Labor cost describes the amount of money an organization spends on each employee, including wages, benefits, and taxes. These costs can be calculated on both an individual and organization-wide basis.
Labor costs can be both direct or indirect and fixed or variable. Especially relevant to HR, accounting, and finance teams, labor costs are often one of the largest expenses an organization has.
Direct vs Indirect Labor Costs
The total labor costs of an organization include both direct and indirect costs.
Direct labor costs are the money spent directly on labor to produce and deliver your product or service—that is, the labor costs associated with employees who play an essential role in getting your product or service to the customer. For example, in an organization that manufactures car parts, the wages of the production line workers and delivery truck drivers are direct costs.
Indirect costs are additional costs that support direct labor costs. They include essential business functions that aren’t directly involved in the production or delivery of a product or service. In our car parts manufacturer example, indirect costs include the wages of payroll, maintenance, and HR staff.
Fixed vs Variable Labor Costs
Direct and indirect labor costs can be fixed or variable.
Fixed labor costs remain the same, regardless of how many sales you make. They are a predictable amount each month, such as the rent for an office space or the wages of salaried employees.
Variable costs fluctuate based on the amount of product or service you produce and sell—for example, the wages of hourly workers.
Why Do You Need to Know Your Labor Costs?
Knowing your labor cost helps you price your product or service to ensure you achieve your desired profit margin. Underestimating or failing to factor in labor costs will reduce your profit margin.
Labor cost is also useful for workforce planning purposes. While it’s easy to see what you’re paying your employees, this is only part of the picture. The true cost of an employee is more than their wages—it also includes taxes, benefits, training, and resources. Knowing the actual cost of each employee helps you make effective decisions around staffing levels.
How to Calculate Labor Cost
To calculate the annual labor cost for an employee, you need to total their employee expenses.
The following are examples of which employee expenses to include when calculating labor costs.
- Pay. This includes wages, bonuses, and commissions. When calculating total pay across your organization, you need to take into account the pay of every employee or worker—salaried, permanent, casual, and temporary. It also helps to use a consistent unit of measurement such as annual pay. If you have a large workforce, you can calculate total pay based on salary ranges rather than individual employees.
- Benefits—such as health insurance, paid leave, and employee wellness programs.
- Taxes. Ensure you factor in any mandatory taxes that you must pay on behalf of your employees—such as social security.
- Recruitment. Ensure you include all costs involved in the recruitment process—such as placing job advertisements, recruiter fees, and pre-employment assessments.
- Training—including onboarding and professional development costs.
- Resources. Labor costs should take into account the facilities and equipment you provide employees to do their jobs—such as office space, desks, computers, software, and stationery.
As an example, let’s calculate the annual labor cost of Jessie, a full-time employee with an annual salary of $42,000. Based on the above list, Jessie’s additional expenses total $8,350.
Jessie’s annual labor cost is $42,000 + $8.350 = $50,350.
We can also calculate hourly labor costs by dividing the annual labor cost by the number of hours Jessie worked in a year.
To work out the number of hours Jessie worked in a year, we calculate the total number of work hours per year minus any time off.
The total number of work hours per year = 40 hours per week x 52 weeks = 2080 hours.
Time off = 14 days x 7.5 hours = 105 hours.
Number of hours worked in a year = 2080 – 105 = 1975.
Jesse’s hourly labor cost = $50,350 / 1975 = $24.49 per hour.
How to calculate labor cost percentage
Once you know the labor costs for your workforce, you can then calculate your labor cost percentage. This metric represents your organization’s labor costs as a percentage of total revenue for a certain period.
Labor cost percentage = total labor costs for an organization / total revenue x 100.
For example, an organization calculates the labor cost of each of its employees last year and determines its total labor costs were $225,000. Its revenue for the same year was $989,000.
The organization’s labor cost percentage = 225,000 / 989,000 x 100 = 22.75%.
Acceptable labor cost percentages vary between industries. For example, it’s common for hospitality businesses to have a high labor cost percentage compared to a service company staffed by office workers.
How to Reduce Labor Costs
When considering how to increase profits, organizations often look at reducing their labor costs. There are several ways to do this.
Redesigning your workforce
Reorganizing your workforce can directly reduce your cost of labor. For example, the use of freelance workers in addition to your core salaried employees during busier times of the year may reduce your labor costs compared to maintaining a staff of full-time employees. In some situations, simply reducing the number of employees in your organization is an effective way to reduce labor costs.
If you employ hourly workers, accurately tracking their time and monitoring overtime—for example, by using a time-tracking app—is essential to managing labor costs. This will highlight any areas of concern that need to be addressed to reduce labor costs. In addition, if your time tracking isn’t accurate, your labor cost calculations won’t reflect the true cost of your employees.
Many employers now offer their employees the opportunity for remote or hybrid work. Not only does this have benefits from an employee perspective, but it may also reduce your costs as an employer. For example, you may be able to rent a smaller office space.
Labor cost is the amount each employee costs an organization in terms of wages, benefits, and taxes. It’s important to understand labor costs within your organization given their direct impact on profit margins and—therefore—overall profitability.
When calculating labor costs for either an individual employee or your whole organization, you need to factor in both direct and indirect costs, as well as those that are fixed and variable.
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