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Take care of your people and protect your business

As an HR professional, you may wonder why you are sometimes faced with verbiage like “cost of labor.” You didn’t sign up to be an accountant or financial advisor. Should you know what this means? How is it applicable to your role and organization? Read on to learn more!

What Is Cost of Labor?

Cost of labor is an accounting term that defines both the direct and indirect monetary amount a company pays its employees plus payroll taxes and benefits. This includes expenses tied to recruiting, onboarding and training.

  • Direct cost of labor. This is the cost that is directly tied to employees who contribute to the creation of goods or provide company services.
  • Indirect cost of labor. This cost is not directly related to the product or services a company provides. This includes costs of support roles, including administrative, supervising, bookkeeping, maintenance, supervising and security staff members.

For example, the wages of a plumber would be considered direct cost of labor, whereas the wages of the receptionist who schedules the plumber’s appointments would be considered indirect labor cost.

How Is Cost of Labor Used?

Now that you have a high level view of cost of labor, let’s see how knowing cost of labor could benefit your organization from an HR standpoint.

  • Reduce cost. Potentially the most valuable aspect of knowing how to appropriately use the cost of labor for your organization is to reduce cost.
  • Employee satisfaction. As employees work for your organization day in and day out, they notice where you spend your money. Spending it on a copy machine that takes an employee 20 minutes to operate because it’s “cheaper” vs. a new scanner that takes 3 minutes will not save you money in the long run, and employees will feel you don’t value their time. Calculating the cost of labor and using it to your advantage in this way helps boost employee satisfaction.
  • Better quality with less effort. With cost of labor, you’re finding a way to do the exact same thing better in less time. Cost of labor helps you best evaluate what processes can be updated to cut costs and what may be helpful to improve to continually contribute to that bottom line.

How to Calculate Cost of Labor

It does you no good to understand how to use the cost of labor if you cannot confidently calculate it. So let’s look at calculating the cost of labor and a few different formulas you can use for your organization.

Step 1: Calculate Hourly Cost per Employee

In order to fully calculate your cost of labor, you’ll need to calculate the average hourly cost of each employee. This will include part-time, full-time, full-time equivalent, exempt and non-exempt employees. Think ALL employees.

  • Calculate gross pay for all employees. This calculation is as follows: pay per hour x hours worked per year.
  • Consider absences and holidays that may be included. On average, most employees will have about 2 weeks off per year, planned or unplanned. You’ll take those hours and subtract them from the hours calculated above.
  • Add in other expenses like benefits or additional perks you provide your employees. Refer to your employer cost for each company-provided benefit and add this into the equation.
  • Calculate the final cost.

For the above formula, let’s use the example of a $15 per hour employee who works full time. Their hours per year are 2,080 with 80 hours subtracted for absences and holidays. This brings us to 2,000. From there, for the purpose of this formula, let’s say other expenses total $5,000, so your formula would read: ($15 x 2,000) + $5,000 = $35,000.

Step 2: Plug Into Your Formula

If you’re an organization without many additional benefits or payroll specific tax costs, here is a simple formula. You’ll need the company’s total income, the total overall payroll expenses for the organization (you will turn this into a percentage in this equation) and the average hourly rate for employee salaries. The formula will read as follows:

Cost of labor = (total company income X percentage of labor) / hourly average salaries.

Let’s break this down with an example. If your organization had an income of 1 million, your overall percentage of labor came to 15% (when you divide the labor cost by gross sales and multiply the result by 100) and your average hourly pay is $12.50, your formula would look like this:

(1,000,000 X .15)/ $12.50= (150,000) /$12.50 = $12,000

Examples of Cost of Labor

While you may understand how to calculate labor costs and feel like a pro, there are different examples of labor costs to be familiar with as you assess each for your organization.

Variable Labor

The most common example of variable labor is your hourly employees that are not salaried. You may request full-time employees not work overtime and part-time employees not work over 25 hours per week, but that is still variable. There are some weeks where your part-time employees work 15 or 20 hours, and some where they hit that 25 mark depending on the demand of the organization. Variable labor costs are managed by monitoring hours and adjusting them in accordance with business needs. This is important to take into consideration during any labor cost analysis.

Fixed Labor

You guessed it! The exact opposite of variable labor is fixed labor. These are your salaried employees who are paid the same amount no matter the season. Fixed labor is not easily changed without substantial change to the operation of the business, as these roles are typically essential for steady completion of day to day functions.

Direct Labor

Direct labor is easily qualified because these expenses are tied to a specific product and are easily tracked. Direct labor is easily justified and qualified for accounting purposes but it can also be qualified as fixed or variable labor. Direct labor refers to employee roles that are necessary to the business, such as product managers, delivery truck drivers, quality control engineers, etc. But this labor can still be done on a fixed or variable level.

Indirect Labor

Costs that cannot be traced back to a product or service needed are qualified as indirect labor. Administrative role expenses or sales team members salary is an indirect labor cost. These services, while perhaps helpful to the success of the organization, are ancillary services overall, and considered a support labor. Therefore they are not typically assigned a specific product or service like direct labor cost.

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Questions You’ve Asked Us About Cost of Labor

First, start by knowing exactly what it is and then evaluate what your organization can do to cut costs. Things like streamlining processes, avoiding overtime and reducing turnoover are great places to start. 

As stated above, direct labor is the wage for employees producing a product while indirect costs are wages for those in a support department not directly related to the services or product of the organization. 

Shalie has over 4 years of experience working in a variety of HR positions and organizations including: working as an HR department “of one”, working with a start-up based in Europe, to working in a fully established robust USA based HR department. Shalie has experience in multiple states and countries with all aspects of the HR spectrum. She has a passion to share her knowledge and experience to benefit the HR profession!

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