How To Calculate Labor Cost: A Step By Step Guide
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, attention needs to be given to your company’s 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 your business labor costs and how to track important metrics that will help you optimize your workforce.
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 about the hourly rate you pay your employee. Labor costs include many other expenses that your company covers.
Only after factoring in these additional expenses can you properly calculate the actual labor costs for your company.
An employee’s individual labor costs equal all the expenses related to them.
These costs may include, 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, etc.)
If your company’s expenses include everything we’ve mentioned above, you’ll get a better idea of the true definition of labor costs.
How to Calculate Labor Cost?
In a few words, labor cost is the total expense incurred for employing a workforce. It includes both direct costs (wages, benefits) and indirect costs (supervision, taxes, training).
Step 1 Determine Gross Annual Wages
To calculate actual labor costs, begin by determining an employee’s gross annual wages. The calculation is relatively simple:
Gross annual wage = annual working hours x gross hourly wage
Let's say Robert, in Arizona, has an hourly wage of $17. 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 $17, we determine his gross yearly wage is $35,360.
Gross Annual Wage Calculation: 2,080 x $17 = $35,360
Step 2 Determine Actual Hours Worked
Let’s continue looking at our example of Robert mentioned above. We may question if Robert actually worked the full 2,080 hours last year. Every employee needs to use sick days or take a break throughout the year and we know 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 we discovered. Fifteen days of paid time off is equal to 120 hours. For the calculation to reflect the actual number of Robert's hours worked last year, we need to calculate the correct figure. According to the formula below, Robert’s actual hours worked are now 1,960.
Actual hours worked = annual hours worked - 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 calculate 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.
From the table provided below, Robert’s additional expenses amount to $7,672.40
Additional Variables that Impact Labor Cost
Some usual labor costs besides an employee’s hourly compensation are benefits, supplemental pay and bonuses, and payroll taxes.
✅Benefits
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 2024, the average cost of employee compensation for workers in the private industry was $43.78 per hour. Wages and salaries averaged $30.76 per hour worked, accounting for 70.3 percent of employer costs. Benefit costs averaged $13.02 per hour worked, and accounted for the remaining 29.7 percent.
Some of the standard benefits that you should take into account include:
- 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
- Equipment and Supplies
- Education and training (onboarding, certificates, licenses, etc.)
✅Supplemental pay and bonuses
To determine the 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 the company's costs for the following:
- Overtime hours and premium pay (pay for extra work hours and hours worked 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 your employees’ hours and maintain valid and accurate records. Tracking your workers' hours is the key to paying them appropriately and staying compliant with 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 (In our example, we're assuming Robert’s employer is new and subject to Arizona’s new employer rate of 2.0% on the first $8,000 of wages.)
Step 4 Determine The Total Annual Labor Cost
What is the formula for calculating total annual 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 Arizona, working for $17 an hour. Even though Robert had 2,080 working hours last year, he reported 1,960 actual hours worked.
So, how do we calculate annual labor costs for Robert?
Our calculation would look like this:
Annual Employee Wages + Other Expenses = Total Labor Cost
$35,360 + $7672.40 = $42,760
When you divide the total labor costs ($42,760) by the actual number of hours Robert worked (1,960), you can see that an hour of Robert's work actually costs your company significantly more than just his wages which are $21.82.
However, this is just an example of how to calculate labor costs, real expenditures can vary significantly.
Calculating all these expenses can be complex. To streamline the process and get a quick estimate of your total labor cost, you can use our free labor burden calculator.
How To Calculate Labor Cost Percentage
Labor cost is a significant expense for any company. In some industries, it is the highest cost. However, it’s not 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. The labor cost percentage will help you determine if your company's labor costs are high enough to potentially harm your bottom line.
Tracking your company’s 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
Labor cost percentages average 25% to 30% of company revenue. Percentages vary significantly by industry - companies providing services might have a labor cost percentage of 50 percent or more. Most production companies will try to keep their labor cost percentage under 30.
Now that you know how to calculate labor cost and labor cost percentage, we're ready to discuss 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 associated with 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. The final sales price must include all the expenses the company encounters.
If any expenses are left out of the calculation, total revenue will be lower than expected. If the demand for a product or service decreases, or if competition forces you to cut prices, the cost of labor must be reduced for your business to remain profitable.
How to Calculate Direct Labor?
Most companies set a standard direct labor cost to which they compare their actual direct labor costs.
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
Step 1 Determine the direct labor hourly rate by dividing the labor cost by the number of hours worked.
labor cost / number of hours worked = direct labor hourly rate
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.
Step 2 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 per unit = total # of products / total # 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.
1,000 / 200 = 0.2 hours per unit
Step 3 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 $3.40.
direct hourly rate x hours to produce one product = labor cost per product
$17.00 x 0.2 = $3.40
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?
Labor costs are one of the biggest challenges facing businesses today. They can eat up a large portion of your revenue and negatively affect your bottom line.
But how can you reduce labor costs without sacrificing quality, productivity, and 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 your company’s 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.
- 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 needed to complete tasks. Provide comprehensive training to ensure your employees follow the best practices.
For example, Timeero is a GPS powered tracking tool that helps you streamline employee time tracking as well as mileage, reporting, payroll, and accounting processes. Just think about all the hours of work you will save!
- Optimize scheduling. Align employee schedules with customer demand and workload to avoid overstaffing, which can negatively impact labor costs and worker productivity.
Timeero can be used to forecast demand, track employee availability and performance, and create well-matched schedules, which aids in preventing scheduling conflicts.
.webp)
- Reduce turnover. Employee turnover has significant costs. Expenses include hiring, training, and onboarding new employees. Implement employee retention strategies like providing competitive compensation and benefits, issuing regular feedback and recognition, fostering a positive work culture, and offering career development opportunities.
Understanding how to calculate and efficiently track labor costs and 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 any data recorded is exact and up to date.
Besides providing accurate estimates of employee costs, Timereo can fully streamline operations related to employee attendance. Timeero increases the efficiency of your current scheduling, management, and payroll systems while saving you time and money.
