The unfortunate math behind consulting companies

Consulting can be a great way to fund a startup or make a bunch of cash. It’s easy to start; Just pick an hourly rate and jump in.

But someday soon you’ll notice there’s only so many billable hours in the day, and you’ll be tempted to expand. Maybe hire an employee for \$30 per hour and re-bill them at \$60. Easy money, right?

Unfortunately the math doesn’t work that way.

Here’s what really happens, and a few ways to combat it.

Double is nothing

Suppose you hire an employee at \$60,000/year. There’s 2,000 working hours in a year — 40 hours per week times 50 weeks, leaving two weeks vacation. So your cost per billable hour is:

Nominal Cost: \$30/hour

In terms of working days (WD), there’s 250 in a 50-week year. In America we have ten federal holidays bringing the annual WD count to 240. Recomputing the cost of the remaining billable hours, we have:

20 WD/month, \$31/hour

We also have employment tax in America. Rules are complicated and vary by state, but as a rule of thumb you pay 15% in taxes including Medicare and Social Security. That changes the annual cost of your employee from \$60,000 to \$69,000 with an associated change in hourly cost:

20 WD/month, \$36/hour

We’ve assumed an 8-hour work day, but any owner of a consulting company will tell you this rarely happens. Oh sure, founders work 60-80-hour weeks, but not employees. Besides, even if you’re in the office 8 hours a day it’s hard to be heads-down-on-task the entire time, and consulting is about billable hours. It’s hard to be billable for 8 hours a day, every day. From what I’ve seen the weekly billables are more like 36 hours instead of 40. That means you’re short 16 hours per month, which is equivalent to missing two full (8-hour) days. With this loss, now we’re at:

18 WD/month, \$40/hour

Then personal life intrudes. You come in at noon because you had a morning dentist appointment. You take off early to wait for the A/C repair guy. You’re sick one day. All very reasonable and it doesn’t sound like much, but two half-days and a sick day means another two days lost:

16 WD/month, \$45/hour

We’ve assumed you’re able to keep your employee completely busy throughout the year without down-time between projects, but that’s unrealistic. If you get two-week gigs, maybe there’s a day between them where the timing didn’t quite work out or you did some post-contract clean-up. If you land a six-month gig that’s better, except it’s hard to time large deals like that to start and end exactly when you want, months in advance; in fact it’s common to have 2-3 weeks of down-time between such things. Either way you lose about 10% of your time, and that’s assuming a healthy incoming project pipeline, so knock off another two days (10% of the 20-day work-month):

14 WD/month, \$51/hour

And let’s suppose you want to allocate just a little time for career development. After all, if you expect to hire and retain great people, they need time to keep learning, stay in front of the latest technology, and just have fun. Maybe that means going to a conference or two, or working on an open-source project, or instituting “10% time” at work (like Google’s 20% time but more reasonable for those of us who don’t have billions in profit from a cash-cow). You see what’s coming of course: That’s another 10%:

12 WD/month, \$60/hour

The true cost of an employee is double the nominal cost. If you bill out a so-called “\$30/hour” employee at \$60/hour, you’ll only break even. You really need to bill out at \$100/hour to make any kind of profit.

Which is hard, because the client you’re billing knows this person doesn’t really cost \$100/hour. And when that client thinks about what’s “fair,” they won’t go through the computation I just did; they’ll base it on the person’s nominal rate plus a little profit for you. This caps the amount you can actually re-bill before client feels ripped off.

I hear you say: “Yeah, but at \$100/hour that’s \$40/hour profit, or \$80,000/year to me! So that’s still really good.” Maybe, but consider this: If your underling is \$100/hour, aren’t you worth \$150/hour at least? And if you worked just 20 hours/week (on average) at that rate you’d clear \$150,000 annually without the hassle of hiring and managing an employee. Isn’t that better?

What to do?

So how do you mitigate these issues? Lots of ways, few of which are compelling, but all of which are quite do-able:

Scale
If you had five of these employees you’d be clearing \$300,000 per year, which sounds more like it. Except not because scaling brings more time and expense:

• The client pipeline is much harder to maintain. Keeping 3-6 projects going year-round is a full-time job in itself — a job resting on your shoulders.
• Employee turnover becomes more common, so you’re permanently in hiring mode. That in itself is time-consuming and expensive, and it’s hard to coordinate new hires exactly when other employees are leaving.
• With six people you’ll need office space with the attendant expenses.
• With all these new tasks, there’s no way you can also manage the projects and client relationships and internal product development, so you’ll need a project manager or a sales person or an office manager or some kind of help, and all of those come out of your profits.
• None of these new tasks are fun or creative. It’s drudgery, and it’s on you. Congrats, you’re a business owner.

With these new expenses it’s not unusual to see that so-called \$300k in profits came back to \$150k. And now you’re doing things you hate doing.

Charge more
Any amount more you can charge goes straight to profits, so even charging a wee bit more makes a big difference at the end of the year.

Often, though, charging more pushes away your existing client base, and you’ll have to find a new breed of folks willing to spend the big bucks. These are generally bigger, more dysfunctional companies with 25-page Master Service Agreements and complex, ever-changing requirements (though no acceptance of “agile” or “lean”). It’s a living, it’s just a different living than being a Cool Cat HTML/CSS whiz doing fun projects for other entrepreneurs who appreciate what it means for you to be a master of Sass.

Also this sword cuts both ways — even little discounts crater profitability. For example it’s common practice to give a 10% discount if the client pre-pays, but although it’s great to have cash up-front, that discount comes right off your bottom line.

Bill more hours
Billing even 5 hours more per week significantly increases profitability.

The problem is convincing your employees to work more, because to them that’s “overtime” on a fixed salary. What’s in it for them?

One answer: Split overtime billings with them. It’s pure profit to you and your employee can earn a significant bonus.

Build a product
Most consulting companies I know have a few internal projects which they hope to someday turn into money-making products. The usual story is:

We built this product because we needed it ourselves. It gives us an advantage in consulting because it accelerates our development and enhances our sales pitch.

But surely we’re not the only software developers on Earth who would find this tool useful, so whenever we have a lull in client work we work on our product. Someday that could cash-flow by itself!

Indeed there are conspicuous companies who grew successful product lines in exactly this manner: 37signals, FogCreek, and most recently Pivotal Labs. Unfortunately, for each of those there are hundreds if not thousands who toil away at pet projects which never see the light of day. Some reasons:

• Converting an internal project to a user-friendly one requires drudgery: Documentation, user interface polish, installers, password-reset, and fixing those 200 bugs that internally you’ve just learned to work around. No one wants to do it, and it’s no one’s job to do it, so it doesn’t happen.
• It’s no one’s job to market or sell the product. No one has the time, and it’s quite possible that in a roomful of consultants no one has the skill-set either. So you “put it out there” hoping that the magical world of “social media word of mouth marketing” will bestow eager users upon your sign-up form. But, of course, that’s not what happens.
• You have five kinda-cool projects, any of which might be awesome if given enough TLC, but because your attention is spread among all of them (and even then only in fits and spurts between client work) none gets to the stage of being usable by anyone else. Lack of focus kills.
• Billable hours trump product development; it’s always second-class, so you get a second-class side-project.

Most of the problems above can be fixed simply by treating the product as a client:

• The product is listed as a client just like all the rest.
• The product is given a budget, even to the point of a separate bank account (and corporation?) so it’s clear how much you’ve can and have spent on it, and the project pays consulting fees (perhaps at cost instead of full-rate).
• Hours are scheduled and prioritized like other clients, and doesn’t get slipped just because it’s not a “real client.”
• If the (potential?) income from the project cannot justify the cost, you might consider it a loss and stop completely rather than continue to limp along as a money-losing enterprise.

If you pay your underlings exactly the number of hours you rebill them, you avoid all of the issues above: No employment taxes, no worries about 36-hour weeks or vacations or project gaps. It’s simple time-arbitrage.

Terrific! Unfortunately, subcontractors charge a lot by the hour — a lot more than employees. Of course they do… exactly for the reasons above!

You haven’t eliminated those effects, you’ve just moved them to someone else’s profit-and-loss report. If you hired that same employee as a consultant she would charge you \$60/hour instead of \$30/hour and your profits are still the same.

Still, there’s a lot less headache using consultants, so this might still be worthwhile. Simpler taxes (in America), no bargaining for vacation time, no prodding them to bill 45 hours this week to make up for last week. Even from a psychological standpoint this might be better: It’s easier to give up \$60 when you charge \$100, but it causes some consternation to pay someone for a “day’s work” when there’s no work to do.

Consulting is a great way to earn a living and a smart way to self-finance a startup.

The trick is to avoid all these traps. For example, you know billing a full 40 hours per week is critical, so make it a habit to review hours weekly to make sure no one is consistently falling behind. As another example, set up incentives where employees get to share in the profits when they bust ass.

It’s always hard. Most consulting companies don’t make much profit, and it’s one in a thousand that has the discipline to launch a successful product during off-hours. If you’re going to make it happen, you yourself need to be serious, disciplined, and relentless.

But you can do it.

And if you do, you’ve just self-financed a startup, made a nice living, mitigated much of the risk of product-only startups, and built a great team in the process.

What are your experiences on either end of the consulting/startup equation? Let’s continue to share tips and traps in the comments.

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• http://www.seomoz.org Rand Fishkin

Jason – While I can agree that there’s challenging math here and that you’ve laid out a lot of this correctly, I have to disagree with this:

“Often, though, charging more pushes away your existing client base, and you’ll have to find a new breed of folks willing to spend the big bucks”

I was a consultant (and ran a growing consulting firm) from 2001-2007. We occasionally lost a new, potential client to price, but never an existing one. My prices went from \$75/hr at the start to \$1,000/hr when we exited consulting completely in 2009, and finding/retaining clients wasn’t the hard part. The tough part was finding people who could join the team and contribute at a high-enough level to make their rates similar. In my experience, at least, the hardest part of scaling was the consultants themselves, not the clients or the rates.

Granted, we did exactly what you suggest and moved into product, which has higher gross margins and scales better :-)

• http://blog.asmartbear.com Jason

That’s great! It’d be wonderful to have a guest post about how you managed to do that…. hint hint! :-)

Of course, most people are never able to charge \$1000/hr…

• http://www.iacob.info Liviu

Wow, \$1000/hr?
Who and what for would pay that amount of money?
I’d love to hear the answer if it’s not confidential.I’m just curious in what branch/niche and/or what project would provide that kind of financial payout.

• http://www.tourea.com Tourea

Wow \$16.6667 a second! I want to know too…

• http://www.pearanalytics.com Ryan Kelly

I agree with Rand here. For some of our customers, they retain us for knowledge on-demand, and not so much the pure output. I think that is an ideal consulting arrangement because we’re not forced to deliver X hours of consulting, and the client is not scrutinizing our hours. They are happy when the results are “up and to the right”, and that’s what they pay for.

But, having said all of that, consulting is not very scalable, particularly when each “consultant” needs to be trained and gain experience over time so they can manage a large project.

We have a new model we’ve been experimenting with for 20 weeks, which is a mix between expensive, non-scalable consulting, and SEO automation software (like SEOmoz’s). And thanks to Rand and SEOmoz for continuing to pave the way for the SEO industry :)

• http://www.osmoseinteractif.com André-F. Landry

Highly agree with Rand.

Those who can bill at 1000\$ / hour will start their own shop and you can’t hire them except as partners in the firm.

• http://www.straysoft.com Stray__Cat

In my experience passing through consulting is a necessary step before going in product mode.
The one competitive advantage that can’t be easily matched is market and industry knowledge, and it can be acquired only by consulting first.

• http://www.stainlesscode.com Dan Stieglitz

Great article, really highlights many of the pitfalls of starting a consulting practice. One thing I would add to the “Use and independent contractor” section: Be careful! Each state has idiosyncrasies regarding ICs and employees, and they can usually deem your ICs to be employees depending on the situation. That means that after paying more for subcontractors– even years later– you can be subject to back-taxes and (severe!) penalties when the state says they were really employees. New York State, for example, has a (\$2000-per-ten-day penalty for employees who were not covered by Workers Comp. policies). Many business have been bankrupted by the state for this reason.

• http://toomanytabs.com Ollie Rattue

Hey,

As usual a really interesting and detailed argument. My personal experience coincides with your thoughts on side projects with a busy company. As they don’t create instant profit, carving out time for them is always hard, so they are only ever worked on ‘as and when’ a spare (read rare) moment appears. Sadly this means they will seldom make it out the door.

Out of interest how long did this post take to write?

• http://blog.asmartbear.com Jason

2-3h for first draft, then 2-4h for editing, art, and the little things like making thumbnails, adding tags, writing the short description for the home page, and similar.

• http://www.skillfair.co.uk/ Gill Hunt

Guess it may be different in the UK compared to US. Here most small consultancies use subcontractors – and there are lots of quite large ones that only have 1 or 2 actual employees. So a very effective model and you don’t have to worry about the biggest problem with salaried staff – the fact that you have to pay them when there’s no billable work to do.

Using consultancy to finance a startup does work – but I think it only really works if the consultancy and the development you need to do are aligned. I’ve come across quite a few software companies that got someone else to pay them to build their product – IBM and Oracle to name but two ;-) But you have to watch out for copyright/IP issues otherwise you might not own the results.

If the development and consulting aren’t aligned you just get continually dragged of your ‘skunk works’ to sort out customer issues – after all they’re paying the bills – which can get frustrating for everyone.

• http://www.cfwebtools.com Mark Kruger

Jason,

I feel like I could have written this article myself. Through trial and error I have gone from a shop of 2 to 14 developers. Along the way learning to justify our rates to potential customers has been a learning experience. There’s one idea I’d like to add. When it comes to justifying rates you can think in terms of “value add”. A company – a “team” – of developers brings some things to the table that an individual contractor can’t.

1) They have aggregate skill sets and knowledge for example. So the whole is a bit better than the sum of the parts.

2) There are resources other than just human that a company can use and share. We have development platforms, subversion, backups, disaster recovery plans, methodology, training, documentation…. things that may or may not be part of the project but are added by the simple event of using a company as opposed to an individual.

There are other value adds. Access to me, a project manager, guarantees etc – where an individual can’t muster enough resources to meet the need.

-Mark

• Tim Burgess

Totally agree. Contractors can cut overheads but you don’t get the extras benefits that come from people with a greater commitment to the company.

• http://brianburridge.com Brian Burridge

Your are right on with your point, no question. I’ve experienced it first hand, and talked to many others who are trying to deal with it now. You’ve left out one piece of this though that complicates it even more. Once the \$30/hour person realizes you are charging \$100/hr for them, their confidence soars and they begin to wonder why they can’t charge maybe, \$80/hour on their own? And often they can, so now you’ve lost them. So the only contractors you can hire and pay \$30/hr while charging \$100/hr for, are ones who aren’t really worth the \$100/hr, or who have yet to realize they are worth that much. Either way, not a great long term solution and one that will come back to bite you.

A local high end hair salon just hemorrhaged all their top stylists. Why? Because one brave soul realized they were worth what they were being sold for to the end consumer, not the 40% of that amount they were taking home. She left and started working for herself. All of her clients came with her. Without marketing, she instantly doubled her profits, while gaining control of her own work world, and thus flexibility. Word spread. Five more stylists left the salon and did the same thing.

• http://www.egltd.com Douglas Hackney

Jason,

Thank you for a well written post, and one I think is very helpful for those new to or considering a services business model.

You touch upon the majority of the business model and operational challenges that I experienced in growing and exiting a services business, and those of the services companies that I have subsequently coached and counseled through growth and exit.

One key aspect for successful scale, and one that is also required if you transition into product, is brand development and management. While all of the challenges you outline can be successfully overcome and / or mitigated to some extent without it, I believe it extremely challenging to do so, much less scale and exit, without a sustained investment of resources in branding.

Technical founders tend to view technical prowess as the primary attribute that determines success. However, with services models, especially in market segments that are already or are rapidly commoditizing, sheer technical capability is rarely the determining factor for survival or success.

A powerful and meaningful brand can enable the pricing, relationships, clients, recruitment and retention you highlight as avenues to success for a services business model, as well as put your company on the radar of well-matched acquirers.

Doug
@dhackney

• http://www.nmbblog.com carol spieckerman

The best solution? Never charge by the hour. Ever.
All outcomes and methods for achieving them are not created equal – hourly billing assumes that they are.
Hourly billing on the high end is unfair to some customers, on the low end, always unfair to you.

• http://www.netpaths.net/blog cayley @ netpaths

@carol I know many high end consultants that only bill per project, but I also know successful ones who only bill hourly (such as lawyers). We do a mix of hourly/project based consulting.

I would be very interested to see some examples from your business that support this position.

• http://www.LotusRockStar.com Rob Novak

Hallelujah Carol. I have managed to avoid hourly RATES like the plague. They immediately (as Jason adeptly points out) put buyer and consultant at odds (“can’t you use a less expensive resource,” “can’t you do it faster?”) and who wants to start a long term relationship at odds? There’s also the ethical dilemma of consultants finding ways to bill a few more hours, put a few more bodies in rooms where they don’t need to be…I’ve been on conference calls where the roll call had 15 people and you could hear 40 hangups at the end – and you know that meant 25 more hours were billed!

I have – once in 12 years – invoiced by the hour, because it was a legal requirement. But the project was firm fixed price. Yes, we take risk when we do that, but if you’re good enough at scope you can make quite good money (\$1000/hr or more) lending very high level skills and subject matter expertise to your clients.

An absolute expert on this subject is Alan Weiss, and this is one of the nuggets I took from him many years ago and have managed to make it work in most situations. I make plenty of other mistakes, true, but this is one I’ll stand by.

• http://www.TimNikolaev.com Tim Nikolaev

Jason,
One follow up question that I have:
when you “hire that same employee as a consultant” wouldn’t that eventually cause problems with the IRS? From what I know you can get away with that for a little while. However if they take directions from you on regular basis and you issue substantial 1099′s it might be flag for an audit?

• http://blog.asmartbear.com Jason

Correct you need to be super careful about that, and people do hire consultants treated as employees and get real penalties. Everyone assumes it won’t happen to them, but it happens all the time.

What I meant in the article is only a financial comparison, but you’re right that it could be misleading as I wrote it.

• http://bobspython.com Bob Roberts

Interesting article. At the firm where I work, we typically try to work at a 4 to 1 ratio of billable to paid rate and yes clients know that there is now way we (the workers) are making that much money!!

• http://labsecrets.com Spencer Forman

Quite true that the “grass is greener” phenomenon can lead a small company to progress through the path from consultancy through product and then back again (after reality kicks in).

Maybe this is due to the misconception that entrepreneurs need revolutionary products, or to put up with unreasonable customers, in order to compete? As a fan of Ron Popeil and other late-night tv salesman, I would argue that success is more easily found by marketing (re-marketing) simple things, to simple people, than in trying to be ground-breaking or make everyone happy.

One suggestion that we have found works is to detach your financial goals from any preconceived notion of what your business really sells or whom they sell to. Be unafraid to jettison any projects or customers that are not producing the bulk of your profit (if you are profitable… gross income if you are not). Just like in dating… sometimes being confident enough to play “hard-to-get” can make you more interesting to potential suitors. Seth Godin has spoken of the 1000 fans concept, which you mentioned in a previous post, and that is a great mantra for any entrepreneur. Simply find 1000 people in this world of six billion (give or take)… and focus on finding the easiest way for them to want to pay you every month. Forget everything else.

Knowing that you have that steady income stream from the simplest to manage relationship or product will ensure that you have the time, energy, and resources to pursue more cutting edge and exciting work… while still remaining in the realm of your business niche.

It is a lot easier to find creative time when you are not constantly chasing your own tail trying to fix complicated bugs or bad relationships.

• http://www.gounfunded.com/ Nick Carter

I too ran a consulting company and eventually spun off a product. The problem that keeps most companies from ever getting that side product off the ground is the fact that if they built it for themselves, then that means the customers will be their competitors… and that’s a hard customer base to grow simultaneous to still keeping the consulting biz afloat.

• http://simplyevolve.com Daniel Waldman

Great read and very timely! I’m going through this right now, actually. I’m a 1 1/2 PR/Marketing shop, looking to grow to 2 1/2 very soon (the half is an assistant, BTW).

I am working with my accountant to develop a financial model, so I can predict exactly what needs to be billed every month, and what the expenses are. We’re estimating that taxes, insurance, etc., all add about 40% onto an employee’s salary.

One thing to remember is that, as a business owner, you get paid last. If done right, you might end up taking a smaller salary on paper, but still get some of the financial benefits. For example, you could take a portion of your profit and lease (or buy) a car in the company name. That will reduce your overall taxes, you get to drive a nicer car, and you end up not having to pay for it.

I only took about 1/3 of my revenues in salary last year, but haven’t reduced my lifestyle dramatically. I took only what I needed to live on (modestly), and kept the rest of the money in the business. That has helped me keep my overhead low and profit margins higher. In fact, at the end of the year, my account told me I needed to spend more money on the business or face paying a bigger tax bill (which I did).

It also depends on if you’re an LLC or S Corp, as there are different tax structures for them.

• mike j

I dont understand why you didn’t just use the standard 140% overhead rate and the 2.4-2.5 billing multiplier used by consultants in so many other industries.

30*2.4 = \$72

If you are lucky you can get away with a 3X billing multiplier but it will like fall between 2.55 and 3.0 in the end.

• B Mont

Other issues (I’ve seen or had to consider):

In a company, you usually have to treat all employees the same for benefits. When you expand, the VERY generous benefits you gave yourself (or should have because they are paid with pre-tax dollars in the company and post tax dollars if paid personally) have to be eliminated because you do not want to give the new employees 100% medical/dental/optical/legal/accounting/training/education/etc. plans.

One mediocre employee or contractor can destroy years of work building a reputation. Especially important in a small market, people move around and talk to friends at other companies – you will get the blame.

Your contractors usually have no loyalty to you – they will leave if they get a better offer, get angry at the workload, or they think you are making a fortune off of their work. You will have to train someone new, face delays, use lots of your time to evaluate the situation/needs, and deal with the angry client.

Besides project managers and office expenses, there will be support staff (either in house or outside). I don’t charge for trips to the store to have posters made, pick up supplies, keep contact with vendors, visit potential clients – I combine these with personal shopping trips and chores. Employees will be on the clock and your client will not be happy paying \$100/hour for delivery service or you will not be happy paying \$60 internally for these non-billable tasks. Using outside services for some of these chores will cost less, but still be an extra expense that you never considered before.

If you are developing a product, you don’t just need marketing help when the product is ready for market, you need it during development to insure you have a marketable product. I’ve seen companies flounder while they added features/changes the market demanded (the internal need that started the product project was slightly different than the final target market.) Now other companies that were behind in development can catch up or big companies can jump in before you recover. [plus you may never regain your reputation - remember the rotary engine?]

When issues arise in old projects, how will deal with them when all the people are now on other projects with deadlines (or no longer working for you). There is no budget and no employees on the project – yet you have angry clients and a problem to fix.

Will you clients be angry when you put a contractor on the project – they thought they hired YOU, the expert, and you give them this new unknown contractor. Be careful the clients know what you are giving them and insure that they don’t feel you pulled a Bait and Switch.

Is your consulting market sustainable? Will you have repeat business? Is your market currently at the top of a bubble and next year your clients will have to actually justify expenditures (expensive consultants are often difficult to justify to the owners of a failing company)?

• Kevin Boulas

This is an interesting take on the economics of consulting. I’ve been around the consulting business for a long time (I’ve had many roles including vice president with full responsibility for a \$20MM P&L, and also founded and grown a consulting firm to over \$1.25MM in annual billings in 3 years, before we – unsuccessfully – went the product route). The key point I would make is that the consulting business has been around for a long time, and I think the economics are well understood . A few rules of thumb:

1. You realistically need to target billing 1,500 hours / year / consultant, on average. That number goes up slightly for lower experienced consultants, and down a little for more highly experienced consultants.
2. Your gross margins for consultants need to be north of 60% – I was hitting 73% for the \$20MM business and we were making a lot of money.
3. This means that whatever you bill your consultants out at will have to cover their salary and still deliver 60% gross profit. If you are paying a consultant \$60,000 / year (ignoring labor burden), you need to make \$60,000 / .4 = \$150,000 a year in billings. You have to make this amount in 1,500 billable hours, which means the lowest you should expect to bill out a \$60K / year consultant is \$100 / hour. Making some assumptions about overhead, this should deliver around 25% net margin a year, or about \$37,500 net profit per consultant.
4. The hourly rate for a consultant matters a whole lot less than the level of commitment from the client – that is to say, if they commit to 1,800 hours of consulting per consultant per year, you are WAY ahead of the game – using the same example, I could make the same money billing that consultant at \$84 / hour. If they commit to a high hourly rate but very few hours a year, it is nearly impossible to scale and make money because of the latency between billable engagements – small engagements mean a lot more selling work (to make \$1MM a year, would you rather sell 2 \$500K projects or 500 \$2K projects?). The trick is to negotiate your rates down only if you can negotiate up the length of the engagement. That doesn’t mean the circumstances around the person billing \$1,000 an hour don’t happen (I knew a guy who charged \$10,000 an hour, and if he liked you would do the work for \$3,500 an hour), and also that there can’t be high utliization at those rates (law firms and lobbying firms immediately come to mind). It just means that the market has to be there with the stomach for those kinds of rates. If your competitor is charging \$125 and you are charging \$1,000, you are going to have a tough time winning as much consulting as the lower priced competitor.
5. So scaling the business comes down to making pretty sure that anyone you hire you can bill for 1,500 hours a year. I also don’t think this implies that you are in constant hiring mode, by the way – a pretty good metric for turnover is 15 – 20% per year, which means if you have 10 consultants, you are hiring 1 to 2 a year. If you are hiring to demand, then constant hiring is a good problem to have; if people are treating your front door like a revolving door, it isn’t because you are in the consulting business.

Of course everything you say about the need for more overhead is true as your business grows, but that is not because you are in the consulting business – it’s because you are in a growing business. And if you are, you’ll be able to pay people to help with those very welcome problems.

The biggest issues I’ve found with growing a consulting business are startup costs – because it is not a capital intensive business (with associated hard assets), you have to fund growth yourself; and cash flow – you have to be ready to carry a couple of months’ costs for any new client work until you can bill hours (typically monthly), invoice, and wait for any AP lag to get paid.

K

• http://whitetailsoftware.com Robert Graham

You mentioned hiring people who can do the work for you at a fraction of your billing rate. Doesn’t that pose a real quality risk as you grow? You’re likely going to have to target less experienced developers. Does this tie in with your thoughts on hiring employee #1 of a startup? Should consultant hires be a marriage as well?

I think it is worth considering hiring people with rates that are as good or better than your rate. Leveraging relationships and maintaining a catalog of work are worth something to many people who would make great consultants in cases where they can ignore those “details”.

• http://www.thejuliagroup.com/blog AnnMaria

As someone who has run a consulting company for years, every bit of this is dead on! It’s particularly true that the higher your rates the more you are NOT getting the mom and pop shop and the more you’re having the 25-page agreements. One piece of advice – hire a GREAT accountant. Mine doesn’t get us business but she does do a lot of the other drudgery work (and SHE likes it!) which frees me to get business and occasionally write some cool code.

While I charge a lot more than \$30 an hour (though, sadly, not \$1,000 ), I have on occasion worked as a consultant contracted to other companies and I’m fine with it because I KNOW the math and if they bid the proposal to get the client, handle the billing, negotiate rates and do all the other pain in the ass drudgery then the prime contractor deserves a cut. It’s only fair.

• http://blog.claritylawgroup.com Sue Wang

Very interesting post, and I love the discussion here. Our law firm is unusual in that we bill like consultants (project rates or monthly rates, rather than straight-up 0.1-hour increments), so we have these same calculations.

One option no one has raised yet: instead of hiring an underling, why not team up with an equal? If your project stream is too much to keep up with, you could look for an exceptional professional who is already out there as a solo but doesn’t have the sales gene. Many small law firms, architecture studios, etc. are composed of 2 or more professionals working on projects brought in by one primary rainmaker. Everyone has a stake in the profits, and anyone who brings in a client gets X% off the top as an origination percentage.

This “first among equals” model lets the rainmaker make more money due to origination fees, minus the risk and hassle of hiring a salaried underling. Since the origination fee is available to everyone, people usually appreciate that client development takes time, effort, and a little magic, therefore the origination fee is fairly earned.

Teaming up with additional principals also eliminates a few of the other risks people have highlighted: deemed employment, flight risk as new hires desire to merge their billing rate and earning rate, and quality control.

The main challenge is finding partners who fit the bill. I’ve certainly been fortunate in finding mine!

• B Mont

Sue Wang stated, “The main challenge is finding partners who fit the bill. I’ve certainly been fortunate in finding mine!”

Yes, you are very fortunate. Very few partnerships survive (After our slow growth and a few disasters burned through all our resources, my former partner, the “rainmaker,” blamed me for “holding the company back” when I pointed out that the new projects he was starting would kill the company long before they produced any profit. I left after a very nasty showdown and the company crashed and burned in a few months.)

I know dozens of business owners and all but one had been in a bad partnership before having any success. The ones that tried a partnership again were very careful to define the business plan and both partners had previous experience running businesses. Most went solo the next time.

Thanks for the brilliant article. We all live it, but when you put the calculations down like this it does paint a very interesting picture.

• Sam Evans

This post is amazing. I’ve been grappling (mentally :) ) with this with friends for a while, as we’re all either at the jumping-into-consulting stage in our careers, or thinking about it.

While the numbers are different for us, this approach is sensible and understandable – I’ll be running our numbers in a similar manner before deciding.

• http://www.westiseast.co.uk Chris West

I just did a similar maths exercise myself, but a different angle (looking at personal productivity, not cost/hour). It’s amazing once you realise that as an agency, you charge by the day, assuming 8 hour days, but actually, employees will at best be able to work 4-5 of those hours once you do the maths. Good work!

• http://www.millingtonandcompanycpas.com Doug Millington@Small Business Accounting

I have worked as a sole proprietor and I have had employees and from my experience I’m significantly more profitable working as a sole proprietor. For all of the reasons you outlined in coming up with the true cost of an employee and the additional daunting task of finding people who actually know what they are doing and don’t need constant supervision. For me I’m not only more profitable working alone but far more content with no headaches.

• http://aaron@technosailor.com Aaron Brazell

Heh, I’m going to go ahead and disagree with you on a few points. :-)

Charging more does, in fact, allow you to do less for more… because you’re absolutely correct that time ends up running away with profit. \$50/h * 10h = \$500. \$100/h * 5h = \$500. Which is better?

On the bill more hours front… as a consultant, if you’re not padding your billable hours for the inevitable QA, back and forth with the client, or the expected unexpected, then you’re doing it wrong. No one is suggesting being dishonest, but there’s always time that is spent that is unbilled because it’s 2 mins here, 5 mins there… so bill it instead.

I also think your math above is accurate if all your assumptions are correct. But I don’t think all your assumptions are correct. Like working 40h weeks. Like taking 10 federal holidays. Etc.

But if your assumptions and premise are correct, then the math works. :-)

• Anonymous

Concur – bill everything, but bill everything you have also documented…

• http://www.efficionconsulting.com David O’Leary

Yup. This is exactly my reality. The big downside to using contractors is the lack of loyalty; they are much more likely to move on to another job after you’ve trained them up with everything they need to know to do the job right.

I really see the products avenue as a key to generating more consistent streams of revenue but am mostly concerned about being able to support the products in a consistently timely fashion.

• http://blog.dennispalmer.com Dennis Palmer

Q: What if we train our people and they leave?
A: What if you don’t train them and they stay?

• Anonymous

This would be a good definition of an employee…

• http://www.txenetworks.com Jason Myers

Jason–excellent post–really made me take a look at our business model as we are, in fact, trying to build a product while using a consulting model to earn a living.

One discussion that I did not see in solution section was using project rates when applicable instead of hourly rates to hedge your bets. Of course, this won’t work in all consulting models (especially ones that cannot predict projects on a month-to-month basis and must charge retainers and hourly rates) But In our business, we have a standard set of deliverables that we sell to clients (we’re very clear about what we will and won’t do for those project amounts), and we get our subcontractors to bid on the work and commit to a price that we will pay them out before we submit a proposal to the client. That way, we can account for the hours that we think it will take us to complete the project, mark up the subcontractors based on what they’ve submitted, and build that profit into the overall project rate for the client.

Of course, the downside for us is a miscalculation in the number of hours in actually working with the client, but to ensure this doesn’t happen regularly, you need to be very clear in your contracts about what the rate includes and what it does not. But for many clients (especially the low-maintenance ones) it works to your advantage when you put fewer hours into a project than you had originally bid.

• http://cornerstonetechnology.com/blog Steve W.

Jason – love the idea of treating your product as if it were just another client – I’ve been struggling to get focus on my product initiatives in the face of growing consulting opportunities – I’m going to give it a go and will let you know how I get on…

• Gretchen

Billing by the hour is not a good way to go. Bill by the project, people. If you have a lot of value to bring to that project, then you bill what your value is worth. If there’s only one good personal chef in town who does vegan then you bet I’ll be paying them whatever price they want if that’s a service I need. If I am the only one who knows the intricate ins/outs of the local data for a particular jurisdiction, and that jurisdiction wants to hire me for data analysis, you bet it’ll cost enough to cover all my income needs – including that personal chef.

• http://blog.asmartbear.com Jason

That’s great advice for a chef, because you know the costs of materials and labor going into it, and massive overruns are unlikely.

In other fields like developing brand new software for people who change their mind midstream on what they want built (like changing the endpoints of a bridge midway through building it), fixed-bid can be a killer; in fact you’ll find some people here (and on HackerNews) complaining about exactly that.

And it’s not as simple to say “You should have spec’ed that first,” because it’s simply the nature of the beast that it changes. Billing hourly allows the client to decide how much cost penalty they’re willing to bear for their indecision, and the consultant is compensated fairly.

• http://predelusional.blogspot.com Stephen

A job shop i worked for had an internal product project, and used benched contractors to make it work. So, you might have a month between contracts, and kick out another month on the product. I wouldn’t have picked these tools, but they worked. I ended up writing much of the on-line help and printed documentation. I did other things too. I recall solving some of it’s biggest infrastructure problems, but not what they were. I’d spend the first day of a stint on the project coming up to speed with where it was, then dive in. I suppose even one day is a fair amount of overhead. The project was managed by having one of the developers be the project lead. When she was working, she’d spend a couple hours a week managing the product. When she wasn’t, she’d also do development. And, eventually the product was shrink wrapped. It was good for contractors like me, because it meant i wasn’t constantly getting new health insurance, and so on. It was good for the company, because they got their product put together on the cheap, and didn’t have to find me again for some next contract.

The company’s main service was really sales. They’d hook up developers with companies that needed them. So, you’d think that they’d be able to sell the product once it was finished. However, this product never sold very much. It was based on a new paradigm in how to do their main business. It wasn’t obvious that it was a good idea. And, since it was written in Visual Basic, it had limited life. I’d have put it on the web – but remember, i didn’t get to pick any of the tools. I have no idea if they had a plan for product updates or bug maintenance. A product may be based on a good idea, but even with good sales staff, you have to be able to sell them. The full plan needs to be good, not just the idea.

• http://balancedscorecard.blogspot.com ccz1

What are you delivering, billable hours or results?

• http://www.uandacpas.com CPA Edison NJ

Thanks for the information .I really admire your idea. Hope to hear from you again soon.

• http://www.pitch.tv/ Pitch TV

Really love to read brilliant content. It is true that I’m pleased for your idea dude. Agree for that the unfortunate math behind consulting companies. Thanks for sharing. :)

• http://scottkantner.com Scott Kantner

One option you didn’t list was to bill on a project basis. After 15 years in around the consulting biz, I can concur with a lot of what you said. In fact, if a consultant can’t bring in 3 times their annual salary in revenue, the model really doesn’t work well because there is even more overhead than the great examples you gave.

If you charge on a project basis, (i.e. a result-oriented basis, not time oriented) it becomes more profitable, as you can give your people incentives to get it done in less time than what is built into the project. I am not suggesting anything dishonest here. The customer pays when he gets the results stated in the project, whether it takes 10 days or 10 months. This requires you to value-price the project, and is a slightly different selling model.

//Scott

• http://www.consulting-strategies.net/ Rick Freedman

The fact that you wrote this piece seriously is astounding, but the fact that your commenters took it seriously is frightening. The math presented here is exactly the sort of math that is presented in the famous “labor day fallacy”, which use identical math to “prove” that there’s only one work day a year, and since that day is Labor Day, nobody ever works (see the labor day fallacy math here : http://www.notboring.com/jokes/work/4.htm )

I guess you’ve never heard of “confirmation bias”, the psychological tendency to accept those arguments that confirm our beginning biases and ignore those that don’t…this piece is a perfect example of the dangers of this malaise. For those commenters who accepted this drivel without doing the math or piercing the underlying fallacies of “Smart Bear”‘s reasoning…shame on you!

• http://blog.asmartbear.com Jason Cohen

Sounds like you run a consulting company that no intelligent, capable person would want to hire or work at.

If you’ll check the comments again, you’ll find agreement from other consultants, not from would-be consultants.

Enjoy exploiting your employees and clients.

• Rick Freedman

…Let me make a substantive response to this, if I may. My belief is that there are some assumptions here that don’t stand up. My experience is that most firms have at least a few “rainmakers” or “heavy hitters” who can do both business development and billable work, and can also train and mentor junior staff, and utilize those juniors to assist them in delivering high-value (and highly lucrative) engagements to their clients. While it’s true that few consultants achieve 100% billability, many firms do have some “bodies on site” that have long-term assignments with zero incremental selling cost and very little admin overhead, and these long-term assignments can cover lots of unbilled time and low utilization for other consultants. Additionally, the owners and entrepreneurs you mention who do work the 60-70 hour weeks, as I frequently do now as a 1-man shop and did when I ran a firm, and who can command premium rates, can also cover some of the unbilledtime you use in your calculations. I’m also a fan of the profit-sharing model, or some sort of incentive, for those who consistently work high utilization or overtime hours, and agree that this can drive profitability. Not sure I agree that firms need much by way of brick-and-mortar…many firms are mostly virtual now, and many can get by with a single conference room or access to one and home offices for most of their staff.

Key point in this whole discussion is that consulting, in my experience, is a value business and not a rate business – if the client percieves (and you are delivering) high value the rates will take care of themselves, as will the profitability. Profitability is a symptom, not a driver – firms that treat their consultants well, help them grow, and focus on delivering high value to the client thrive, despite the seeming hurdles that Jason rasies, and those that don’t are stuck in the commodity trap that he describes.

Finally, please excuse my rant – Jason’s challenge that I exploit my partners and consultants irked me…still disagree with his conclusions but should have stayed on topic.

• http://blog.asmartbear.com Jason Cohen

I think the difference in opinion here comes from a difference in the type of consulting we’re talking about. You’re referring to consulting shops with dozens of employees who can afford a “consulting consultant” whereas, as I stated at the beginning and end, I’m specifically talking about one-man consulting shops who think that they can easily make lots of money hiring a person or two, and even more specifically about people who do that thinking it will fund a product company, which is typically what I write about.

You asked elsewhere “tell me where my comments are wrong.” They are not wrong if, as you said yourself, you get continuous, long-term billing, and bill >40 hrs/week, and be strict about 2 weeks’ vacation, and bill person A at \$200/hr even though person B is doing the work. In fact, I made exactly these points in the article, minus the billing switch-a-roo.

I understand your new point that consulting is value-based and not rate-based. If that’s the case, you could do fixed-bid, and then the client agrees what the value is regardless of how much profit you take, which is of course just and fair, and pointed out by other commentors. But that’s not what you said the first time when you stated that people should charge \$200/hr for other people’s work.

Indeed, to answer your final “irk” — and you are understandably irked because I did indeed attack you — I still don’t see why this isn’t exploitation.

To be specific: If you put person A on the invoice when person B did the work, that is absolutely dishonest and exploitative of trust and wallet of the client, regardless of whether that’s “industry standard.”

• Rick Freedman

Jason;

Not to prolong the point, but I’d never deceive the client by claiming that work was done by someone different…I’m referring to a scenario in which work is done by “the firm” rather than by a named individual. As firms try to migrate out of the commodity trap I find many are also evolving from a “named consultant at a specific rate” model to a “named result at an extimated price” model that allows the firm flexibility in assignment and allows the client some space for evolving requirements. I’m absolutely an opponent of fixed bid or “not-to-exceed” pricing unless the discovery is so complete and the work is so fixed that the risk can be squeezed out of the equation, which is a pipe-dream in my experience.

• http://www.consulting-strategies.net/ Rick Freedman

Jason;

Based on what? (besides the fact that you don’t like being challenged)…Check out my credentials:

http://www.amazon.com/Rick-Freedman/e/B000APKF5U/ref=ntt_athr_dp_pel_pop_1

In fact companies around the world pay me to help them build and improve their consulting practices, and consultants around the world consider me a mentor and a coach, and organizations around the world pay me to train and coach their employees, and although I’ve offered a money-back guarantee of value for my services for over 20 years not a single client has ever paid less than the full price I contracted for. And in fact I’m the author of ESI International’s (the worldwide project management training firm) “Agile Project Management” course and teach it to clients like NATO, The US Dept of Labor, Motorola and dozens of other clients around the world. If you’d like to see the opinions of the poor exploited workers who’ve been associated with me, check my LinkedIn recommendations here:

So, tell me where my comments are wrong, Jason…glad to have a debate on this. Tell me how your magic math is different from the math of the Labor Day fallacy. Tell me where you consider leverage in your calculations. Tell me where the \$73 Billion in worldwide revenue (as calculated by Gartner for just the Top 10 firms) came from, if this is such a losing business. Explain to me how services saved IBM from the grave if consulting is such a loser. Teach me about the non-exploitative firms where project managers are overhead instead of billable revenue generators. Show me the “hundreds if not thousands” of firms that waste their time on pet projects ( a number you pulled out of the air, or I’ll eat my car). Back up one of your assertions with facts instead of voodoo math, opinion, suppostition, and hearsay.

• http://www.pmcorporatelaw.com Cyprus El.