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How To Calculate Labor Cost: A Step By Step Guide

Find out all you need to know about labor costs and how to reduce them.
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No matter what kind of business you're running, odds are that your labor expenses make up the most significant part of your operating costs.

It’s important to compensate your employees adequately for their work, but if you want to run a profitable business, you need to keep an eye on your labor costs. If labor expenses go unchecked, they can get out of hand and significantly impact your bottom line.

But how is labor cost calculated? 

In this guide, we’ll show you how to monitor labor costs for your business and how to track important metrics that will help you optimize your workforce. 

You’ll also learn tips and best practices to reduce labor costs and increase productivity.

Let’s get started!

What Is Labor Cost?

If you're wondering how labor costs affect your company, keep in mind that labor cost isn't just the hourly rate you pay your employee. It includes many other expenses that your company covers. 

Only after factoring in all these additional expenses can you calculate the actual labor costs for your company. 

The labor costs for a particular employee equals all the expenses related to them. It includes their wages and additional costs incurred on their behalf.

These costs may be, but are not limited to:

  • Social Security Taxes
  • Medicare Tax
  • Health Insurance
  • Retirement Contributions
  • Disability Insurance Cost
  • Life Insurance
  • Overtime hours
  • Paid time off
  • Bonuses
  • Training costs
  • Meals
  • Equipment and supplies (protective gear, uniform, cell phone, desks, chairs…)

When you think about your company’s expenses for everything we’ve mentioned above you’ll get a better idea of what encompasses labor costs.

How Is Labor Cost Calculated?

Step 1 Determine Gross Wages

To calculate actual labor costs, begin by determining gross annual wages. The calculation is relatively simple:

Gross annual wage = annual working hours x gross hourly wage

Let's say Robert works in Arizona at a minimum wage of $13.75 an hour. He is scheduled to work 52 weeks out of the year, 40 hours each week, which amounts to 2,080 annual working hours.

When we multiply the annual number of hours Robert works by the gross hourly rate of $13.75, we determine his gross yearly wage is $28,600.

Step 2 Determine Actual Working Hours

Following the previous example, we may question if Robert actually worked all 2,080 working hours last year. Every employee needs to use sick days or take a break throughout the year. We can see that Robert was given 15 days of paid time off the previous year.

This means we need to modify our calculation according to the new facts. Fifteen days of paid time off is equal to 120 hours. To reflect the actual number of Robert's working hours last year, we need to calculate the correct figure.  According to the formula below, Robert’s actual working hours are now 1,960.

Actual working hours = annual working hours - hours not working

Step 3 Factor In All Other Expenses

In the third step of our calculation, we will add in all the other expenses that should be included in our total labor cost formula. 

To get the actual labor cost for a particular employee, we will need to take into account all expenses that allow an employee to perform their job. 

So, what are the additional variables that impact labor cost?

Some usual labor costs besides the actual compensation to the hourly employee are benefits, supplemental pay and bonuses, and payroll taxes.


Employee benefits make up the majority of labor costs that a company has to pay. Even though the figures vary from one industry to another, benefits make up around 30 percent of employer costs for employee compensation.

According to the US Department of Labor, in March 2023, the average cost of employee compensation for workers in the private industry was $40.79 per working hour. Wages accounted for $28.76, or 70.5 percent of costs, while benefits were $12.02, or 29.5 percent.

Some of the standard benefits that you should take into account are

  • Health insurance
  • Additional insurance, such as dental, vision, life, or disability
  • Retirement plan (for example, matching 401(k) contributions)
  • Paid time off (sick and vacation days) 
  • Meals at work
  • Needed Equipment and supplies
  • Education and training (onboarding, certificates, licenses, etc.)

✅‍Supplemental pay and bonuses 

To determine actual labor cost for an employee, all supplemental pay and bonuses received by an employee must be taken into consideration. 

When it comes to supplemental pay and bonuses you will include company's costs for the following:

  • Overtime hours and premium pay (pay for extra work hours and pay for work on weekends and holidays)
  • Shift differentials (additional payments for working a non-traditional work schedule)
  • Non Production bonuses (Christmas or end-of-year bonuses, which are given at the employer's discretion and unrelated to production)

When it comes to calculating overtime pay, your company needs to follow FLSA and state regulations, which can vary significantly from one state to another.

FLSA also requires you to keep track of employees' hours and maintain valid and accurate records. Tracking employees' hours is the key to paying them appropriately and staying within compliance of legal regulations.

✅Payroll taxes

You also need to factor in payroll taxes when calculating total labor costs. Some of the basic taxes most companies pay include:

  • FICA taxes  at 7.65%  (Social Security 6.2%, Medicare 1.45%)
  • FUTA taxes  federal unemployment tax has a standard rate of 6%, but exceptions may apply
  • State unemployment taxes which vary by state

Step 4 Determine The Total Annual Labor Cost

What is the formula for calculating labor costs?

Total annual labor cost = gross wage + other annual costs

The total labor cost can be calculated after you've gathered all the expenditures your company has made on behalf of an employee, such as healthcare, taxes, etc.

Let's take our previous example of Robert.  He is a non-exempt worker in California, working for $13 an hour. Out of 2,080 working hours last year, he reported 1,984 working hours. 

So, how do we calculate labor costs for Robert? 

Our calculation would look like this:

Labor cost calculation example

Annual Employee Wages: $27,040 

Other Expenses: $7688.56

Total Labor Cost: $34,708.56

Total Labor Cost = Annual Employee Wages + Other Expenses 

When you divide the total labor costs ($34,708.56) by the actual number of hours Robert worked (1,984), you can see that an hour of Robert's work actually costs your company significantly more than just his wages which are  $17.50.

However, this is just an example of how to calculate labor costs,real expenditures can vary significantly.

How To Calculate The Labor Cost Percentage

Labor cost is a significant expense for any company. In some industries, it is the highest cost. However, it is not enough for you to just know how to calculate labor costs. 

Many times a deeper analysis is needed to evaluate your company spending, this is where defining the labor cost percentage is helpful.  This percentage will help you determine whether your company's labor costs are so high that they will potentially harm your bottom line. 

Tracking the labor cost percentage is the key to solid business management and growth. This key metric displays the overall labor cost as a proportion of gross sales, comparing your total labor costs against your revenue. 

To calculate labor cost percentage, first determine your annual gross revenue. You can find this info at the top of your company's income statement. If you want to calculate labor cost percentages for shorter time periods, you can use gross sales from interim reports or calculate them by adding weekly or daily income totals.


The next step is to calculate the total labor costs for your company, including all the expenditures we've mentioned above. 

Finally, you can calculate the labor cost percentage by dividing the labor cost by gross sales and multiplying the result by 100. 

Labor cost percentage =  ( total labor cost / gross sales) x 100

Commonly, labor cost percentages average 25% to 30% of the revenue. Percentages vary significantly by industry - companies providing services might have a labor cost percentage of 50 percent or even more. However, production companies will try to keep this percentage under 30.

Now that you know how to calculate labor cost and labor cost percentage, we're ready for another important concept related to employee labor - direct labor.

Direct vs. Indirect Labor Costs

There are two main categories of labor costs: 

  • Direct costs are related to the expenses for the employees producing goods or providing a service.
  • Indirect (overhead) costs are associated with employees who are required to support the production or services process.

When a company sets the sales price for a product, they consider the costs of labor, material, and overhead cost. The sales price must include all the expenses the company encounters.


If any expenses are left out of the calculation, the total revenue will be lower than expected. If demand for a product or service falls, or if competition forces you to cut prices, the cost of labor must be reduced to remain profitable.

How Is Direct Labor Cost Calculated?

Most companies set a standard direct labor cost to which they compare their actual direct labor costs. 

For example, suppose the direct labor cost per hour for assembling a product is $12. The company expects an employee to take 30 minutes to assemble each product. If the company produces 1,000 products, the standard direct labor expense will be $6,000 ($12 x 0.5 x 1,000).

To calculate the actual direct labor cost per unit of production use the following direct labor cost formula: 

Direct labor cost per unit  = direct labor hourly rate X time needed to produce one unit

First, you need to determine the direct labor hourly rate by dividing the labor cost by the number of hours worked.

Let's assume that using the formula we've given above, we've calculated the total labor cost for an employee to be $17 an hour. 

We then need to determine the number of hours required to make a single product. We can calculate this figure by dividing the total number of products by the total number of direct labor hours needed. 

Hours required for a unit = total number of products / total number of direct labor hours

For example, if it takes 200 hours to produce 1,000 items, 0.2 hours are required for a single unit.


We can then calculate the labor cost per product by multiplying the direct labor hourly rate by the time needed to produce a single product. If the hourly rate is $17, and it takes 0.2 hours to produce a single product, the direct labor cost per product is $3.4 ($17 x 0.2).

It’s important to determine the difference between the standard and actual direct labor cost when evaluating your company spending.  

If the actual direct labor cost is lower than the standard labor cost, this is great news for your business. If the actual direct labor cost is higher than the standard labor cost, this is an indication that your company is spending more revenue than recommended to produce one unit.     

To improve the ratio of actual vs standard labor costs, you will need to identify effective ways to reduce costs without harming employee incentives and productivity.

How Can I Lower Labor Costs Effectively?

As we can see, labor costs are one of the biggest challenges facing businesses today. They can eat up a large portion of your revenue and affect your bottom line. 

But how can you reduce labor costs without sacrificing quality, productivity, or customer satisfaction? 

Here are some practical tips to reduce labor costs:

  • Avoid overtime. Overtime can quickly increase labor costs as employees are paid higher rates for extra hours worked. To avoid this, monitor employee work hours closely, plan ahead for peak periods, and hire part-time or temporary workers as needed.

Besides enforcing the overtime policy, some of the best time-tracking tools, such as Timeero, can help you avoid unnecessary and unapproved overtime by alerting you when an employee works over their scheduled hours.

You can set up Timeero to send notifications when an employee goes overtime.

  • Streamline processes. Another way to reduce your labor expenses is to identify and optimize workflows and procedures to minimize errors and inefficiencies that lead to higher labor costs. Use technology, automation, or outsourcing to reduce the amount of time-consuming tasks, and provide comprehensive training to ensure your employees follow the best practices.

Cut labor cost by streamlining time-consuming tasks.

For example, GPS employee monitoring tools like Timeero can help you streamline various procedures, such as tracking employee time and mileage, reporting, payroll, accounting, and more. Just think about all the hours of work saved! 

  • Optimize scheduling. Align employee schedules with customer demand and workload to avoid overstaffing, which can negatively impact labor costs and productivity.

Scheduling your staff is easy with Timeero.

You can use software to forecast demand, track employee availability and performance, and create well-matched schedules, preventing potential scheduling conflicts.

Use the ‘Who’s Working’ dashboard to always stay updated on who is available for work.

  • Reduce turnover. Employee turnover incurs significant costs, including hiring, training, and onboarding of new employees.  Implement employee retention strategies like competitive compensation and benefits, regular feedback and recognition, fostering a positive work culture, and offering career development opportunities.

Understanding how to calculate labor costs and efficiently track them will increase the quality of your company’s workforce management system.

How Can Timeero Help Me Reduce Labor Costs?

GPS time tracking apps, such as Timeero, help you maintain relevant and accurate attendance data.

With real-time insight into your employees' working hours, you can rest assured that your data is exact and error-free.

Besides providing accurate estimates of employee costs, Timereo can fully streamline operations related to your employee attendance. Timeero will help you increase the efficiency of your current scheduling, management, and payroll systems while saving you time and money.

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