Why does labor cost matter?

It’s important to know how much money you’re spending on your labor if you want to improve productivity and increase profit margins. The cost of labor usually rises when you train new employees, pay overtime and provide insurance or retirement benefits. For example, it may cost you less to promote one of your employees instead of investing in training and orientation for a new hire.

The following is part of labor cost and must be factored in when performing your calculations:

• Salaries or hourly wages
• Health insurance
• 401(k) benefits
• Overtime pay
• Training and safety programs
• Paid time off in the form of vacation or sick days
• Performance bonuses
• Any employee costs that your business reimburses

The impact that labor costs have on your business may be different depending on the industry you’re in. Some industries have more variable expenses than others. For example, if your profits depend on the number of products that you sell and your sales representatives earn a salary in addition to their commissions, poor sales can increase your company’s labor cost relative to your revenue.

Fixed labor cost vs variable labor cost

Fixed costs are expenses that you can calculate with certainty, whereas variable costs may change depending on your needs over time. A good example of the difference between fixed and variable labor costs is the payment of wages for salaried workers and those with an hourly rate. If you’re paying someone a salary, you know exactly how much they’ll receive for the year, while the pay for hourly employees may be contingent upon on how many hours they work each week.

Independent contractors hired for specific purposes represent another form of variable labor cost. If you hire a temporary worker for a special project and that person leaves your company upon completion of the project, their pay is a variable expense. The same can be said for maintenance workers, seasonal employees and outsourced functions.

Overtime is another variable cost to consider. Keep track of your busy seasons and determine whether it’s more beneficial to expect your current employees to work more hours or to save money by hiring workers until business slows down. New employees require training and may not be as productive as someone who has been with your company for a long time, so consider this when making your decision.

Read more:How to Calculate Overtime Pay

Ways to calculate labor costs

There are two ways you can look at your labor costs. You could calculate labor costs as a percentage of your total sales. For example, if you have sales of $1 million this year and you paid your staff a total of $150,000, your labor cost as a percentage of sales would be 15%.

If you want to know what portion of your total business expenses go toward labor, you can calculate labor cost as a percentage of your total operating cost for the year. This method leaves profit out of the equation and determines if your labor costs are excessive compared to the rest of your overhead. In the above example, if your total operating costs for the year were $600,000, then your labor cost was 25% of your total overhead.

There are more factors you need to consider other than the pay for your employees. Benefits are a form of wages you provide to your staff members, so don’t forget to include them when you’re calculating labor costs.

Calculating the labor cost

The total cost of labor per employee depends on the benefits you provide and the type of employees your company needs. When calculating your labor cost as a percentage of sales or total overhead, you must first determine the total cost of your labor for the period. Start by calculating all of your employees’ salaries and the average hours expected of your hourly employees.

Include overtime pay when coming up with worker pay for the period you’re calculating. Then determine the cost of payroll taxes and withholding. The next step is to add vacation and sick pay. If you’re providing insurance and retirement benefits, add the monthly or annual cost of your benefits package.

Tally the cost of equipment and training and add that to the total. Examples of material costs include uniforms, supplies and travel costs. If any of your employees received bonuses, include those in your calculation. Once you have added up all of your labor costs, use the following equations:

• For labor cost as a percentage of sales, divide the cost by your total sales and then multiply by 100. For example, (150,000 / 1,000,000) x 100 comes to 15%.
• For labor cost as a percentage of total operating cost, divide your labor cost by your total overhead and multiply by 100. For example, (150,000 / 600,000) x 100 is 25%.

Use the Average Variable Cost Formula to determine profitability

To determine whether the cost of labor and the price of your products and services are properly balanced, you can use the Average Variable Cost (AVC) Formula, which adds the cost of labor to all of your other expenses, such as utilities, shipping costs, outsourced work, maintenance and lease costs. If you divide your total expenses by the number of units you’ve sold over a time period, you get an average cost per unit.

This is important because it tells you if you’re able to sustain the cost of your labor and overhead. As long as your products make more money per unit than they cost to produce and deliver to the consumer, you’re in a great position. If your costs exceed your sales, you need to determine how you can reduce costs and whether to charge more for your products or services.

Related:Calculating Cost of Goods Sold (COGS) in Your Small Business

Ways to control labor costs

If you’re looking to improve your margins, reducing your labor cost can make your business more profitable without needing to raise prices. Consider the following options when reining in your costs:

Find ways to limit overtime

If you employ hourly workers, make sure that you’re only paying overtime when absolutely necessary and you’re not accidentally scheduling workers for more than 40 hours a week. You can also implement a program to reward employees who don’t miss shifts; whenever someone calls in, you need to get someone to cover their shift and the person who covers may end up earning overtime for the shift.

Cross-train your workers

If your employees know how to perform multiple functions, they can assist the team during busy shifts and reduce the need to hire additional staff. While training is an investment, it often pays dividends because your employees become more productive and efficient.

Reduce shifts during slow periods

If you know when your slow periods are, adjust your scheduling to avoid having workers on the clock without much to do. For example, if Tuesday evenings see reduced traffic, schedule fewer employees on Tuesday so that you can have them work on a Friday or Saturday night instead.

Restructure your paid time off

You may be able to reduce labor costs simply by combining vacation and sick days. Instead of giving a specific number of vacation days and sick days, offer a total number of paid days off that employees can use however they choose. In many cases, you can cut about a week of paid time off per year using this method.

Offer pre-tax deductions to reduce the cost of taxes

Some benefits, such as health insurance, reduce the taxable income of employees. This can save you money because reducing taxable income also reduces how much you’re required to contribute to Social Security and Medicare.

Reduce employee turnover by hiring the right people

Retaining employees reduces your labor cost significantly. Each time you accept a new hire, you need to commit money to training and orientation. Seasoned workers are more productive than newer ones because they’re already aware of expectations and acclimated to their duties.

Read more: 13 Effective Employee Retention Strategies

Labor cost FAQs

What is a good labor cost percentage?

This varies by industry. Service industries typically have greater overhead than manufacturing businesses. Most companies try to keep the cost of labor below 30% when taken as a percentage of sales. If you’re in a service field, it’s acceptable for this percentage to be greater.

What are the overtime rates in my state?

Each state regulates overtime differently. Some states require double time for work on holidays and weekends or when employees work more than 8 hours in a single day. Check with your state’s Department of Labor to make sure you’re paying overtime properly.

What are indirect labor costs?

Indirect labor costs are slightly different than variable labor costs. They are wages paid to staff that don’t have a direct role in producing products or delivering services. Executives and those in human resources and accounting are examples of workers whose wages are indirect labor.