Outsourcing

How much should a contractor pay a subcontractor?

A long-time employee has decided to make consulting his profession, and he's not sure what kind of cut a prime contractor should take from the bill before paying the subcontractor. Here's our advice.

Tim Heard is a technical recruiter for JC Malone, a career placement service. Tim shares his career advice by answering questions from TechRepublic members or commenting on employment trends.

Question
After a 15-year career as a salaried employee, I am entering independent consulting, and I have a question related to subcontracting: What is a fair "cut" for the prime contractor to take, or what are typical ranges?

For example, suppose the contract pays $80 per hour, and the subcontractor is paid a percentage of this rate. Obviously, both parties want to maximize their percentage of the hourly rate. The prime contractor deserves to make some margin from this contract due to his owning the client relationship and the burden of having to administer the contract and the subcontractor's pass-through billing. But, let's say the prime contractor's overhead and acquisition costs were very low. What is a reasonable percentage for the prime to take?

—Darrell

Answer
This question goes to the heart of some of the changes that are taking place in IT consulting. In the “good old days” when money was flowing more freely, vendors were able to get away with what I consider outrageous markups on the rates that they paid their consultants. It wasn’t unusual, for example, to have a consulting firm or a prime contractor bill a client as much as double what they actually paid the contractor. While those situations still exist, they are becoming a thing of the past.

I don’t have any hard-and-fast rules regarding what one ought to charge for one’s labor, or bill to a client, but consider these points.

What’s the markup?
The markup a prime contractor adds on top of your pay rate can depend on a number of factors. (By markup, I mean the total amount that the vendor adds on top of your pay to get the bill rate that is charged to the client.) If you’re an employee of the vendor, the markup will automatically be higher than if you’re working as an independent contractor because the vendor will need to offset the cost of things like Social Security withholdings, liability insurance, and possibly benefits before even considering a profit margin.

If you’re working as an independent contractor, the markup will be lower and the pay rates generally higher.

Other less tangible considerations include the amount of “float time” that must take place before the client pays for your services, and the general amount of risk associated with the situation.

For example, my company maintains a contract with a prominent employer in which we have agreed not to bill the company for any contractor who works for a week or less and is let go because he or she didn’t work out. We agreed to those terms based on our confidence in the quality of the people we place, and the value of the business brought to us by the client.

However, on one occasion, a contractor notified me after four days on the job that she was pregnant and that her doctor had just put her on total bed rest. In that case, the contractor was paid a rate of nearly $60 per hour and we had to swallow the entire cost when she packed up her belongings and moved back home to be with her family. (As an employer, we were obligated to pay her for the work she had done.)

A rule of thumb for independent contractors is that the vendor should be allowed to mark up your pay rate by about 15 percent when billing the client. This allows the vendor a respectable profit without making the bill rate outrageous. When you’re an employee of the company, the markup can be as much as 50 percent if the company is offering you a very solid benefits package and some employment guarantees.

Be aware that just as profit margins are being pushed down, so are wages. As you discuss your rate of pay with the vendor, don’t be caught off guard if the rates aren’t as high as you thought they would be. Right now, market forces place the employee/contractor at a disadvantage, because of the overabundance of talented people.

Before you accept an engagement
Before agreeing to let a consulting firm or a staffing company vendor submit your resume for an opportunity:
  1. Discuss pay and benefits thoroughly. Leave some room for negotiation once the client has reviewed your resume, but make sure you have a good idea of what will be provided. For example, if a vendor isn’t going to provide you with benefits, they need to be willing to pay more. I called a candidate a few weeks ago who had just released his resume to a competitor without discussing these issues. I happened to know that the client was requiring that all resumes be submitted along with a bill rate, so the other recruiter was obviously locking the candidate into a rate to which the candidate hadn’t even agreed.
  2. Find out what the vendor will be billing for your services. This strikes at the heart of whether you’ll be able to establish a healthy relationship with the other party. They have every right to make a decent living, but if they aren’t willing to discuss specific dollar figures with you, find someone else to work with.
  3. Understand the relationship between the vendor and the client. Does the vendor contract directly with the client, or is it a subcontractor one or more levels down the food chain? While you need not reject a subcontractor outright, understand that this will add levels of cost to the client.

When I was trying to help my company get into the technical staffing business, we agreed to a subcontracting relationship with a prominent national staffing company that was itself contracted to a very well-known consulting company. We naively entered the relationship with the expectation that we would have the opportunity to fill openings on a national scale. We thought that even if we had to reduce our profit margins, the increased number of placements would more than make up the difference.

The reality was that we generally got the openings that the other two companies didn’t want, and were later astounded to learn the amount of markup that the other two were stacking on top of our own. Despite jumping through hoops and finding what I considered to be some “needle in a haystack”-type candidates, we made very few placements because our candidates were generally priced out of competition.

Final note
The figures that I have tossed out as examples are by no means iron-clad guidelines. Think of them as a starting point for discussion. Going back to your original question, you can see that in some circumstances it might make sense for you to ask for around $69 per hour, assuming that you’re taking care of your own taxes and benefits. On the other hand, as an employee, the same situation might warrant an hourly pay rate between $53.50 and $61.50, depending on benefits.

Ultimately, the contractor/vendor relationship is all about trust—trust between the vendor and the contractor and trust between the vendor and the client. Cost has obviously become a driving force too, but those that survive are going to be the ones who can run a little leaner than the rest, and still keep their customers happy. Determining whether you can trust someone is a bit of a challenge, especially if you’re in a situation in which you haven’t worked in a while and someone is offering you employment. Taking the time to ask questions and assess the person on the other end of the phone will be worth it in the long run.

If you have any questions, feel free to post them to the discussion forum, and I’ll do my best to address them.

Best of luck in your new role.
1 comments
Not Deb
Not Deb

Years ago I had been told that as an independent your goal was to get as close to 80% as possible.  And honestly I think I only got that percent once.   (and when they negotiated a raise with the customer they lied to me about the amount and it dropped my %.   


Now I have subs working for me.   And I have to say it depends on the situation.  At one customer, I have much less that I have to do to build and maintain the customer relationship beyond getting strong people and paying them timely - after they start.   But at others I had to spend years cultivating the customer and getting past the procurement stone walls.  

Also at one site the rates are extremely low and if I took a fair % to me, I couldn't pay a decent rate so I take a hit in order to get the right people to stay. 

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