The True Cost of an Employee

January 7, 2016

Employees are expensive. It’s important to know the difference between an employee’s hourly wage and their hourly cost to the business. Like freelancers, employees also have an hourly rate, but it isn’t immediately clear what that is. A simple answer would be to divide the annual salary by the number of days worked in a year to get that employee’s daily rate, but this doesn’t calculation doesn’t account for the true cost of the employee and is naïve to the actual value that they create for their employer. To get an idea of how this works, we’ll reverse engineer the hourly rate for an employee that makes a 6 figure salary, \$100k annually.

To start off, we need to determine how much an employee actually costs their employer. In reality an employee usually costs close to double their salary. A salary is only a small part of the cost of an employee, there are additional expenses like:

vacation,
statutory holidays,
sick days,
health insurance,
employment insurance,
taxes,
office space,
utilities,
furniture,
equipment,
software licenses,
office parties

Any perks that come with the job will also increase the true cost of the employee, unless those perks are hugs from an overly friendly boss.

For the sake of this example, let’s make this simple and say that, on average, an employee costs double what their hourly salary works out to be. Our $100k salary works out to a $200k expense for the business. If we work out the hourly cost of this employee, based on 40 hours per week, 52 weeks a year, it’s \$96. You’re probably thinking that employees don’t work every day, but if we consider that the company is still pays for each vacation day and bank holiday, those are paid days, they just don’t require that the employee come to work for those days.

The important thing to note is that an employee with a 6 figure salary costs about $100/hr to employ. For this reason, I think that you should consider $90/hr your minimum freelancer rate. However, we’re not done yet, let’s dive a bit deeper into the cost.

Why do businesses hire employees? Generally speaking, employees get hired to help the business make more money; it’s a form of horizontal scaling. Assuming that there is an unlimited supply of work and suitable employees, if one employee can increase profits by $10k a year, 10 employees increase profits by $100k. Since each employee is hired to contribute to their employer’s bottom line, they have some task, or part of their job that creates value (or income) for their employer. Realistically speaking, not every hour that the employee spends at work will be spent on tasks that contribute to the company’s bottom line.

If we’re being really generous, we could say that an employee spends 80% of a their time doing actual work, in most workplaces, it’s somewhere between 40-80%. The human resources term for this concept is utilization. Utilization is a percentage based measurement of the time that the employee is doing productive work, while at work. How often that resource is utilized. It’s in the best interests of the organization to get their employee utilization as high as possible.

Days off are 0% productive, things like water-cooler time, meetings, breaks, and personal internet browsing and phone calls cut into the time that the employee can spend on value creation; that’s okay, it’s expected. Under most work environments it’s impossible for employees to focus on creating value for the entirety of the working day. This point is, businesses pay their employees for a lot of hours that are not productive time. As long as the business can still make more money than the employee costs, employing them results in a net profit for the organization.

Let’s translate this back to freelancing. As a freelancer, you’ll have some method of billing, either based on an amount per time period (hour, day, or week), or per project. As a general rule, 100% of the time you bill for is time that you are being productive, so we should consider those hours as being 100% utilized. The client only pays us for the hours we work so we need to make sure that embedded in those hours are all of the benefits and inefficiencies that an employee would receive. There are two differences, as a freelancer, you’re aware of this fact and can choose how many billable (productive) hours to work per week, and you get to make your own benefit package.

If we were to consider an employee’s time, like a freelancer’s, each employee does do ‘billable hours’ - the value creation hours, but these hours are mixed in with non productive time where they aren’t creating value. If our six-figure salaried employee spends between 40-80% of their time on activities that create value, then realistically, we’re looking at a cost per hour of billable time of $125 at 80% utilization and $250 at 40%.

There are two things that we haven’t factored into this equation: the time it takes to train someone, and the time it takes to fire someone.

What happens when an employee leaves, or the business grows? It must hire someone new. When an employee is hired, the time spent training them is an investment that the business hopes to recoup. After a number of weeks where the employee’s productivity is low, they’re making a gamble that the employee will be productive enough to have a net positive effect on the bottom line.

On the other side of the equation, when an employee has to be let go, the business must perform its due diligence in order to ensure that they are not liable and will win if the former employee takes them to court. This process is good and is in place to protect employees, but when a problem employee must be let go, the process takes time, during which the organization must still be paying that employee’s salary.

If we’re to take these stats into account, they must be averaged out over the utilization of all employees, lowering the percentage further. The process of hiring and firing employees will also cut down on the productive time of the person who is in charge of them, so much so that when the organization grows, this responsibility must be delegated out to an HR department. Yet somehow, despite all this, almost all successful businesses have employees and can afford to pay their salaries. This isn’t a case against employees, however, it’s just an exercise to illustrate that premium freelancer rates aren’t actually outrageous.

If your productive hours are creating the same end result as a 6 figure salary earner, from a purely cost perspective, charging $200/hr is realistic. That said, most people who are in the position to buy your services either haven’t done these calculations, or don’t care, so you can’t just tell them you charge $200/hr and that you’re “really, really fast.” You need to have some other method of illustrating how you’re worth it. Pointing out inefficiencies in your client’s business isn’t going to magically place you in their good books, it’s going to make you look like a know-it-all jerk.

Instead, to get the client on board, you’re going to frame your value in a language that the client will understand. This way, it won’t matter how much you charge, as long as you can illustrate that you are going to deliver exactly what client needs, and that the overall budget fits within their expectations.

To do this, you just need to win the client’s trust.