How to Calculate Labour Costs — (Part 2) Who is Actually Working For Us

One of the biggest mistakes I’ve run into is the definition of an employee. For a basic fact, it seems to be very poorly understood. In fact, several of the myths and mistakes are directly related to misunderstandings in this area. And that misunderstanding seems to apply equally to HR managers, IT managers and others who should know better.

Most of us know that some people are employees and others are contractors. But companies are constantly being caught for crossing the line. The “Microsoft effect” is far more common than we would like. It’s a risk that many companies have embraced without need.

First, recognize that there are two separate sets of rules. The first applies to general employment. The second applies only to labor standards issues. Think of them as two different ways of looking at or grouping workers. We could combine them of course, but that would just make the situation more complex than it needs to be. Instead, we’re going to concentrate on the general rules and leave the labour standards issues to a separate discussion.

For general understanding, there are five — and only five — types of workers. I say workers and not employees because two are not employees. They are:
<ol>
<li>Salaried Employees</li>
<li>Hourly Employees</li>
<li>Non-time based Employees</li>
<li>Freelance or Independent Contractors</li>
<li>Contracted Employees</li>
</ol>
A salaried employee is a full employee of the company and is generally eligible for all benefits. They also incur all employment taxes. Typically, their salary is stated on a yearly basis although monthly is also occasionally used. Payment is typically a fixed amount less deductions paid on a set cycle which can be anything from weekly to monthly.

An hourly employee is also a full employee of the company. Again, they are generally eligible for all benefits. And they incur all employment taxes. Their salary amount is stated on a per hour basis. However, often it is necessary to project that amount out to one year for comparison to salaried employment. Payment will vary based on the number of hours they work less their deductions. Again, it occurs on a set cycle which can be anything from weekly to monthly.

Non-time based employees are again full employees of the company. They are generally eligible for all benefits. And again, they incur all employment taxes. However, unlike either salaried or hourly, their salary is not time based. Typically, it is productivity based or a combination. For example, piecework and commission are both non-time based as is base plus commission. Payment varies based on variations in the underlying productivity unit less deductions. And again, payment occurs on a set cycle which can be anything from weekly to yearly. In fact, in base plus calculations it is not unusual to pay the base on one cycle and the productivity portion on another cycle.

Freelance or Independent Contractors are probably the most misunderstood group of workers in any company. First off, they are not employees. They are, in fact, companies of their own. They do not receive benefits and they do not incur employment taxes. At least not from their clients’ point of view. In fact, they do incur benefits and employment tax costs; however, their own companies incur the costs. This cost must then be included in their basic rate. Payment is negotiated up front and the amount may vary depending on numerous factors. Hours, days, weeks, months and quarters are all common bases for calculating rates. Even fixed amounts for a project are common.

Contracted Employees are probably not what you think they are. A more common term for them is contractors or consultants. The legal term is a third-party employee. What they really are is an employee of a contracting company. Unlike a freelancer who owns the company that employs them, they are employees of a third party. They simply happen to be working on your site on their employer’s behalf.

If we take another look at the five types of worker, we will realize that there are really only two types of worker — our employees and someone else’s. The difference between salaried and hourly employee is the period of time we base the payment on. The difference between hourly and non-time based is the unit we use to calculate the pay. In fact, for calculating minimum wage you will need to reconcile all three. If we consider freelance and contracted the only difference is who owns the company that employs them.

It’s when we confuse the employee and contractor that risks and myths arise.

In the next article in this series, I’ll discuss some of the costs that are frequently ignored and provide a set of quick rules of thumb for calculating costs of labor.

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