Rates vs Wages

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It's difficult to directly compare a contractor's hourly rate to an employee's wage. Simply multiplying up produces figures which make contractors seem more expensive. For example, taking 173 hours in a calendar month at a rate of 40 hours per week this contractor:

contractor (£28 / hour) * 173 =  £4,844 / month
                                £58,128 /  year

appears far more expensive than this employee:

                     employee =  £3,500 / month
                                £42,000 /  year

But this is mostly due to taxation and an overestimation of billable hours because of differences in working practice. In fact this contractor would cost the employer no more than this employee at worst, and quite possibly a lot less. This article explains why that is, and how to convert between contractor rates and employee wages to make a fair comparison.

Contents

Approximately equivalent rates and wages

Before going into a detailed explanation, here's a chart of approximately equivalent rates and wages. These figures were calculated using minimal estimates for interruptions and holidays, and averages for sick days and error corrections. The approximate salary should therefore be considered an upper bound. The actual equivalent is likely to be less in practice.

per hour approximately equivalent salary
£20 £30,000
£22 £33,000
£24 £36,000
£26 £39,000
£28 £42,000
£30 £45,000

Accounting for non-billable hours

The contract between a company and its employee is different from the contract between a company and a contractor.

An employee has a contract of service. This means, in exchange for being available during the hours agreed and doing whatever the company asks, the company will pay the employee an agreed amount. This payment must happen whether or not the company uses the services of its employee.

A contractor has a contract for services. This means, the contractor will provide the agreed services and invoice the company for their use. This invoice will only include the services actually used by the company.

This difference in contract terms makes it difficult to compare the monthly cost of an employee with the monthly invoice from a contractor. The following sections show how to account for these differences.

Non-working days

Because contractors often work on short projects, they usually take their holidays between jobs so it's easy to forget that they don't bill for holiday time. An employee, on the other hand, has holiday time built into their wage as a hidden cost.

In addition to their holiday allocation, employees also benefit from 8 public holiday days and an average of 8 days of sickness, maternity / paternity leave and so on. A contractor would not invoice for these either so they should also be excluded from the calculation when comparing to an employee.

Given a normal holiday allocation of 20 days per year and 16 other absent days that means employees work 224 out of the 260 potential working days. On average that represents 18.74 days per month. In comparison a contractor will be invoicing for an average of 20.41 days per month. This difference is hidden if you try to compare an employee's monthly wage to a contractor's monthly invoice. However you can account for this approximately by either adding 9% to an employee's cost or subtracting 8% from the contractor's before making the comparison.

£3,900 * 1.09 = £4,251
£4,250 * 0.82 = £3,910

Working practice

When providing the service of computer program writing, only the hours spent writing the program are billed. In contrast, a typical employee does not usually produce work for 100% of the time they are present at the office. There are many potential interruptions, for example:

  • breaks for drinks, cigarettes, toilet
  • phone calls
  • errands
  • technical problems

Companies hide the cost of such interruptions in the employee's wage. Interruptions totalling 25 minutes in a day, a conservative estimate, represents approximately 5% of the working day. (Actual interruption time measured over two projects by Powered Up Games came to 26% of the working day on average.)

This parameter varies the greatest from company to company and has the greatest effect on the monthly cost.

Quality

It is not possible to eliminate all errors in the workplace, either for employees or contractors. However, an employee is paid for their total time working on a project. In contrast, a contractor is paid only for the finished product. A contractor does not usually expect the client to pay for mistakes and therefore doesn't bill for the time to rectify them.

The actual amount of rework due to errors varies between programmers. A good figure to work with is 2%.

Adjustment for all non-billable hours

Assuming an average working day of 8 hours, removing 5% for interruptions, and 2% for error corrections, we can work out the approximately equivalent hours that an employee would work over a month:

average employee hours per month = 18.74 * 8 * 0.95 * 0.98 
                                 = 140

Remember that this figure accounts for the holiday entitlement of an employee so it shouldn't be used to predict the invoice from a contractor. The average hours billed by a contractor can be worked out by substituting 20.41 days:

average contractor hours per month = 20.41 * 8 * 0.95 * 0.98 
                                   = 152

Accounting for employer's National Insurance

The cost of an employee is greater than their salary. Even discarding benefits and bonuses, every employer must pay National Insurance for each employee. This is currently 12.8% of their salary above the Earnings Threshold. For 2007-2008 this threshold is £5,225 (£435 per month). So an employee on £42,000 (£3,500 per month) costs:

12.8% of (£42,000 - £5,225) = £4,708

in National Insurance. The cost to an employer (ignoring non-working time) is therefore at least £46,708 (£3,893 per month.) Contractors deal with this tax themselves so the contractor's invoice is the total cost.

Other differences

Additional benefits that a company grants to its employees are also not included in a contractors rate's:

  • pension scheme
  • company car
  • expenses
  • private health insurance
  • royalty scheme
  • bonuses
  • share options

To compare like with like you need to put a figure on these benefits and add that in to the comparable employee's wage (or subtract it from the contractor's fee).

Putting it together

As an example we'll convert a contractor on £28 per hour to the approximately equivalent wage of an employee:

          contractor hourly rate = £28

equivalent monthly employee cost = 140 * £28
                                 = £3,920

equivalent monthly employee wage = (£3,920 + £435 * 0.128) / 1.128
                                 = £3,525
                                 
 equivalent yearly employee wage = £42,300

Or working in reverse we can calculate a rate to approximate a wage of £42,000:

            employee yearly wage = £42,000
            
           employee monthly wage = £3,500
           
           employee monthly cost = £3,500 + (£3,500 - £435) * 0.128
                                 = £3,892
                                 
      equivalent contractor rate = £3,892 / 140
                                 = £28

In both cases the monthly cost of an equivalent employee is still likely less than the actual monthly invoice of the contractor due to the provision of holidays for the employee. An alternative way of looking at it is that while a contractor is due only money, an employee is due money + holiday entitlement. While an individual monthly invoice may be greater, projected over the year they would be the same on average.

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