As I go about setting up my business, one of the difficult decisions I had to make was what to charge for my services. I thought it would be an interesing exercise to document my thoughts during so that others can give me some advice and so that clients can see the thinking behind my rates.
My first step, as it is with many things that I do, was to put together a spreadsheet (an excerpt of which is included below). My approach was to look at the hourly rate for a contractor or consultant and compare that number to an annual salary of an employee, all other things being equal. Of course, all other things are not equal, so after I put that framework in place I then looked at the major differences between consultants and employees and it is the subjective assessment of the value of each of these items that will allow you to decide on an appropriate hourly rate for a consultant assuming you have a decent idea on what level of annual salary you would have had in mind for that person should you have hired them as a full time employee.
Productivity of employees
In an ideal world everyone would be paid based on their output. That way businesses could be assured that when they price their goods or services that they can effectively lock in a given level of gross profit. That system would also be great for individuals as they could have more freedom to decide how and when they worked, knowing only that they had to achieve certain outcomes to get paid.
However, it is rare for the output of employees to be able to be measured so accurately. What happens in most cases is that employees are hired based on a fixed rate (annual, daily or hourly) based on the employers assessment of how much value they can get from that employee. In effect, employees are being paid for “face time”, potentially with a small component of their package based on a performance based bonus.
In one of my , author and entrepreneur, Paul Graham, gives his (rather forthright) thoughts on this way of working:
The basic idea behind office hours is that if you can’t make people work, you can at least prevent them from having fun. If employees have to be in the building a certain number of hours a day, and are forbidden to do non-work things while there, then they must be working. In theory. In practice they spend a lot of their time in a no-man’s land, where they’re neither working nor having fun.
That may have been deliberately written in a way to elicit strong reactions, but there is certainly an element of truth to his statement. I have read various articles on the productivity of normal office workers and most of them estimate the productive time at somewhere between 50% and 80% of the work day. In the more pessimistic estimates they generally don’t count phone calls and emails as productive work. I don’t think that simple assumption is valid as some (many?) emails and phone calls would certainly count as productive time, but there is no doubt that there are a lot of disruptions during the day. Not to mention that it is just not possible to concentrate for 3 or 4 hours at a time without giving your brain a break.
In the case of consultants, however, they would be expected to be productive for very close to 100% of the time they are being paid for as there would be an expectation that they would go “off the clock” when they stop working for the client. An honest consultant would, anyway.
In the table below (enhanced with the help of Excel 2007′s greatly improved conditional formatting tool) I have incorporated a range of assumptions regarding the ratio of productive hours in a day. As you can see, the higher the productivity of the employee the lower the implied hourly rate of those productive hours.
Assumptions:
- 52.1 weeks per year x 5 week days per week x 7.5 work hours per day (excl. lunch break) = 260.7 days
- 20 days annual leave + 11 days public holiday + 8 sick days = 39 lost days per year
- 4.95% payroll tax + 1.5% workcover + 9% superannuation = 14.95% tax & super
The aim of this table to is find a comparable rate for a consultant (who is paid only for productive time) relative to an employee based on various levels of productivity on the assumption that it is impossible for them to be productive all of the time.
Ease of ending the relationship
Ending a relationships with employees is a lot harder than ending the relationship with contractors or consultants. Even with the unfair dismissal laws being much more relaxed for small companies, letting an employee go is still a difficult process, takes up valuable time for the manager(s) involved, and unless clearly performance related, can be costly if redundancy payments are required.
From the same article by Paul Graham:
…The list of what you can’t ask in job interviews is now so long that for convenience I assume it’s infinite. Within the office you now have to walk on eggshells lest anyone say or do something that makes the company prey to a lawsuit. And God help you if you fire anyone.
Nothing shows more clearly that employment is not an ordinary economic relationship than companies being sued for firing people. In any purely economic relationship you’re free to do what you want. If you want to stop buying steel pipe from one supplier and start buying it from another, you don’t have to explain why. No one can accuse you of unjustly switching pipe suppliers.
There is clearly an advantage here in using contractors/consultants in that ending the relationship, for whatever reason, involves little more than a phone call. To look at this another way, there is a substantial hidden cost in using employees that does not exist with consultant and justifies a higher rate for consultants than a simple “salary divided by hours” formula implies.
Fixed versus variable costs
Employees must be paid regardless of the needs, and capacity to pay, of the business. Contractors or consultants need not be used when there is no work to be done or no cash to pay them. To put it simply, employees are fixed costs and contractors/consultants are variable costs. This flexibility can be vital during tough times and could, in extreme cases, mean the difference between a company making it through a difficult period and going under. While there are laws to ensure that companies don’t employee staff as contractors when the nature of their role is clearly more like that of an employee, where other reasons exist for staff to be hired as contractors (eg. fluctuating levels of work, need for outcome based payments, etc) then there are clearly business benefits of using contractors and consultants.
Access to higher skilled business people
SME’s cannot usually afford to hire people that have the skills to command $200k+ salaries, thus if they want to bring some of those skills or experience into the business the only way to do that is via contractors/consultants on a part time basis. Another option is, if the potential for the business is significant, to try to bring them into the business via equity ownership. However this involves a whole new level of commitment and risks.
Are you buying the mind or the body?
As an increasing number of jobs are falling under the description of , the definition and measurement of staff productivity is changing. The link between hours worked and employee output is becoming less clear and the level of output gained from knowledge workers in their most productive hours can be many times that of their least productive hours.
Let’s take a hypothetical example of two employees. One is employed to do nothing but screw lids onto bottles while the other is hired to do nothing but think and make suggestions on how to improve the company. The first worker’s output is measured by nothing more than the number of bottles with correctly applied caps, while the second worker by the number and quality of their ideas.
In the case of the first worker the number of tops screwed onto bottles will correlate very well with the hours they work. Beyond a certain number of hours each week this will decline due to fatigue, but up to a certain point if you add another hour worked you get approximately the same number of tops screwed onto bottles as you did in the last hour. In the case of the knowledge worker this is far from the case, and making them work longer will not likely lead to substantially more or better ideas. This could be for a variety of reasons. Firstly, ideas are based on creativity, intelligence and past experience, and none of these change based on hours worked each week.
Secondly, ideas are not always best developed in the office. I personally know that my best ideas have been developed while walking, driving, showering and reading (and not always the stuff I would read at work). And whether I work 1 or 40 hours in a week, I will still take every idea I have outside of work hours to work. Thus, employing me for 1 hour yeilds a huge return for my employer relative to the last hour which, if it is keeping me from driving, walking, showering or reading, might actually be reducing the time available for truly creative thinking.
In reality, I needed more than 1 hour in the office so that I had a good knowledge of the business upon which to develop ideas, however it is unlikely to require 40 hours in the office to gain this understanding.
I have tried to represent this idea in the following chart:
The chart shows the knowledge worker being extremely productive in the first hours of the week they work (not necessarily Monday morning – it could be any 4/8/12/etc hours if that is all they work) as they incorporate new information they learn about the business and introduce those ideas gained from past experience or external experiences to the business. Beyond that, however, the amount of value they add for more time spent in the office flattens off. The person doing manual labour, on the other hand, is relatively constant in that the more they work the more they produce based on a relatively predictable formula.
In reality, barely anyone falls at either of these extremes of the scale, and most of us would generate some output based on hours worked and some based on knowledge and experiences. Take, for example, your accountant. A part of their work is based on analysing your data, preparing reports, submitting your tax return, etc, and this is very much related to the time they spend doing the work. Another part of their job is advising you in relation to issues like tax, and this is based more on their past experiences. For example, it might only take you 10 minutes to ask your accountant a question about a tax issue and get a response that adds hundreds or thousands of dollars of value to your business. Most knowledge workers are in a similar position, so that the difference in productivity from the most productive to least productive hours each week is not as great as suggested for the theoretical knowledge worker used in my example, but there is no doubt that there is still a substantial difference.
Without straying too far off topic, this idea is also part of the justification for the significantly larger salaries of some workers (say, listed company CEO’s) relative to others. They do not get paid ten times as much as another employee of the company because they work 400 hours a week, but because the value they can contribute via one or two good ideas (based on past experience, intelligence, creativity and which can potentially be tapped by the company in only a few hours each week), can be substantially greater than the combined output of several employees.
(What it doesn’t explain, however, is why there isn’t an even greater push towards the use of advisers/consultants/contractors/part-timers to replace their more highly paid full time resources, on the assumption that by cutting both their hours and their salary by a given percentage, they will not lose anything like that same percentage of their total value to the business. This is particularly so when you consider the next point.)
Variety of experiences
Related to the last point is the issue of consultants/contractors having a variety of experiences each week. I talked earlier about how important past experiences, intelligence and creativity are to the output of knowledge workers, and that the passing of each week does not have much impact on those factors. However, while we can only have a limited number of new experiences each week which are restricted by the hours in a day, we can increase the variety of experiences we encounter during that time. In the case of a consultant that is working with a number of clients at any time, they are encountering a much wider variety of situations each week than an employee or contractor that is working 40 hours a week for the same employer. And the broader the experiences, the wider the variety of new ideas that the consultant is likely to come up with. While all companies most likely need a certain percentage of their workfore working full time and concentrating solely on getting stuff done within that company, it is hard to argue against there being substantial value in having some members of the broader team (ie. including consultants) out in other offices, meeting different people, seeing different things, etc.
So, if you want to bring some new skills into the business and are given the choice of hiring one senior team member and paying them $150k a year or five people each spending a day with you and four days out with other companies for $30k each, maybe the second option isn’t such a bad idea? Sure, there are downsides, and it would depend very much on the nature of the work being done. However the concept certainly has some merits provided you take a medium to longer term view and accept that the output of your business is not purely the number of bottle tops screwed on each day, but also the number and quality of ideas that are brought into the business which ultimately improve the company over the medium to long term. And without wanting to start a whole new discussion, just think about the marketing benefits of this model with 5 members of your broader team out with other companies 4 days a week, including time with the clients of those companies, all the time looking for opportunities to talk about your business and help find new clients for you… at someone else’s expense!
Final words
There are other differences between employees and contractors/consultants that impact the thinking decision as to which is more appropriate for a given situation and what rate to pay each of them – the cost of accommodating employees and provide them with technology, the time involved with managing staff such as performance reviews, etc. I have my own views on how much all of these factors have on the relative value of each group and what rate I believe is appropriate for a consultant relative to the salary of an employee with a similar set of skills, but these are subjective decisions and I’ll leave it you to make your own judgements for now.
If you have any thoughts or comments on this topic I’d love to hear from you.
