If you manage a business, regardless of its size, you’ll incur some production costs. Labor costs are a key fraction of these costs, provided you employ workers. As such, it is important for you to understand what labor costs are, how to calculate labor costs, and how they affect your business. You're probably aware of what labor costs and creating paystubs entail. However, your idea may or may not be correct. This article gives you a comprehensive insight into labor costs.

Labor Cost: Meaning

Labor cost is simply the cost of having employees or the total amount paid for all employees. The labor cost covers the gross wage, payroll taxes, and other additional benefits that your staff receives. As a business owner, it is essential that you keep tabs on your labor costs. That way, you can compare it to your revenue periodically to ensure you’re not running at a loss.

Determining Labor cost: Formula for Labor cost

Mathematically, your labor cost can be determined using this simple formula:

Labor cost per hour = (gross wage + total additional annual costs) / work hours per year

Labor costs cover every expense associated with your staff’s employment. So, to calculate your labor costs, you must identify all labor-related expenses.

A Practical Example

To fully understand the concept of labor cost calculation, we’ll be using the practical example of James, an hourly employee that works full time for Company ABC. The company, ABC, has 40 employees. James is paid \$15 hourly and, as a full-time staff member, works 40 hours per week. Let’s determine the labor cost for James.

Step 1: Calculate the Gross Pay

The first step when calculating labor costs is to determine the gross wage of the concerned employee. Gross employee pay is the product of the hourly rate and the total number of hours worked.

Gross pay = gross hourly rate x number of hours worked during the pay period being calculated

So, to determine James's gross pay for a year,

Gross hourly rate = \$15

Hours worked = 40 hours each week x 52 weeks in the year.

So, James’ gross pay = 15 x 40 x 52 = \$30,000.

Step 2: Determine the Actual Hours Worked

The total available work hours in a year is 2080. However, it is very unlikely that James worked all 2080 hours. Let’s assume James was absent from work for 10 of 2080 days.

Then the hours not worked will be: 8 hours per day x 10 days = 80 hours.

You can now calculate the actual hours James worked.

Actual hours worked = total annual work hours – hours not worked

So, James’ actual worked hours will be 2080 hours – 80 hours = 2000 hours.

James worked for 2000 hours in a year.

Step 3: Calculate All Annual Costs Per Worker

Now, you need to consider expenses due to other benefits James enjoys. Aside from the gross pay, a business typically has employee benefits and other incentives. All of these need to be accounted for to have an accurate estimate of your labor cost.

Payroll Taxes

Employee benefits

• Training
• Healthcare and insurance
• Employee meal plans
• Vacation days
• Sick days
• Public transportation stipends

Other potential costs

Here’s a breakdown of James’ annual additional labor cost.

• Social security: \$1860
• Medicare: \$435
• FUTA: \$45
• The state unemployment tax is \$240.
• Health insurance : \$3,450
• Benefits: \$1,330
• Overtime: \$555
• Meals: \$555

So, aside from the gross pay James receives, Company ABC pays an extra annual cost of \$8,470 for having James on their team.

Step 4: Calculate the Total Annual Payroll Expense

It's now time to calculate the total annual payroll cost of having James work for company ABC. To do this, simply sum up the gross pay and the additional labor costs.

Annual payroll cost = Gross pay + additional annual costs

For James, that will be \$30,000 + \$8,740 = \$38,740. So, company ABC spends \$38,740 for James' input into the company.

Step 5: Calculate the hourly labor cost

You can now determine James' labor cost per hour.

Hourly labor cost = annual total payroll cost/actual hours worked.

So, for James, we have: \$38,740/2000 hours = \$19.37 per hour.

The actual labor cost per hour for hiring James is \$19.37.

Calculating Labor Cost Percentage

Beyond knowing your total labor cost, the goal is to see how your costs relates to the revenue. The labor cost percentage shows that relationship and helps you know whether or not you’re maximizing profit.

Labor cost percentage = (labor costs for all employees / total revenue) x 100

After calculating your labor cost percentage, take some time to analyze the results. Are you performing optimally, or should you reduce labor costs to improve your profit margin? The lower your labor costs, the higher your profit margin.

Labor cost percentages vary by industry. However, the average labor cost percentage is between 20% and 30% of the gross revenue. Labor-intensive businesses like restaurants may record a labor cost percentage as high as 50%. Manufacturing industries, however, should not have a labor cost percentage higher than 30% for optimal profitability.

Reducing Labor Costs: Handy, Easy-to-follow Tips

Keeping your labor costs in check is critical to the sustenance of your business, especially when labor accounts for a large chunk of your business's expenses. Does this mean paying ridiculously low wages in a bid to cut down on expenses? Certainly not. However, putting certain guidelines in place may significantly reduce your expenses. Here are some of them.

Ensure Accurate Time Tracking

If you get time tracking right, you’ll save your business some labor cost expenses. While it may not seem significant in real time, mistakes in time tracking may cost your business an arm and a leg, especially when you have a larger number of employees.

Use effective tools that accurately monitor actual working hours. Ideally, one that:

• This allows your employees to clock in and clock out seamlessly.
• offers geofencing
• It allows you to manage teams with ease.
• Let us set the physical boundaries within which employees can track working time.

Certain labor cost components are fixed, and there’s not so much you can do about them, e.g., FICA taxes, state unemployment taxes, and certain employee benefits. But, you do have control over the overtime your employees work. Schedule your team to make the most of normal work hours and reduce overtime to the bare minimum.

Study your business trends. If there’s a part of the week when you have massive customer engagement and visits, plan your working hours around that time. For example, if you run an event planning business and most of your engagements are during the weekends, it’ll be smart to reduce your employees work hours on weekdays and have them focus on weekends. That way, you make the most of your labor costs.

Have Employees' Administrative FAQs Online for Self-Service

Human resource personnel, supervisors, and managers often spend a large chunk of time answering employees' questions about payment policies, vacation usage, healthcare insurance, and other company policies and benefits. Answers to these frequently asked questions may be made available online so each employee can self-assess them, leaving more productive time to work.

Scrap Buddy Punching

Buddy punching occurs when an employee is running late or unable to come into the office and has a co-worker punch the time card (or clock in) on his behalf. This practice is detrimental to your business as it means you’re paying for hours not worked. An easy way to do this is to incorporate biometric verification into your check-in procedure. Consider using fingerprint verification and coded badges.

Reduce Employee Turnover

Hiring new employees is more challenging and expensive than retaining existing staff. So, help your employees feel appreciated and happy. By reducing the chances of unnecessary employee turnover, you’ll save on recruitment and, consequently, labor costs.