community and editor of The IoT Magazine and Chatbots Journal. Ayush serves on the board of several startups and is a seed investor.

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