What is labor cost?

Labor cost is the total amount a business spends on its workforce. It includes direct pay and indirect costs associated with employment. You can break it into two categories: direct and indirect labor. 

Direct labor costs

Direct labor includes the cost for employees who are directly involved in producing a product or delivering a service. For a restaurant, this can include cooks and servers. For a construction company, this can include carpenters and plumbers working on a job site. It covers wages, overtime and benefits.

Indirect labor costs

Indirect labor includes costs for employees who support business operations rather than directly producing goods or services. That includes roles in human resources (HR), accounting, marketing and site maintenance. Their wages are still part of your total labor cost, but you may categorize them differently in your budget.

What’s included in total labor cost?

To calculate your labor cost accurately, include all related expenses. An accurate calculation likely includes:

• Gross wages and salaries: The total amount paid to all employees, both salaried and hourly, before deductions.
• Overtime pay: Any wages paid at a premium rate, such as time-and-a-half, for hours worked beyond the standard workweek.
• Commissions and bonuses: Includes all performance-based pay, such as sales commissions, annual bonuses or non-discretionary bonuses.
• Benefits contributions: The amount your company pays for employee benefits. These contributions often include health, dental and life insurance premiums.
• Payroll taxes: Employer’s share of taxes, such as FICA (Social Security and Medicare) and federal and state unemployment taxes (FUTA and SUTA).
• Paid time off (PTO): All paid hours that aren’t worked, such as vacation days, sick days and paid holidays.
• Training and safety programs: The cost of onboarding new employees, conducting training sessions, providing personal protective equipment (PPE) or paying for certifications.
• Employee reimbursements: Any other costs your business repays, such as uniforms, travel, remote work stipends or cell phone usage.

Why calculating labor cost percentage is important

Tracking labor cost as a percentage of revenue informs critical spending and pricing decisions. You might also calculate it for these reasons:

• Set product and service prices: Affects how much you need to charge for your products or services to make a profit.
• Create accurate budgets: Allows you to forecast spending and set realistic hiring budgets.
• Improve employee scheduling: Shows whether you’re overstaffed during slow periods or understaffed during busy times. You can adjust schedules to meet demand without overspending.
• Make hiring decisions: Demonstrates whether you can afford to hire a new full-time employee or if it’s more cost-effective to use temporary staff or pay existing employees overtime.

Fixed labor cost vs. variable labor cost

Fixed and variable costs make up your total labor cost. Separating them helps you understand which expenses you can more easily control.

Fixed labor costs

Fixed costs don’t change weekly, allowing you to calculate them easily. For example, you know an employee’s yearly salary, regardless of business volume. Many benefits, such as health insurance premiums, are also fixed costs.

Variable labor costs

Variable costs may change with your business needs, production volume and hours worked. Examples of variable labor costs include:

• Wages for hourly employees
• Overtime pay
• Pay for temporary or seasonal employees
• Pay for independent contractors
• Sales commissions

You have more immediate control over variable costs. You can manage overtime and adjust hourly or temporary workers’ schedules to match your business’s slow and busy periods.

How to calculate labor cost percentage step-by-step

You can calculate your labor cost percentage for specific periods, such as weekly, monthly, quarterly or annually. Follow these three steps:

Step 1: Determine your total labor cost

Add up all the labor costs for your chosen period. The formula is:

Gross Wages + Overtime + Benefits + Payroll Taxes + All Other Costs = Total Labor Cost.

Step 2: Determine your total revenue

Next, find your business’s total revenue (also called total sales) for that period. For example, if you’re calculating your labor cost for one month, you need to use the total revenue from that month.

Step 3: Calculate the formula

Finally, divide your total labor cost by your total revenue. Then, multiply that number by 100 to get your labor cost percentage.

The formula is:

(Total Labor Cost / Total Revenue) x 100 = Labor Cost Percentage

A step-by-step example

If you own a small café and want to find your labor cost percentage for the previous month, consider the following example:

Step 1: Add up all your labor costs for the month.

• Hourly wages: $10,000
• Overtime pay: $500
• Payroll taxes (employer share): $800
• Benefits (insurance): $1,200
• Total Labor Cost: $12,500

Step 2: Find your café’s total revenue for that same month.

• Total Revenue: $50,000

Step 3: Calculate the formula.

• ($12,500 / $50,000) = 0.25
• 0.25 x 100 = 25%

Your labor cost percentage for the month is 25%.

An alternative formula: labor cost as a percentage of total expenses

You can also calculate labor cost as a percentage of your total business expenses. This method shows what portion of your spending goes toward labor, compared to other costs such as rent, utilities and materials.

The formula is:

(Total Labor Cost / Total Operating Costs) x 100 = Labor Cost as a Percentage of Operating Costs

Example: Using the previous café example, your total labor cost was $12,500. If your total business expenses for the month were $40,000 (including labor, rent, food supplies, utilities, etc.), you could use this equation:

• ($12,500 / $40,000) = 0.3125
• 0.3125 x 100 = 31.25%

Your labor cost is 31.25% of your total business expenses.

How to manage and control labor costs

If your labor cost percentage is above your target range, you can manage it with these steps:

Improve employee scheduling

Once you identify peak and off-peak periods, you can align staffing levels with actual customer demand. You can use scheduling software to prevent accidental overtime.

Cross-train your employees

If your employees can perform multiple jobs, they can assist different departments during busy times. Cross-training can reduce the need to hire additional staff and help make your team more flexible.

Manage overtime

Aim to pay overtime only when necessary. You can implement a policy that requires manager approval for all overtime hours. Consider whether it’s less expensive to hire a part-time employee than to pay consistent overtime.

Review your PTO policies

You can streamline labor cost management by consolidating vacation and sick leave into a single PTO category.

Offer pre-tax deductions

Some benefits, such as health insurance, can reduce an employee’s taxable income. Doing this might save your business money by reducing the amount you’re required to contribute to payroll taxes.

Reduce how often employees leave

Hiring new employees involves recruiting, onboarding and training costs. Finding ways to reduce turnover can decrease your labor costs over time.

Automate tasks

Search for opportunities to use technology. Software can automate tasks like payroll, scheduling and inventory. For some businesses, self-service kiosks or automated phone systems can also handle simple tasks, which allows employees to complete more complex work.

Consider calculating your company’s labor cost percentage for improved forecasting. By determining expenses for direct and indirect labor, you can address areas for cost savings.