Career Development

What is Labor Cost? Definition, Direct vs. Indirect Costs and Examples

February 25, 2020

Labor cost is a financial term that's used interchangeably with "cost of labor" on financial reports. This value is arrived at by calculating the cost of all employee pay and benefits. If you're in human resources, finance, accounting or executive leadership, you may need to understand labor cost and how it impacts you. In this article, we define labor cost and give examples of how to use it and how it's calculated.

Related: Base Salary and Your Benefits Package

What is the "cost of labor"?

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 cost of labor 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 products, and without an understanding of direct and indirect costs companies may find it challenging to arrive at the right cost of 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 includes essential costs that are predictable.
  • Variable: Variable costs increase and decrease with variables like production demand and economic conditions.

Related: Learn About Being an Estimator

Easily apply to jobs with an Indeed Resume

Example of labor cost

Here are four examples of labor cost:

Direct labor cost example

Direct labor costs refer to costs that are derived directly from supply chain employees involved in production. This could be assemblers, manufacturers, heavy machinery users, fabricators, craftsmen and artisans, delivery drivers and other logistical employees essential for getting goods into consumer's hands.

One example of a direct labor cost is the hourly salary of a quality assurance inspector adjusted to include healthcare benefits and short-term disability. Another example could be the annual salary of a welder who works on the production of line of a steel parts manufacturing company. Yet another option for direct labor costs is the payment made to a logistics company responsible for delivering goods across the country.

In each case, 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.

Indirect labor cost example

Indirect labor refers to any employee whose role is not essential to the direct production of a product. These employees still play important roles like administration, supervisory roles and finance but they aren't involved in the supply chain. An example of indirect labor costs is the salaries of employees in the human resources department.

Another example of indirect labor costs would be the salary, benefits and bonuses of a chief financial officer of a Fortune 500 company that manufactures auto parts. Since this employee is not directly involved in the production of auto parts, their salary represents an indirect cost.

Fixed labor cost example

Fixed labor costs are costs that are unlikely to change for a period. For example, the annual salary of an essential production worker in a given year might be a fixed labor cost. While the 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.

Variable labor cost example

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

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

How to calculate labor cost?

There are several ways to calculate the various labor costs associated with workers. Here's a simple labor costs formula:

1. Cost of Labor = (total sales x percentage of labor) / hourly average of worker salaries

Example: Total Sales = $1,500,000
Percentage of labor = 12%
Average hourly rate of labor = $12.90

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

This calculation is a very 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 benefit or payroll tax cost.

2. To find the average hourly cost of an employee, you can follow these steps:

  • Gross pay: You'll calculate this first. Gross pay calculation is Hourly Rate of Pay x Projected Hours Worked Annually.

If an employee makes $10 per hour and works 40 hours a week, that looks like 10 x 2010 = $20,800

  • Consider absenteeism: Employees get holidays and sick days, so use industry or company averages to determine how much sick time you need to account for.

In this example, we can predict 10 days of absenteeism for a total of 80 hours. Subtract it from total hours worked annually.

New Annual Hours Worked calculation: 2080 - 80 = 2000

  • Add other expenses: Turn to additional financial data to understand the full picture of employee cost. Calculate the cost of benefits and other employee costs.

In this example, the individual employee cost increases by $5,000 per employee, bringing the Annual Payroll Labor Cost = $25,800.

  • Calculate Actual Hourly Labor Cost: Actual Hourly Labor Cost = Annual Payroll Labor Cost / New Annual Hours Worked:

$25,800 / 2000 = $12.90 / Actual Hourly Rate