For any organization, keeping the labor cost low is one of the priorities. It is how you can keep profitability high, and overtime costs low. Still, many companies keep labor costs in their reports when they analyze profit and loss. This can result in poor efficiency and overspending.
The only solution to the problem is to learn how to calculate labor costs.
However, calculating labor costs is not as simple as there are some factors to consider and how different types of costs involved. This blog covers everything you need to know about calculating labor costs.
Table of Contents
Understanding labor cost
Labor cost refers to the total expenditure incurred by a business in employing and compensating its workforce. It’s not just about the wages or salaries paid to the workers but also includes all the related costs, such as social security and Medicare taxes, that employers are mandated to pay.
Understanding labor cost is essential because it is a significant component of your organization’s overall expenses and is crucial in determining profitability and budgeting. To ensure that unmanaged labor cost is not impacting your bottom line, you must compare them to your revenue to ensure business growth.
Components of labor cost
To truly understand how to calculate labor cost, it’s necessary to know the components of labor cost. These components together affect the overall expenditure on the workforce and include:
- Base salaries or wages
It is the regular agreed-upon amount paid to the employees or hourly wages regularly. The job position, skills, and experience determine the base salary.
- Overtime wages
Overtime pay is one of the most significant components of labor costs and is usually 1.5 or 2 times the regular pay.
These are additional employee payments for performance, meeting targets, or achieving specific goals.
Benefits of calculating labor cost
The costs associated with offering work benefits such as health insurance paid time off, and retirement contributions.
1. Payroll taxes
Employers also pay taxes based on employees’ wages, such as federal, state, and local taxes, social security contributions, and Medicare taxes.
2. Training costs
Some organizations have training and development programs that incur costs for skill development programs, workshops, and seminars.
3. Labor-related expenses
Uniforms, tools, equipment, and other items necessary for workers to work more productively are miscellaneous costs.
Calculating labor cost
You must know all the components listed above to calculate the labor cost. Once you have those values, it’s a simple calculation.
Here’s how to calculate the labor cost per hour:
Labor cost per hour = (gross pay + all annual costs) / actual worked hours per year
A non-exempt worker gets paid $15 per hour; how will you calculate their labor cost?
First, we calculate their gross pay. It is calculated as
Gross pay = gross hourly rate x number of hours worked during the pay period
For a worker, the total number of hours per year will be calculated as follows:
The total number of hours per year = 40 hours per week (assuming they worked minimum hours) x 52 weeks = 2080 hours
Therefore, the gross payment will be:
$15 x 2080 hours = $ 31200.
Hourly labor cost
You must know how to calculate labor cost per hour for hourly workers.
In our example, the hourly wage is $15. But we want to calculate the total hourly cost per hour. Here’s the formula to do it:
Hourly labor cost = annual payroll cost / actual hours worked
First, we need to find the actual hours worked. For that, we will use this formula:
Actual worked hours = total number of hours per year – hours not worked
Suppose the employee worked for less than 10 days in the year.
So, their actual worked hours will be = 2080 hours – (10 x 8)hours = 2000 hours.
Next, the annual payroll cost = gross pay + other annual costs.
In our example, all other costs, such as benefits and overtime, are $1500.
So, the annual payroll cost = $ 31200 + $1500 = $ 32700.
Finally, hourly labor cost = $32700/2000 hours = $16.35.
Factors affecting labor cost
Given several components of labor costs it is evident that it is affected by various factors. You must know these factors to manage labor cost and bring it down effectively.
1. Skill requirements
Different industries have varying labor cost structures, mainly based on the supply and demand of skilled workers. You can expect higher labor costs if there is a shortage of skilled labor.
The level of employee compensation you offer, including wages, salaries, and benefits, directly affects labor costs. While you can control the several compensation benefits you offer, such as merit increases, performance-based bonuses, and health insurance contributions, you still need these costs to attract the right employees. It’s a balancing act that managers have to master.
3. Labor productivity
If the workers spend hours at the job but are not productive, it will be negative labor costs as you are not generating revenue from the salaries paid. This is why you must focus on efficient and productive employees who can generate higher output with the same labor hours, thus reducing labor costs.
3. Labor laws and regulations
Labor laws and regulations also decide your labor cost, as you must abide by minimum wage and overtime regulations. Compliance with these labor laws and regulations results in additional costs for employers.
Strategies to control labor cost
We study labor costs to ensure that labor costs do not adversely affect our profit margins. We also want to offer appropriate compensation to workers to keep them engaged and motivated.
Here are some strategies that organizations can implement for managing and controlling labor costs effectively.
1. Workforce planning and scheduling
How can you expect to calculate labor costs correctly if you are not planning and scheduling your workforce? The process is necessary to ensure that the labor resources align with the production demands. Workforce planning and scheduling can help accurately forecast staffing needs based on historical data, seasonality, and business trends. It avoids overstaffing or understaffing, reducing unnecessary labor costs.
2. Time and attendance tracking
A reliable time and attendance tracking system, such as Truein, can help accurately measure employee work hours. Truein is an AI-powered face recognition time and attendance system that offers robust shift scheduling and leave management capabilities. Its GPS-enabled tracking option ensures there is no time theft. It easily integrates with payroll and HR software to calculate wages accurately and control overtime costs. Its real-time tracking and auto-scheduling features can also enable proactive adjustments to schedules and staffing as needed.
3. Performance management
Companies should focus on performance management and productivity improvement initiatives. It will help optimize labor utilization. You should set clear performance goals, and managers and supervisors should provide regular feedback to workers so they can proactively improve their productivity and efficiency, reducing wasted time and increasing output.
Understanding labor cost is essential to make informed financial decisions regarding productivity and revenue optimization. Knowledge of labor cost components empowers you to calculate labor costs accurately. Consider the factors affecting your business’s labor cost and implement appropriate strategies to control costs.
Can I calculate labor costs based on an employee's annual salary alone?
No, labor cost is not based solely on an employee’s annual salary but includes various components such as bonuses, overtime pay, payroll taxes, and benefits.
How can I reduce labor costs without compromising productivity?
You can use workforce planning and scheduling to anticipate the supply and demand of the workforce, implement time and attendance tracking with reliable tools like Truein for accurate work hours calculations, and improve employee training and development.
Are labor costs the same across all industries?
Labor costs vary significantly across industries due to skill requirements, labor market dynamics, and industry-specific regulations.
Should I include training costs in labor cost calculations?
If the training costs directly impact the employees’ learning and development within their roles, they can be included in labor costs. If not, then it is a more general or unrelated cost.
How often should I recalculate labor costs?
The frequency of recalculating labor costs depends on the nature of your business needs. However, you should review and recalculate labor costs regularly, such as monthly, to ensure that labor costs remain accurate and up-to-date.