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What is Labor Cost and How Do You Calculate It?

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When a business sets the sales price of a product or service, it calculates the cost of materials and overhead. These costs are taken into account when determining the price to charge. 

It is important to properly calculate your labor cost. You may need to cut some costs if your business becomes less profitable.

One of the most important costs to determine is your labor cost. 


What is Labor Cost?

Labor costs are any costs that are direct and indirect when paying for labor. These are all overhead costs to run your company and include everything related to employee wages.

For example, labor costs include payroll taxes, overtime, insurance, benefits, training, and meals.


What is a Direct Labor Cost?

direct labor cost is the wages paid that produce the goods or services. It includes anything regarding the wages such as payroll taxes, benefits paid, workers’ compensation insurance, any company match to a 401k or other plan. 


What is an Indirect Labor Cost?

Indirect labor cost is any labor that supports the business but is not directly involved with the manufacturing of materials. These wages include administrative roles such as HR, accounting, or office staff. It can also include any managerial role, engineering, IT, or maintenance worker. 

These employees are not working directly on the product or service. 

For example, if you own a construction company, your builders and anything involved in their wages are direct labor costs. The person running your office, or your foreman is indirect labor costs.


Fixed and Variable Costs of Labor

Labor costs can also be classified as fixed or variable costs. 

Fixed Labor Costs

Fixed labor costs are costs that are unlikely to change. Examples of this are those people who earn a fixed salary such as managers or supervisors. 

Variable Labor Costs

Variable labor costs are costs that may variate due to changes in production or services. For example, a landscape business may need more landscapers in a peak season such as summer. Any of those employee’s wages are variable labor costs. If you hire temporary employees from an agency, those would also be considered variable labor costs. Another example of a variable labor cost is hiring someone to fix broken equipment.



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How to Calculate Your Labor Costs

According to the Small Business Administration (SBA), calculating your labor costs can be more expensive than you think. They state that labor cost is typically 1.25 to 1.4 times the salary. You have to consider everything you spend on that employee. When calculating your labor costs, you should determine every amount that goes into employment. 

Here is a list of items to consider when calculating your costs. Calculate for each employee:

  • Gross pay
  • Hours worked 
  • Absent days 
  • Overtime
  • Taxes
  • Insurance
  • Benefits
  • Supplies
  • Any other costs associated with labor

Once you have determined the above amounts you calculate your costs.


Annual Gross Income + Other Labor Expenses and Divide Total Hours Worked

Labor expenses are any other variable and fixed labor costs such as taxes, insurance, benefits, equipment, and any other supplies. There are also calculators online that can help you find your labor cost percentage.


Example of How to Calculate Your Labor Cost

For example, an employee works 40 hours a week at a pay rate of $20 per hour. Their annual income is $41,600. 

Gross Income – $41,600

Then add up other labor expenses spent annually:

Taxes and Insurance – $8,000

Benefits – $5,000

Equipment, Supplies, and Other Labor Costs – $2,000

Total annual costs – $15,000

Calculate absent days and hours worked per year = 15 days which is 120 hours

Net hours worked = 2080 hours minus 120 hours = 1,960 hours

The annual labor cost calculation would be:

Gross Income + Other Labor Expenses / Hours Worked

$41,600+$15,000 = $56,600 which is your annual payroll labor cost

Divide by 1,960 hours = $28.88 total hourly labor cost

If you want to determine your labor cost percentage, take your annual payroll labor cost which is $56,600 in this example, and divide by your total revenue.

If your revenue is $200,000

Your labor cost percentage is 28.3%


Breakdown of Calculations

Here is a breakdown of these calculations to help you understand your costs: 


Taxes

There are mandatory costs, including employer payroll tax costs such as federal unemployment tax, federal payroll tax, and state unemployment taxes.

FICA taxes are the gross wages that an employer pays for social security and Medicare. The employer pays 7.65% on compensation.

FUTA is federal unemployment tax. According to the IRS, the FUTA tax rate is 6% The tax applies to the first $7,000 you paid to each employee as wages during the year. Your state wage may be different. 

If you pay wages subject to state unemployment tax, you may receive a 5.4% tax credit, which would make the FUTA tax rate after the credit .6%. 

State Unemployment Tax – Varies with your state and the number of claims you have made. 


Insurance

You would also include worker’s compensation and any insurance that may be needed for the work to be performed. If you need liability insurance, these costs would also be included.

If your business needs to be bonded, you will also add those costs. 

While all of these costs can add up, some of these may be tax deductible. 


Benefits

Other costs to consider are health insurance and other benefits. Under federal law, there is a federal tax credit for small employers that choose to provide at least 50% of the cost of health coverage.

What benefits will you provide your employees? This category is anything you supply your employees that aren’t direct wages. 

Some examples include:

  • Health and dental insurance
  • Any paid time off
  • Bonuses
  • Any equipment or materials to perform the job

What other costs do you spend on your employees? Here are some other costs to consider that you may pay:

  • The cost of recruitment, including background checks and drug testing
  • Training
  • Miscellaneous items such as protective gear, uniforms, or tools. 
  • Vehicles
  • Desks, computers, phones, and supplies
  • Miscellaneous other items such as meal plans, travel, massages, etc. 

Consider all of these when calculating your annual labor expenses. 


Implement Good Systems and Processes

It is important to implement good systems and processes to help ease your labor costs. They help you with your calculations to ensure you know exactly what your labor costs are, and you don’t have to guess. 

For example, a good payroll system can help you know exactly how much you are paying in payroll and employment taxes. 

Using a time clock app like ezClocker will help you know exactly how many hours an employee is working. It helps you to control overtime and expenses. With ezClocker’s job labor cost report you can tell how many hours each job took and what to charge your customer. ezClocker’s job feature allows you enter a list of jobs and assign them to your employees. When an employee clocks in they will be presented with a list of jobs to pick from, this will allow you to categorize each time entry by job. ezClocker also allows you make changes to a schedule and employees are immediately alerted on their phone so they don’t miss a shift.

Additionally, think about processes you should develop to perform good quality of work. Think about what measurements or steps should be written down as a process to ensure all employees follow the required guidelines. 

Finally, consider implementing great hiring practices and your labor costs will go down as well. Turnover is an indirect labor cost. When you are spending too much time recruiting for the same position because of turnover, your labor costs increase. 

Think about everything that can affect your labor costs and how you can tighten them. Compare your labor costs to your industry’s labor costs. What systems, processes, and practices can you put in place to reduce them?


employee-time-tracking-with-gps

Author: Kimberley Kay Travis

Kim Travis, co-owner of Travis and Adams Consulting Group, has over 20 years’ experience in human resources and leadership roles. She has specialized knowledge in employment law, employee relations, recruiting, management consulting, leadership development, manufacturing safety programs, and writing business articles and blogs.

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