Building software is expensive

And, making software is not like making widgets. They may call it computer science but maybe they should call it computer science + art + bureaucracy (or maybe not). Developing software is difficult, fluid, and impacted by many people, across multiple disciplines, with differing views. Ya think?

As a person responsible for building a software solution, of course you want to:

• Build something awesome to solve an expensive business problem for yourself, or for a paying client (quality)
• Complete the project within a specified time (schedule)
• Hire the right people with the right skills to build the right features (scope)
• Do all of the above to make the process, project and solution profitable (costs)

You’ve seen the conventional project management triangle. Here’s a different view(stolen from here).

Read on, we’ll help you…

Calculate the real costs of employees and contractors for your software development projects.

This will help you manage the costs side of the PM triangle to add more profitability to your software development projects.

What many do

Believe it or not, many managers (maybe even you) calculate costs by determining an hourly rate for hiring an employee developer. Then, compare the rates to a candidate contractor to make a hiring decision (assuming other similar factors, like skills, knowledge, experience, etc).

As the hiring manager, here might be a typical analysis…

Joe the contractor, is offering his services at $80/hour, which equates to $166,000/year (that is if he works all 52 weeks in a year, and only for 40 hours a week).

You know you could hire an employee near $120,000 year (doing the math backwards, this equates to about $58/hour, and… you would get ‘free’ hours for anything above 40 hours a week).

Why it’s flawed

Maybe you’re thinking, “for sure, I’m gonna find and hire an employee for $120K a year, certainly not a contractor for $166K. No. way. Dude.”

Not so fast, Mr-or-Mrs. hiring-manager.

Of course, you know this is flawed and too-simplistic of a calculation to determine the real costs of employee versus contract worker.

For one, there’s many hidden costs when determining an hourly rate for an employee. You want to account for this. You might actually save money by hiring a contractor. After all, loads of domestic and global companies are doing it.

An Intuit study suggests contingent workers will swell to 40% of the workforce by 2020

Wow, huh?

Employee costs. Why it’s complex.

You probably noticed the obvious missing elements for the calculations above.

Employee Benefits. Pretty smart, aren’t ya?

Alright then, let’s include:

• $120,000 : Base salary
• $17,000 : Insurance (medical, dental and life, US average)
• $3,600 : 3% bonus
• $9,200 : Payroll taxes (6.2% for for social security + 1.45% for Medicare)

Add those up and you get a more realistic number for the annual cost of an employee, $150,000.

The comparison now looks a bit different, eh?

• Joe, the contractor at $166K
• Sheeba (I just made her up) the employee at $150K

But wait, how about them infrastructure costs?

Ready. Set. Fire away:

Phone systems, computer equipment, administrative staff, payroll services, accounting fees, advertising, books, hardware and software licenses, subscriptions, corporate web design, corporate taxes, digital certificates, filing fees, furniture, meetings, office supplies, meals, entertainment, travel, training and career development, workers comp, printing services, recruiting, rent, voice and data communications…

…ahhh, stop already. There’s a slew-fest more of these indirect costs. You get the idea.

Thought I did, too… but, how do you allocate these indirect costs to better calculate an employee’s real cost?

Perhaps, you could simply total up all of the indirect costs, then divide them by the number of employees in the company? Seems fair at first glance. But, not all employees eat up the same amount of infrastructure costs. The CEO uses a helluva lot more than the cafeteria worker. The question becomes, what ratio to apply to any specific employee?

Glad you asked. Consider the salaries for each below:

• Ed the CIO : $225K
• Sheeba the developer: $120K
• Connor the clerical: $35K

With a total of $380K in salaries for this 3-person company, you could generalize the amount of infrastructure costs each person uses: Ed at 60%, Sheeba at 32% and Carrie at 9% (by dividing each salary by $380K).

With this, you derived a more realistic cost to hire someone at a $120K salary: $158,000 ($120K * (1+.32)).

But this is still too simplistic and not very accurate.

A more common approach is for companies to allocate indirect costs based on three main categories. This is based on Cost Accounting Standards.

1) Fringe benefits; 2) Overhead and; 3) General & Administrative (G&A)

This could get complicated. However, this report (see items 24, 26 and 27) makes it much easier by establishing a rough rate for each category: Fringe 35%, Overhead 25%, G&A 18%. These values differ year-to-year, and by company.

Apply these cumulatively to determine a single cost multiplier of 1.99 (1 + 0.35) * (1 + 0.25) * (1 + 0.18). Woa. That’s a big number. Yup, this is saying it costs nearly twice the amount of the stated employee salary.

So then, the real cost of a stated salary of $120,000 really becomes $238,800 ($120K * 1.99).

You still feel the same about hiring that employee?

The contractor and their real costs

Remember previously where I mentioned that contracted services will swell to 40% of the workforce by 2020? You think companies are doing this because it costs more than using an employee? Silly question, right?

According to Businessweek Magazine, employers can save up to 30 percent by hiring an independent contractor.

That’s because they avoid paying costs in the Fringe benefits and Overhead categories previously discussed.

But, a contractor does grind up those G&A costs. We can use that multiplier to easily determine a more realistic contractor cost. Let’s do it.

Remember Joe the contractor wants his 80$ an hour? After adding the G&A multiplier of 18% we get a new value of $95 an hour. This would equate to an annual amount of $197,600 (using 2080 work hours -or- 40 hour work weeks for 52 weeks).

Let’s compare. Finally.

Rather complicated so far. Hopefully, it was worth it. Welcome to a simpler place when using our multipliers for indirect costs.

❱ For Sheeba the employee, what looks like $120K in salary is really:

• $238,800 annually ($120,000 salary * 1.99 cumulative multiplier)
• $114/hour ($238,800 / 2080 works hours in a year)

Note: The salary stays the same, while the hourly drops when Sheeba works past 2080 hours.

❱ For Joe the contractor, hiring him at $80/hour is really:

• $95/hour ( $80/hour * 1.18 G&A multiplier)
• $197,600 annually ($95 * 2080 work hours in a year)

Note: This hourly rate will remain constant, and the annual amount will increase if and when Joe works more than 40 hour work weeks.

How ya like them apples?

Still wonder why so many companies are hiring contractors?

But hey… not so fast

We did those calcu-comparisons based on a 40-hour work week, or 2080 hours in a year. Many, if not most people, work more than that, right? Let’s factor that in and have yet another look.

Say the average workweek for your people is 45 hours.

That’s 2340 work hours in a year.

More math, please:

• For Sheeba: $238K / 2340 hours = $102/hour
• For Joe: $95/hour * 2340 hours = $222,300/year

Now what does it look like when we compare their total spend for a year?

• Sheeba the employee: $238,800
• Joe the contractor: $222,300

That certainly brought the numbers closer together.

What’s the average workweek for your peeps?

And might this affect your hiring decision?

Yet more to consider

We talked about a lot. Coming down the stretch.

But don’t forget about these possible tie-breakers.

It takes time (and bucks) to hire an employee. While this may have been captured above via the indirect costs (recruiting, interviewing, etc.), this does not account for lost sales, lost cost-savings or lost company productivity. While it may be fuzzy to calculate, this is a real cost of doing business.

Ramp up time. It cost money to train new employees to learn the system, the job, and other nuances of the company. Again, part of this overhead is included in infrastructure costs, part of it is lost opportunity and productivity.

Let’s rapid fire through some more:

• A contractor is easier to hire and cheaper to fire, or to switch to a new one
• Bypass any hefty recruiting fees, hiring a contractor over an employee. We learned, this raises the cost of all employees (overhead).
• An underperforming employee can be kept on the payroll for months. That hurts the corporate pocketbook.
• Any employee-filed lawsuits will cost plenty
• You can try before you buy, then hire the contractor as an employee
• It can take weeks to hire an employee. Thus, the candidate can be lost to someone else.
• Budgets often allow for a contractor. A way to proceed even without an open, employee headcount.
• Companies usually spend more time recruiting and confirming employees. Others get involved, costing time, money and lost productivity.
• With an employee the company can retain important knowledge learned on the job, about internal systems
• For the contractor, the amount can skyrocket for work beyond 2080 hours
• An employee is more likely to be committed to the company’s long term success
• Ramp up time for a new employee stays in house, vs re-learned for each new contractor for the same position
• Employees get paid for vacation days. Contractors build it into their rates.
• Many consultants have been around the block, seen many code blocks, learned many tools, are adaptive to many environments and people.

As you can see, many of these items may be difficult to calculate. But they are important and worthy of your consideration.

Use what’s important to you, based on your corporate M.O.

If Nothing else

• It costs a load to build software
• Do what YOU can, to control the costs side of the project manager triangle. This will help you maximize your ROI.
• The contractor workforce is growing… and growing… and growing and the skills available are expanding
• Consider industry categories and standards to help you determine the real costs of an employee (Fringe, Overhead and G&A)
• Do the same for a contractor, sans the Fringe and Overhead costs
• Factor in the less-calculable items that apply to your organization

As you can see, there’s plenty to ponder when hiring a worker to help build your software product, project or solution.

A little due diligence will go a long way to improve your profits.

What did we miss? What can you add? Do tell.