Crunching the Costs: Employees vs. Contractors - What really is more cost effective?

The True Costs of Employees vs. Independent Contractors: Unveiling the Hidden Expenses

As a business owner or manager, one of the most critical decisions you'll face is whether to hire employees or bring on independent contractors. While many might believe that the difference between the two boils down to a simple 20-25% rate gap to account for things like holiday pay, KiwiSaver contributions, and ACC levies, the reality is far more complex and involves a plethora of hidden costs that can significantly impact your bottom line.

Let's dive into the true cost of employees and why comparing them to independent contractors requires a more nuanced perspective.

Employee Benefits Extend Beyond the Obvious

Running a business comes with a myriad of expenses, and employees benefit from many of these without a direct charge. Your office space, phone systems, computer equipment, administrative (or non-revenue generating) staff, and various other infrastructural elements are all used by your employees daily, essentially for free. While you don't bill your employees for these resources, they undeniably derive value from them.

Consider these common indirect costs, which are often associated with employing staff:

• Advertising

• Assistance Programmes

• Bank service charges and fees

• Computer hardware and software

• Insurances

• Office supplies

• Phones & data

• Professional memberships, registrations & affiliations

• Rent of Office space

• Training & Development

• Travel

• Wellness initiatives

• And many more...

These indirect costs represent expenses that your business incurs due to its workforce. Employees indirectly consume resources, affecting your company's finances. But it doesn't end there.

It's important to note that the overhead percentage can vary based on factors such as the size of the organisation, industry norms, and the level of benefits provided. By accurately identifying these percentages, businesses can make informed decisions regarding budgeting, resource allocation, and financial planning.

Productivity Loss Factors: Employees vs. Contractors

To accurately gauge the cost of employees, we must also account for productivity loss factors, which are typically not applicable to independent contractors. These factors include breaks, presenteeism (employees being physically present but not fully engaged), and distractions from colleagues.

Contractors generally face fewer distractions and less presenteeism, contributing to their lower productivity loss, and where these things do occur, it is unlikely that associated time related to these will be on-charged to their client (you)

Let's break down the productivity loss percentages:

1. Breaks: Assuming 1-hour break (1x 30-minute meal break and 2x 15-minute rest breaks) for employees across a 8 hour work day, employees have a break percentage of 12.5%.

2. Presenteeism: According to a KPMG Econtech study indicates that employees lose around 20% of their time to presenteeism, leading to a further 0.52% loss in productive time.

3. Distraction from colleagues: Distraction from colleagues can vary depending on the work environment. For internal employees, assuming they are distracted by colleagues for 30 minutes per 8-hour workday, the distraction percentage is 6.25%.

These calculations lead to an average hourly productivity loss percentage rate of 19.27% for employees on top of the already agreed 20-25% finance related employment costs.

Intelligently Distributing Indirect Costs

Now, let's address how to distribute these indirect costs across employees to gain a more accurate picture of their real cost. A simple method would be to divide the total indirect costs by the number of employees and add the resulting portion to each employee's annual compensation.

However, this approach oversimplifies the problem. To distribute indirect costs intelligently, it's common practice to use salary as an approximation of seniority, which reflects an employee's share of corporate infrastructure and resources used. Indirect costs are typically grouped into three primary categories:

1. Fringe Benefits: Includes healthcare, retirement contributions, paid time off, and more.

2. Overhead: Covers business expenses not attributed to a specific project, like rent, equipment, office supplies, and communication charges.

3. General & Administrative (G&A): Encompasses broader business expenses, such as executive salaries, legal fees, and accounting costs.

These costs are assigned as percentages, often varying by industry and circumstances. General estimates suggest overhead costs can range from 20% to 50% of an employee's salary. To find the overhead percentage, divide total overhead costs by total labor costs (including wages, benefits, and taxes) and multiply by 100.

For example, according to a Deltek report, common rates for these categories are approximately: Fringe 35%, Overhead 25%, G&A 18%.

When combined, they yield a cost multiplier of 1.99, meaning that each employee typically costs the company almost twice their base salary.

Contractors: A Different Equation

Now, you might wonder if contractors also impose hidden costs? While it's true that contractors require some level of organisational support, their usage is significantly lower than that of employees. Moreover, contractors don't benefit from employee perks such as healthcare or retirement contributions, making their costs primarily influenced by General & Administrative expenses.

In the end, determining whether to hire in-house employees or independent contractors should be based on a comprehensive understanding of the hidden costs involved. Every business situation is unique, but awareness of the factors outlined in this article will empower you to make sound financial decisions that align with your specific needs and objectives.

Remember, when it comes to assessing the true cost of employees versus independent contractors, it's always better to delve deeper and consider the full spectrum of expenses, ensuring that your business operates on solid financial ground.

By comparing the total hourly costs, it becomes clear that contractors may have a higher upfront rate but can be more cost-effective due to the absence of benefits, taxes, and lower overhead costs. However, it's important to note that this comparison is based solely on the financial implications and does not consider other factors such as control, expertise, or long-term commitment.

Ultimately, the decision between employing full-time employees and utilising contractors should be based on the organisation's specific needs, goals, and budget. Both options have their own advantages and disadvantages, and it's crucial to evaluate which option aligns best with you organisation's requirements.