What Is Labor Cost? (Definition, Formula and Examples)

By Indeed Editorial Team

Updated November 30, 2022 | Published February 25, 2020

Updated November 30, 2022

Published February 25, 2020

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

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Labor cost is a financial term used interchangeably with "cost of labor" on financial reports. This value calculates the total cost of employee pay and benefits. If you're in human resources (HR), finance, accounting or executive leadership, you may need to understand labor cost and how it impacts you and your company.

In this article, we’ll explore labor costs, including indirect and direct costs, provide examples of how to calculate it and answer some frequently asked questions about cost of labor in the U.S.

Key takeaways:

  • To fully understand the cost of labor, a company needs to know what the direct and indirect labor costs are, as well as the fixed and variable costs.

  • Factors included in labor cost include employee wages, payroll taxes, sick days and benefits.

  • If cost of labor isn’t accurately calculated, it could lead to a product being priced incorrectly and, consequently, have a negative effect on profits for a company.

What is the cost of labor?

Definition: Cost of labor is the amount paid by an employer to cover an employee’s wages and benefits, plus related payroll taxes and benefits.

Labor cost is an important value that finance and accounting professionals calculate to determine the direct and indirect price that a company pays for labor.

The direct labor cost includes the cost of wages and benefits for employees who are directly involved in producing the product or service commodity. The indirect cost of labor refers to amounts paid for employees that support the commodity but aren't directly involved in making it.

Understanding the cost of labor helps companies price their products, and without an understanding of direct and indirect costs, a company may find it challenging to arrive at the right cost for its products. As a result, a deep understanding of labor cost and how to use it is beneficial for the economy.

Cost of labor can be further broken down into fixed and variable costs:

  • Fixed: Fixed costs are usually contracted costs but sometimes include essential costs that are predictable.

  • Variable: Variable costs will increase and decrease with variables like production demand and economic conditions.

Related: Learn About Being an Estimator

Direct vs. indirect costs of labor

Here's more on how direct labor costs and indirect labor costs differ:

Direct labor costs

Direct labor costs refer to costs that are derived directly from supply chain employees involved in the production. This group could include assemblers, manufacturers, heavy machinery users, fabricators, craftsmen and artisans, delivery drivers and other logistical employees essential for getting goods into consumers’ hands. Examples of direct labor costs include:

  • The hourly salary of a quality assurance inspector is adjusted to include health care benefits and short-term disability.

  • The annual salary of a welder who works on the production line of a steel parts manufacturing company. 

  • The payment made to a logistics company responsible for delivering goods across the country.

In each of these cases, the employee whose salary and benefits are being accounted for plays an essential role in producing a product and distributing it through the supply chain.

Read more: Direct Labor: What It Is and How To Calculate It

Indirect labor costs

Indirect labor refers to any employee whose role isn’t essential to the direct production of a product. These employees' roles may include administration, supervisory roles and finance, which are still important roles but they aren't involved in the supply chain. Examples of indirect labor costs include:

  • The salaries of the employees in the human resources department

  • The salary, benefits and bonuses of a chief financial officer of a Fortune 500 company that manufactures auto parts

Read more: What Is Indirect Labor? Definition and How To Calculate It

Fixed vs. variable costs of labor

Here's a comparison of how fixed and variable labor costs are different:

Fixed labor costs

Fixed labor costs are costs that are unlikely to change for a known period. For example, a fixed labor cost for a company would be the annual salary of an essential production worker in a given year. While this employee could get a pay increase, employers have a good idea of the term of the salary relative to when increases are likely to occur.

Related: Total Fixed Cost: What It Is and How To Find It

Variable labor costs

Variable labor costs are costs that increase and decrease with production. One good example of a common variable labor cost is the rate of an hourly employee. Several industries rely on variable labor, especially around the shopping holidays. These include manufacturing companies, restaurants and retailers. To fill the production needs in peak season, businesses will direct-hire hourly employees or work with agencies to find temp workers.

Another example of a variable labor cost might be the cost associated with contract workers who respond to things like equipment malfunctions and/or emergency repairs that are critical for business functioning. These things occur on a case-by-case basis which makes them more difficult to predict.

Related: How To Calculate Variable Cost

Simple cost of labor formula

The following is a basic calculation that assumes the cost of benefits and payroll taxes are rolled into the average hourly rate, or that the company doesn't have additional benefits or payroll tax costs.

Cost of Labor = (Total sales x Percentage of labor) / Hourly average of worker salaries

Example: If the company's total sales were $1,500,000, the percentage of the labor equaled 12%, and the average hourly rate of labor was $12.90, we would arrive at labor costs this way:

($1,500,000 x .12) / $12.90 = (180,000) / $12.90 = $13,953.49

Related: What Is Cost of Production? (With Formula and Steps)

Calculating the actual cost of labor

Here, we’ll go through the steps of calculating the average hourly cost of an employee, including absenteeism and other expenses:

1. First, calculate gross pay

Gross pay = Hourly rate of pay x Projected hours worked annually

Example: If an employee makes $10 per hour and works 40 hours a week, then we would use: 10 x 2010 = $20,800

2. Include absenteeism in your calculation

Employees receive holidays and sick days, so use industry or company averages to determine how much sick time and how many holidays should be included.

In the original example above, we can predict and factor in five days of absenteeism and five holiday days for a total of 80 hours. You would then subtract this from total hours worked annually as follows:

New annual hours worked calculation: 2080 - 80 = 2000

3. Add other expenses in your calculation

Refer to additional financial data to find any other employee expenses to include, such as costs of providing benefits. For instance, you could find an additional $5,000 in expenses per employee.

In the original example above, you would then increase the individual employee cost by $5,000 per employee, bringing the annual payroll labor cost to $25,800.

4. Calculate the actual hourly labor cost

After following the three steps above, we are ready to apply the formula for our final calculation:

Actual hourly labor cost = Annual payroll labor cost / New annual hours worked

Using the above example, our calculation would look like this:

$25,800 / 2000 = $12.90 actual hourly rate

Related: Cost of Living vs Cost of Labor: What’s the Difference?

Factors that determine labor costs

Factors will vary by industry (for example, an airline company versus a local restaurant), but some of the factors most all businesses will need to account for include:

  • The cost of hiring

  • The cost of onboarding

  • Wages

  • Payroll taxes

  • Health care

  • Sick days

  • Vacation days

  • Benefits

  • The source of your workforce

  • Human resources

Related: What Is the Cost of Hiring Employees?

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