Contractors are usually engaged via an intermediary or a recruitment agency. Intermediaries typically will offer some flexibility of choice for the client in respect of the pricing model.
However, selecting the right pricing model can be a tricky problem. They vary quite considerably and are each suited to different scenarios!
But which one should you choose for your contractor services? More importantly, is there a credible alternative to paying a contractor a day rate?
In this post, we outline the pros and cons of three pricing models which can be used as an alternative to paying a day rate. Helpfully, we also explain when you should use each contract pricing model with your intermediary.
1. Cost-Plus Pricing Model
Cost-plus pricing is a pricing strategy that guarantees a fixed percentage upside to the intermediary. To calculate a cost-plus price, the intermediary would typically consider the pay out to the contractor as the ‘cost’ element over which a fixed percentage of profit is applied.
Let’s use an example:
Costs associated with hiring a contractor = £5,00 per day. A mark-up fee of 15% is charged by the intermediary which will total £75. The total cost-plus charge is £500 + £75 = £575. Thus, £575 will be charged to the customer for each billed day of the contractor.
What are the advantages of Cost-Plus pricing?
Alignment of parties – When an intermediary is paid upfront with an openly-declared margin, it usually indicates that the margin is competitive. Why else would an intermediary expose their margin if that wasn’t the case? Therefore, the client and contractors trust the intermediary in commercial matters.
Flexibility – Cost-plus pricing allows the intermediary to present contractors to the client who may be better suited but charge a higher day. This is because the intermediary is no longer constrained in what they would be paid by the client.
What are the disadvantages of Cost-Plus pricing?
IR35-unfriendly – Contractors getting paid a day rate is a classic scenario that HMRC cite as one of the pointers to disguised employment. A cost-plus arrangement with the contractor (when coupled with the contractor signed up on a day rate basis) is a risky proposal as far as IR35 goes.
High day rate – The intermediary has an incentive to support a high day rate demand by contractors. If the perceived value of the service is deemed high by the customer then the price will be high. To mitigate this, a client must take a lead role in rate negotiations and be firm on matters concerning day rate of the contractors.
When to use Cost-Plus pricing:
- When the intermediary is recognised by client as a trusted partner. And in turn, the intermediary honours the pricing discretion it holds, and negotiate with contractors suitably to keep costs down for the client.
2. T&M (Time and Materials) Pricing Model
In a T&M pricing model, the client agrees to pay the contractor for the time spent by the contractor to perform the work at a set daily or hourly rate.
What are the advantages of T&M pricing?
Engagement – A T&M model offers a good clear way of engagement. The rate card is a useful indication for clients to apprise themselves of market rates before a candidate is identified.
Flexibility – There is also a high degree of flexibility. Daily rate-based contracts allow businesses to accurately estimate and contract for any increases to the scope of work beyond what is initially agreed.
What are the disadvantages of T&M pricing?
High Margins – A disadvantage is that T&M can be very expensive and high margins can be achieved by the intermediary. With a lack of an agreed margin with the intermediary over its subcontractor costs, the contractor is at risk of being negotiated hard by the intermediary.
High Involvement – When contractors engaged on T&M, the perception is that they are at the disposal of their clients. As a consequence, high involvement may be required by the end client to ensure the team is delivering the programme objectives within the agreed hours.
When to use T&M pricing:
- Long term projects
- Project scope is not fully known
3. Fixed Price Model
In a fixed price model, the client is charged a set price for a service offered. This is regardless of hours worked or resources involved in completing a project. When determining the price at the outset, the time taken and resources required must be estimated as accurately as possible.
What are the advantages of Fixed pricing?
Outside IR35 – A fixed price model is aligned with SoW (Statement of Work) based work. Consequently, a fixed price model is most conducive to outside IR35 work.
Meets ‘financial risk’ indicator – An indicator of the employment status of a worker is whether any personal financial risk is incurred as a result of the performance of the work duties. As a contractor is being paid a fixed price – thus assuming a high degree of financial risk – they will meet this indicator.
The best contractors will always have a choice of outside-IR35 clients to work with. Therefore, if an end client wants to attract the best contractors, the work on offer is best constructed as outside-IR35 work package. The pool of available candidates for inside IR35 positions will always be smaller.
See our Guidance for Contractors: Retaining Your Outside IR35 Status.
What are the disadvantages of Fixed pricing?
Unrealistic – A fixed price model can create cash flow issues for the end contractor who may have no other income stream.
Less accountability – A true fixed price arrangement can cause a lack of regular reporting on part of the end contractor (as they own the scope of work). This can create ancillary problems in other dependent parts of the project.
When to use Fixed pricing:
- Limited or fixed budget
- Accurate estimation of time and costs is possible
Mindful can help
There are credible alternatives to paying a contractor a day rate! Interestingly, many organisations seeking professional services specify that they prefer one type of billing over the other.
We believe it may be best to break the job into regular and milestone-based parts and have a regular retainer payment along with stages payments for goal-orientated work.
This is now part of our standard offering of intermediary services where we are supplying outside-IR35 services through our network of subcontractors. See our How We Work page for further information.