Labor Cost

Brent Watson
Brent Watson

Table of Contents

What is the impact of hiring an employee on your company’s bottom line? Knowing your company’s labor cost can help you answer that question and ensure sustainable workforce growth and profitability.

Watch the world’s largest HR encyclopedia be built in real-time

Subscribe to get a weekly roundup email of all our new entries

What is Labor Cost?

Labor cost refers to how much money is spent on each employee. Several different factors which impact this number will be covered in more detail in the article. Labor costs comprise your organization’s largest expense, so using this information to price services and products ensures your company earns a profit while maintaining sustainable workforce growth.

Indirect vs. Direct Labor Cost

Direct labor costs refer to money contributing to the successful creation and sale of your product or service.This applies both to employees and technology that is utilized in the creation of your product.

Indirect labor refers to services that support direct labor costs. If your furniture company creates 10 or 500 pieces of furniture, HR still needs to complete payroll and finance still needs to run numbers for forecasting. While these actions don’t directly contribute to production, they are essential in running and maintaining a business.

Why is it Important to Know Your Labor Cost?

Knowing your labor costs helps you forecast in several different areas. Let’s review three of them.

  • Accurate workforce planning. When leaders approach you requesting increased employee count for their teams, knowing your labor costs can facilitate a productive conversation to discuss what can and cannot be done. This allows both you and the team lead to understand how their requests impact the business profitability.
  • Product/service pricing. Everyone starts a business expectating to make any money. Utilizing your labor cost alongside competitors’ product prices allows you to identify the profit range and avoid furloughing or firing employees because there was a miscalculation.
  • Business partners. One of your responsibilities in HR is to be a strategic business partner to the organization. Labor costs demonstrate an understanding of individual and team needs while ensuring business success. No department or service operates completely by itself. The decisions of HR and other departments have a direct impact on the business.

How To Calculate Labor Cost

A basic formula to calculate business cost is adding up all your employee expenses each year and then adding 10-12% to include taxes. Let’s break this down into different steps and explain the reasoning behind it.

Employee Payroll

Employee payroll will be the bulk of your costs. To keep things organized when calculating this number, ensure you are using the same measure of time for each employee or salary group. The most common measure is annual income. Salary groups can help ease the calculation by organizing roles into salary ranges rather than adding up each individual income. This needs to be done for salaried and hourly employees.

Federal income tax is withheld from your employee’s payroll. There is not a matching employer tax for this, but it is good to be aware of when an employee asks why they got less money than expected.

Health Insurance and Benefits

Your second largest contribution to labor costs will be employee health insurance and benefits. If your organization is larger, you may have a lower cost per employee. How much the employer pays for benefits depends on the health insurance you coordinate with your insurance broker.

Remember that health insurance and benefits can help you attract and retain top talent. Talk through the pros and cons when changing health insurance to make sure it is aligned with your business strategy.

Matching Taxes

Your business is responsible for contributing to Social Security and Medicare taxes. Your responsibility includes matching what is withheld from your employees’ paycheck. To help calculate this amount, refer to this guideline provided by the IRS.

Recruiting and Retaining

To understand how much it costs to have one employee, consider how much is spent on recruiting and training for them. It costs money to have job ads, maintain your company website and have employees participate in the interview process.

Often your newly hired employee will need training to solidify certain aspects of the job. Even if your employees have all the technical skills to do the job, there is still the process of onboarding.

Take into account if you hire seasonal workers or contractors as this will increase your overall labor costs.

Workspace and Supplies

The purpose of labor cost is to understand how much money each employee costs. It is therefore important to consider the workspace and technology each employee will use. The more employees you have, the more space you will need to facilitate their work. This can come in the form of desks, computers, machinery,  etc.

Ways to Lower Labor Costs

Some business decisions can help reduce labor costs. It is important to weigh the pros and cons of each decision before making them. Take a holistic few to maximize the good and minimize the bad.

Hybrid or Remote Work

Some companies rent a smaller work space and allow employees to work a few days from home. Similarly,rather than giving each employee a desk at the office, employees can work with a vendor or create an internal system to allow them to reserve a desk during a certain time or day. This reduces the cost of office rent and monthly utilities.

Full-Time Hire vs. Outsourcing

Other companies have reduced labor costs by replacing their contract work and temporary employees with a full-time employee. To see if this is an option for you, analize how much is spent on these services and if it will be cheaper to hire someone full or part-time.

Adopt More Efficient Processes or Technology

Technology has evolved significantly over time and many services are available that automate a manual process. Review your processes and see if there are redundant steps. Just because something was done one way when the company was founded does not mean it is the best way. Look at proposed changes from different angles and do a practice run to see if it will really help.

Questions You’ve Asked Us About Labor Cost

Fixed labor costs are the amount of money you have to pay each month no matter how many products you sell. Factors that play into this are your employees’ base salaries and benefits, and can also include overhead costs.
Variable labor costs refer to expenses that change depending on how many products are made. Some examples include hiring seasonal workers or contractors to meet high demand. The Postal Service is a great example of this during the holiday season.
Brent Watson
Brent Watson

Brent Watson enjoys problem solving, analyzing data, team building, and becoming an HR Guru. His work experience comes from the employee experience, recruiting, and training arenas. After attending a local HR conference, Brent knew that he had found his people and the problems he wanted to solve for in the business world.

Want to contribute to our HR Encyclopedia?

Other Related Terms

Posts You Might Like

What is People Management Software?

What is People Management Software?

People management software sounds important, but what exactly does that mean? Does your business need it? What businesses benefit most? All these questions and more are answered as we dive into the fascinating world of people management software and determine what’s best for your company.

Read More »
The Ultimate Guide on How to Manage Employees in a Small Business

The Ultimate Guide on How to Manage Employees in a Small Business

When it comes to running a small business, we know that managing employees is often one of the most difficult tasks. People are complicated, and finding a way to keep your employees happy and productive can be challenging. This article shares specific advice for what you can do in the three phases of the employee lifecycle to get the most out of each employee.

Read More »

Want to join our network of contributing HR professionals?

Scroll to Top

Submit a Question