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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, the odds are high that your labor costs make up the most significant part of your operating expenses.


It would be best if you compensated your employees adequately for their work. However, if you don't track and monitor these costs regularly, they can quickly escalate and harm your bottom line.


But how to calculate labor costs? We've gathered all the info in this step-by-step guide so that you can make the proper calculations for your business and keep track of important metrics.


What Is Labor Cost?

If you're wondering how much labor costs your company, keep in mind that labor cost isn't only 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 cost for the particular employee equals all the expenses related to them. It includes their wages and all the additional payments made 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
  • Meals
  • Equipment and supplies (protective gear, uniform, cell phone, desks, chairs…)


Think about your company's expenses for everything we've mentioned above. Then, you'll get closer to figuring out how to calculate labor costs.

How to Calculate Labor Cost

Step 1. Determine Gross Wages

Start calculating actual labor costs by working out gross wages. The calculation is relatively simple:


Gross wage = annual working hours x gross hourly wage


Let's say Marco earns $20 an hour. In a year, Marco is supposed to work 52 weeks, 40 hours each week, which comes to 2080 working hours.

When we multiply the annual number of hours Marco is supposed to work with a gross hourly rate of $20, we can set his gross yearly wage as $42.600.


Step 2. Determine the Actual Working Hours


But did Marco clock in all the 2080 working hours last year? Every employee needs a break, and we can see that Marco had 15 days of paid time off the previous year.


So, we need to modify our calculation according to the new facts. Fifteen days of paid time off is equal to 120 hours. So, now we can calculate that the actual number of Marco's working hours last year was 1960.


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 all the other expenses that we should include into our total labor cost. 


We must consider all related expenses the company pays for Marco so that he can work that comes on top of his gross pay. After we factor in all these expenditures, we get the actual labor cost per hour for a particular employee. 


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

Benefits

Benefits are a large piece of labor costs 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 December 2021, the average cost of employee compensation for workers in the private industry was $38.07 per working hour. Wages accounted for $26.86 or 70.5 percent of costs, while benefits were $11.22 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,
  • Equipment, and supplies,
  • Education and training (onboarding, certificates, licenses, etc.).

Supplemental pay and bonuses 

To determine the actual labor cost, you must include all supplemental pay and bonuses an employee gets. Here you will include the company's costs for:

  • 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), and
  • Nonproduction 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 the 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 under legal regulations.

Payroll taxes

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


  • FICA taxes (7.65%) include: Social Security 6.2%, Medicare 1.45%,
  • FUTA taxes (federal unemployment tax) with a standard rate of 6%, but exceptions may apply),
  • State unemployment taxes - taxes vary by state.

Step 4 Determine the Total Annual Labor Cost

After you've gathered all the expenditures your company has for your employee, you can use the total labor cost formula to sum up:


Total annual labor cost = gross wage + other annual costs


Let's retake Marco for example. He is a non-exempt worker in California, working for $13. Out of 2080 working hours last year, he clocked in 1984. So, how to calculate labor costs for Marco? Our calculation would look like this:


How to calculate labor cost


Now, we get the total labor cost is $34,708.56 by adding the total of other expenses - $7,668.56 to the annual wages - $27,040.


When you divide the total labor cost by the actual number of hours Marco worked, you can see that an hour of Marco's work actually costs your company significantly more than just his wages - $17,5.


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


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 is not enough for you to just know how to calculate labor cost. To be able to make a deeper analysis of your labor costs, you should keep track of a labor cost percentage. That is how you will be able to determine whether your company's labor costs are so high that they can harm your bottom line. 


Keeping track of 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 to your revenue. 


To calculate labor cost percentage, you should 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 periods, you can use gross sales from interim reports or calculate them by adding weekly or daily reports figures.

 

The next step is to calculate 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.


Suppose the company doesn't allocate the cost of labor adequately. In that case, it can cause the inappropriate price of goods or services and, thus, harm profits.


When a company sets the sales price, they consider the costs of labor, material, and overhead. The sales price must include all the expenses the company has. If any expenses are left out of the calculation, the profit will be lower than expected. If demand for a product or service falls, or if competition forces cutting prices, the company must reduce the cost of labor to remain profitable. 

How to Calculate Direct Labor Cost?

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


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



There are a few steps to calculate actual direct labor cost per unit of production, using the following  direct labor cost formula: 


Direct labor cost per unit  = direct labor hourly rate X time for producing one unit.


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


For example, let's assume that using the methodology we've given above, we've calculated the total labor cost for an employee for an hour is 17$. 


Then, we 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. For example, if the hourly rate is $17, and it takes 0.2 hours for a single product, the direct labor cost per product is $3.4 ($17 x 0.2).


You shall determine the variance between the standard and the actual direct labor standard cost per unit. If the actual direct labor cost per product is lower than the standard, it is positive for your company. 


And  If the actual direct labor cost per product is higher, the company spends more to produce one unit than is planned, which can be harmful. If this is the case, you need to cut labor costs.


As this can be challenging, you need to identify effective ways to reduce costs without harming employee incentives and productivity.


How Can Timeero Help You Reduce Labor Cost?


By understanding how to calculate labor costs and keep track of it, you will better fit your workforce to your company's needs. 


GPS-powered time tracking tools, such as Timeero, can help you always have relevant and accurate data on your workforce attendance. As you can have real-time insight into your employees' working hours, you can rest assured your data is exact and free of human error.

This way, all your labor cost calculations will be accurate, and you can use them to manage your workforce further.

Besides providing reliable data on your crew, Timereo can  fully automate operations related to your employee attendance, helping you with efficient scheduling, management, and payroll while saving you time and money.

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