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The Hidden Value of Software Consultants

Customers of our mid-size software consultancy are generally well-established companies who have experience hiring vendors to help them with large, complex software builds. Market rates for software consultants are generally available to anyone who does a little research, and as such don't normally surprise customers.

However, the amount per billable hour customers are willing to pay, given that their perceived hourly cost for equivalent internal full-time staffers is less by “about half,” makes many customers reluctant to move forward with a consultancy. Enthusiasm wanes further upon consideration of consulting costs for ongoing maintenance and improvement of their software assets, since companies consider operational costs separately from those of strategic investments.

While it isn’t arguable that the direct cost per hour is lower for salaried employees than external consultants, this simple analysis in itself misses all of the hidden costs of having employees, particularly those of the creative class of software developers, which significantly drives up the total cost per hour for their work. Furthermore, it doesn’t consider the boost a company gets from softer factors like the attrition rates, cultural cohesion, rigorous time capture, reduction in stress, and an increase in time and attention to more strategic matters.

...this simple analysis in itself misses all of the hidden costs of having employees, particularly those of the creative class of software developers, which significantly drives up the total cost per hour for their work.

This article examines some of these hidden costs, and proposes scenarios where it might be better for the customer to consider outsourcing their software development function entirely. It also looks at some of the risks of outsourcing relative to in-sourcing. I will use the word “company” to represent a purchaser of software services, and the word “consultancy” to represent an external seller of these services.

This article is written from the perspective of a choice between “in-sourcing” and “near-shore” outsourcing as opposed to what is commonly referred to in the industry as “offshoring”, which normally implies a much different service level and a substantially lower cost-per-hour model. For the purposes of this article, I will use the term “outsourcing” as being synonymous with “near-shoring.” The costs and benefits of offshoring relative to in-sourcing and near-shoring are the subject of another article.

Hard Factors

The most obvious cost drivers for employees relative to contractors arise from the work for which companies pay them, but from which no direct revenues are derived. These are benefits packages, vacations, sick days, statutory holidays, training days, and overhead days (days made necessary simply by having an employee, e.g. time spent communicating company business to them; in my model, I’ve set this to about 5% of the employee’s time). If the total number of potential working days (excluding weekends) in a year is 260 (52 weeks * 5 days a week), then a person with 3 weeks’ vacation can be expected to be directly productive during about 210 of these:

Potential working days / yrVacation days / yrSick days / yrTraining days / yrStat HolidaysCompany Overhead days / yrWorking days / yr

Furthermore, there are a number of costs associated with onboarding and management of employees, which adds to their cost per hour relative to that of an external consultant. These include annual bonuses, employer taxes and contributions (EI, CPP, Medical and Dental insurance copayments, and PST), training costs (e.g. for courses or conferences), infrastructure (office space / cleaning, computer, phone, internet access). If the company offers stock options or shares, these would also affect the bottom line. Here are some sample annual costs for an employee with a base salary of $90K, typical for an intermediate or senior software developer in the Toronto market:

SalaryBonusInfrastructureTrainingEmployer Taxes and ContributionsTotal Direct Annual Cost

Then there is the human resources cost. Employers of software professionals have to manage higher-than average industry turnover rates, the cost of hiring in a very competitive market (often invoking referral fees), and employee ramp-up times that exceed other industries. Whenever an employee leaves and is replaced, these fees are incurred again. Assuming an agency referral recruitment fee of 15% of the annual base salary, conservative interviewing costs of $2K per hire, ramp-up cost of $5K (HR, employee, direct managers, team), and an attrition rate of 20% (the employee is replaced every 5 years), if we amortize the HR costs over a 5-yr timespan, we get the following average cost per year:

Referral FeeInterview costRamp-up timeYear 1 HR CostAnnual Attrition Cost (20%)Average Annual HR Cost (5 yrs)
Calculation: (20.5 + (4 x 4.1)) / 5 = 7.4.

Assuming 8 working hours in a typical workday, we thus have a cost of $125.7K over 1680 hrs (210 days), or about $75 per working hour. Using hard factors alone, if the equivalent external consultant charges less than this per billable hour, it may be better to choose him or her, from a bottom line perspective.

Soft Factors

It’s worth mentioning that if a software consultancy hires the same consultant at $90K, their cost per billable hour will also be about $75. In order for the consultancy to be profitable, their bill rate has to be more than $75 per hour. Stated another way, the consultant has to generate more value than this, per billable hour.

If a software consultancy hires the same consultant at $90K, their cost per billable hour will also be about $75. In order for the consultancy to be profitable ... the consultant has to generate more value than this, per billable hour.

Concurrently, if a company is evaluating the use of external consultants, they must consider the relative value-generating capacity of a staff member over the more highly-priced consultant. To examine the reasons one might choose this path, we have to turn to soft factors.

Soft factors don’t appear on the balance sheet because they aren’t traditionally thought of as assets, and are hard to quantify, but ironically they can make more of a difference than the things that are counted. They eventually do affect future revenue streams, but it is difficult to show causation. Let’s take a crack at that here.

A software developer working at an external software consultancy can potentially be more productive than an equivalent developer working in-house for the following reasons:

  1. Software consulting vendors run multiple projects at once. Thus, even if a team member is assigned to another project within the vendor shop, knowledge of the client’s business remains within the vendor company, and can be accessed for some time to come. This allows institutional business and technology knowledge to be better preserved.

    Estimated value: 2% or $1.50/hr.
  2. Software consulting managers were often themselves once software developers, and as such are more able to motivate the developers on their payroll, relative to managers at companies in other industries, since they better understand their needs. Higher motivation equates to higher productivity.

    Estimated value: 5% or $3.75/hr.
  3. Birds of a feather flock together. Creative, productive people like to have access to other people like them. They ask questions, get perspectives, share their work, and are better informed, appreciated, and understood. It is easier to create a context of shared experience the bigger the set of like-minded people in an organization. The proportion of developers at a consultancy is much higher than that of an internal team in another industry, all other things being equal.

    Estimated value: 5% or $3.75/hr.
  4. Software developers at consulting companies can avoid stagnation better than those at companies in other industries, by switching from project to project and having a wide exposure to many different platforms. This lowers the attrition rate by allowing an employee to manage their development within the walls of one company for a longer period of time. It also allows them to grow more in experience more quickly by being exposed to multiple business domains and technology stacks in a shorter period of time. This makes them both more motivated and more productive.

    Estimated value: 10% or $7.50/hr.
  5. Software consultancies have a culture of software development, which software developers are attracted to. This lowers the recruitment costs, increases the ability of the company to attract top talent, and tempers the attrition rate relative to developers at a company for which software development is not itself the primary business goal.

    Estimated value: 10% or $7.50/hr.
  6. Given the hourly billing model, software consultants must generally account for every hour that they invoice. This usually means that at some level, they are responsible for tracking all of the effort they expend on a weekly basis, and explaining any variances relative to plan. It is well-accepted fact that when these things are measured, people are more likely to be more productive. Most companies do not require internal staffers to track time, in contrast with consulting companies.

    Estimated value: 10% or $7.50/hr.
  7. Software consulting vendors are able to make higher quality hires more of the time relative to companies in other industries, due to their primary focus on hiring and talent development (note that this is not necessarily true of placement agencies, whose main motivation is to simply send resumes and hope they stick, in order to collect the referral fee). The argument that these developers will be 25% more productive should not be that controversial.

    Estimated value: 25% or $18.75/hr.

The sum of all of these gives us an increase in the relative value of the outsourcing by 67%, or $50/hr, bringing the “value” per billable hour to $125/hr.

This analysis hasn’t yet considered the cost to the business of managing its own internal software team, which notably includes the stress and time related to managing the team, and the distraction from the company’s main strategic considerations, which could easily account for an additional cost premium of 30- 40%. All of a sudden the value derived per billable hour could jump substantially to $150/hr.

Benefits of In-sourcing

We should also consider some of the factors that might drive the value curve in the opposite direction, i.e. the benefits of in-sourcing:

  1. More direct control and influence over staffers: Estimated value: 5% or $3.75/hr.
  2. Better preservation of institutional knowledge (tempered by the potentially higher attrition rate mentioned previously). Estimated value: 5% or $3.75/hr.
  3. Better synergy and alignment with company goals: Estimated value: 10% or $7.50/hr.
  4. Decreased reliance on external party means lower risk: Estimated value: 10% or $7.50/hr

In order to realize these benefits, companies have to have managers that are willing to motivate, inspire, and manage these teams (requiring additional investment). Some companies have a culture that allows them to do this, and as such may realize a big part of this 30% benefit, driving the relative value of outsourcing down by $22/hr.

Long Term

Some of the risk associated with outsourcing may be mitigated over the long term by the cultivating a trust relationship between the company and their chosen consultancy. This is dependent on how well the consultancy delivers services their clients, and the recognition that this is in the shared interest of both parties. Indeed, development partners sometimes become so deeply embedded within the companies they service that they are viewed as indistinct from the company’s internal team.

Finally, software consulting vendors will often offer discounts on the “retail” hourly rate in exchange for longer-term commitments from their clients, which reduces their risk. Values for these might typically be 5% for a 6-month commitment, or 10% for a 1-yr commitment. These can be provided because the risk for the vendor is lower, the longer the commitment. Such a discount widens the value gap in favour of choosing external consultants.

Comparisons between costs for internal and contract staff can be difficult to control. I hope this article lends some perspective to apples-and-oranges comparisons vis-à-vis hourly rates of external software consultants, and the effective hourly rates of internal development staff.

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