Updated: Jul 28
Companies have employees, that’s a fact. But how much do those employees actually cost the company? And is there a way to reduce those costs and still operate at a high performance level?
Outsourcing IT services has become an important factor to consider when it comes to any modern business. Regardless of the industry you are focused on, it is safe to assume you have had a specific IT need at one point or another.
But how do you know if it is worth hiring an in-house software development team, or if you should outsource that service to an independent contractor?
That is an excellent question, and quite complex to answer with a few words. We are going to try to shed some light on the matter to help you make an informed decision next time you need to in this article.
One of the most important factors to consider is the cost. Let’s take an example case to compare outsourcing to in-house software development teams.
The Annual Salary is calculated using a standard base of 2080 work hours per year.
At first glance it seems like a no-brainer. It is clear that hiring an employee to deal with your custom software development needs costs much less than an outsourcing company.
If only it were that simple!
Unfortunately, there is a lot more to consider before we come to an accurate analysis. In reality, calculating the cost per employee versus the cost of external consultants goes beyond hourly rates and annual salaries.
In fact, let’s dive in the overhead costs to consider when comparing the two options.
One key factor to keep in mind are benefits. Typically we can find the following perks at most companies:
Insurance (medical, dental, life)
Annual Bonus / 401k Contribution
Payroll taxes (company paid portion)
Now that we know we need to evaluate benefits, let’s update the cost per employee analysis.
$95,000 Base Salary $15,000 Insurance (medical, dental, life) - company paid portion $ 2,500 Annual Bonus / Company 401K Contribution $ 8,000 Payroll taxes (company paid portion) ======== =============================================================== $120,500 Better approximation of total annual cost (salary + benefits)
With that information we are now closer to the real cost of an employee. However, we are still $25,100 short of the $145,600 we calculated previously for the outsourcing consultant. That is still a big saving for the company.
Nevertheless, there’s more to consider. Additionally, there are many more items to consider when it comes to your employees that may not be immediately apparent. For example, some additional factors may be:
Bank service charges and fees
Computer software licenses
Insurance (liability, workers compensation, etc.)
As mentioned before, these are some indirect overhead expenses related to employees, but it doesn’t mean the list is complete. There may be more or less factors, depending on each case, but those are some standard expenses, typically found in most companies.
How do we calculate those expenses and then distribute them across employees?
Unfortunately, there’s no easy way to calculate this as not all employees have the same costs or use the same infrastructure. However, there is a guideline which we can use to categorize and evaluate these costs. The idea is to pool indirect expenses in three primary categories:
Fringe benefits. Health care, retirement contributions, paid vacations, etc.
Overhead. Business expenses not attributable to specific project – rent, computer equipment, office supplies, etc.
General & Administrative. Expenses attributable to running your business – corporate executives’ salaries, accounting fees, administrative staff’s salaries, etc.
The calculations from this point forward become quite complex and go beyond the scope of this article. For more information you could check these Cost Accounting Standards provided by the Defense Contract Audit Agency.
Taking into account all the information and the following extract we can obtain a multiplier which will be applied to the cost estimation formula.
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.
It is important to mention that these values may vary due to many factors, but the multiplier typically ranges between 1.5 and 2.5.
Applying it in practice.
Going back to the original use case we can calculate that the true cost for an employee is almost double. Taking the original $45 per hour and multiplying it by the value obtained before (1.99) we get an actual cost per hour of roughly $90 ($45 x 1.99). Which in turn results in an Annual Salary of almost $190,000 ($90 x 2080 hours = $187,200).
Finally we can observe that the actual cost for an employee is closer to double from what we originally anticipated.
Don’t we need to provide some corporate infrastructure for the consultant as well?
Yes, but the amount of infrastructure and overhead expenses are greatly reduced when it comes to outsourcing companies or consultants. One key difference is that they don’t receive benefits from the company. Another factor is that in many cases the external consultants work remotely using their own equipment.
Therefore, the cost for outsourcing your software needs is only affected by the General & Administrative category from above. Using the multiplier for that category obtained from the previous calculations, we get the following formula. $70 x 1.18 = $82.6 per hour, which in turn results in $82.6 x 2080 hours = $171,808 Annual Salary.
Considering the results from our use case, at the end it is cheaper to hire an outsourcing company to take care of your software needs. Of course, this is just a generic situation, but one that fits a variety of real life circumstances and conditions.
Similarly, it is hard to tell if this is the way to evaluate your particular case, but hopefully it gives you some guidance what to consider when you are making your analysis.
In addition, an important thing to take into account is that this article only focused on the financial side, but there are multiple other factors to consider. Things like security requirements, location, corporate policies, external contracts, etc. add up to the final decision.
As with anything, there are trade-offs and benefits going either way. The important thing is to evaluate and determine the priorities.
Taking the above information into account, it helps narrow down the options when it comes to making the right decision for your company.
And remember, often nearshore and offshore providers can be much cheaper and produce the same or even better results for reaching your goal.
Disclaimer: This article is based on a research made by Hyam Singer from Toptal. It is also worth noting that the analysis is based on the requirements to run a business in the USA. Factors to consider may vary in different countries.