How to Calculate Labor Cost and Why it Matters

Man holding up two scales, one with money and the other with people

Knowing how to calculate labor cost is essential if you want to run a profitable operation since labor is by far the largest expense most businesses face. Specific costs vary by industry, but it accounts for as much as 70% of total expenses in some fields. As of the latest BLS data, the average non-government worker costs employers $40.23 per hour worked. For government workers, that number jumps to $57.60 per hour.

If you do not have a reliable labor cost formula, there is no way of knowing how much each additional employee actually costs your organization. Without this intel, it is impossible to project your current and future hiring capabilities accurately. You cannot properly price your goods or services if you do not know the labor cost associated with producing them.

While calculating labor cost may seem straightforward, many businesses take an approach that is too narrow, merely accounting for the cost of employee wages. This is part of the labor cost formula, but your true labor cost includes the full range of expenses associated with attracting, onboarding, training, and retaining your employees. This also includes payroll taxes, benefits packages, and other expenses associated with employees, like space and equipment.

Here, we will discuss the importance of calculating labor costs thoroughly and accurately and give you a reliable breakdown of every expense you should factor in.

Why Calculate Labor Cost?

You would not sign a contract for a new office space without doing the math to see if you could afford the monthly rent, right? Likewise, you should not hire a new employee before you fully assess whether the benefits of hiring them will outweigh the financial cost.

As companies grow, many run into trouble when they overestimate their staffing needs and underestimate the true cost of labor. In the best-case scenario, this ends up hurting profits, and in the worst case, it results in laying people off.

Using a labor cost formula gives you a precise dollar figure for what every hour of labor directly costs your organization. With this number in mind, it is much easier to determine how many full-time and part-time employees you can afford to bring onboard, rather than guessing.

Knowing your labor costs helps you set optimal prices, which maximizes your profits. If you underestimate your labor costs, you will set too low prices and wind up with margins that are not feasible to stay in business. If you overestimate labor costs, you will set prices that are too high and unable to compete in the marketplace effectively. Labor costs should be considered alongside the cost of goods sold when you are deciding how much to charge.

Finally, calculating your labor cost helps you pinpoint revenue leaks that are eating into your earnings. Some examples include employee cell phone usage, company vehicle mileage, and hiring costs. Monitoring spending trends in these areas can also help you flag potential fraud.

How to Calculate Labor Cost

Now that we have established why getting an accurate read on your labor cost matters, here are six categories of expenses you need to factor into your labor cost formula.

Recruitment

You begin accruing labor costs before you even hire your first employee. After all, it costs money to maintain a website, promote job listings, participate in job fairs, and conduct other recruiting activities. Some niche roles may cost you more to fill, while other roles, like entry-level positions, may cost less. The average amount it costs to attract an employee for any role is known as cost-per-hire.

Recruiting costs are calculated by summing all of your internal and external recruiting expenses. Some common recruiting expenses to include in your calculation are job board fees, background checks, drug testing, career fairs, setup and maintenance of your careers page, and fees paid to recruiters.

Wages

This is the most obvious employee expense, and it is pretty straightforward. This is the total cost of salaries or hourly wages you pay to all of your employees.

Make sure that whatever unit of time you are using to measure wage costs—typically looking at the cost of employment for a full year is the simplest—you use the same time frame for all of the other categories outlined here.

Benefits and health insurance

Employee benefits are another major labor-related expense. Of the $40.23 hourly employee cost, we told you about earlier, $11.86 of that was made up of benefits. That is roughly 30%.

Generally speaking, the more employees you have, the less your benefits will cost per employee. Health insurance premiums, employer retirement contributions, retirement program administrative fees, paid time off, and supplemental pay like overtime should all be included in your benefits calculation.

Employment taxes

For every person you employ, your company bears a tax burden. This includes federal income tax, Social Security and Medicare taxes, and unemployment. Federal income taxes are withheld from the employee’s wages, so we do not include them here (as they are already covered as part of the wages category above).

Social Security and Medicare taxes are also withheld from employee wages, but the employer is responsible for paying a matching amount on top of that. Federal unemployment taxes are paid strictly by the employer. To calculate your portion of the expense for each of these taxes, use the guidance from the IRS.

Training

New employees are not typically productive right out of the gate. Rather, you are going to spend some time and money training them, and these costs should be factored into your labor expenses. According to a report by Training magazine, U.S. businesses spend an average of $1,207 per employee on training.

When adding up your training costs, consider travel, training materials, equipment, software, and other digital programs, and payment for outside help. If you want to get super precise, you can also include loss of productivity, i.e., the amount of money you are not making because the employee is not fully productive yet. These figures might be more readily available in some fields, like sales, while they are not as quantifiable in others, like service-based businesses.

Overhead

You are probably familiar with overhead expenses like rent and utilities; you might think these are separate expenses from labor costs. In fact, though, your overhead is directly tied to the number of employees you have. The more people you hire, the more desks you need and the more square footage of space you will require, so it makes the most sense to include overhead as part of labor costs.

Some items to factor into your overhead costs include the cost of your physical workspace (mortgage or rent), property taxes, utilities, office supplies, equipment, and maintenance. These should also be included if you provide company vehicles, cell phones, laptops, or other devices for employee use.

Additional costs to consider

In addition to the regular, recurring costs covered above, do not forget to work in flexible costs, like seasonal or temporary labor, and one-time costs that only come up occasionally, like holiday bonuses.

Also, consider the cost of contractors like freelance graphic designers or consultants, keeping in mind that these expenses might actually go down as you add employees (like if you bring on an in-house graphic designer to eliminate the need for outsourcing).

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Labor Cost Formula

Once you have dealt with all of the categories above, it is time to add them up.

To calculate your true labor cost, total the expenses in the categories above and divide the sum by the number of employees you have. This will give you the cost per employee per year (or whatever unit of time you settled on).
Next, you want to break this cost down by hour. To do this, divide the cost per employee from step 1 by the number of hours worked per year. Assuming a 40-hour workweek with two weeks of paid vacation, most employees work about 2,000 hours annually.
This is your true labor cost per hour.

Using this figure, you can easily do the math to understand how much each additional full- or part-time employee will add to your expense sheet every year and, in turn, see whether it is a feasible expense.

Ways to Reduce Labor Costs

If you’ve run the numbers and you’re a little dismayed at your true labor costs, it might be time to take steps to rein them in. Here are some options.

Optimize productivity

This one’s a no-brainer: ensure you’re empowering your staff to be as productive as possible while at work. This includes automating repetitive tasks and streamlining workflows to complete the job in as few steps as possible. As you examine your workflows, you may find that some tasks can be eliminated entirely without negatively impacting the overall product. All of these things can save you labor hours, which translates into lower costs.

Get a handle on overtime

The next step is to examine the overtime your employees are racking up closely. In many companies, there’s a skewed perception about overtime, and employees clock it with little to no oversight. Ideally, overtime should be an option of last resort when an urgent project can’t be completed within normal work hours rather than a standard part of the job.

Put a lid on excessive overtime by enacting measures like requiring manager approval for overtime beyond a certain number of hours. You can also offer incentives like bonuses for employees who stay within the bounds of the normal 40-hour week.

Supplement your full-time workforce

As you can see, based on our earlier breakdown, employees come with more costs than just paying them for their time. Instead of hiring full-time employees, consider using contract or temporary workers to meet your needs instead, as they don’t require all of the benefits and tax expenses of full-time workers.

Combine sick and vacation time

Traditionally, sick time and vacation time are divvied into two separate buckets, but some employers are getting creative and finding cost savings by combining the two. For example, let’s say you typically provide two weeks of paid vacation and ten sick days. Instead, you might offer three weeks of paid time off in a single bucket to be used at employees’ discretion. Not only does this save you five days of PTO per employee, but it also empowers workers to make decisions about the best use of their time.

Hire strategically

Hiring more full-time workers can sometimes add up to a net gain–if you hire smart. For example, let’s say you’re in a field like construction that requires estimates. If you’re losing out on work because your estimator is overloaded and takes two weeks to provide a quote, hiring another estimator could easily pay for itself as a new business. This is why it’s so important to have a strategic staffing plan.

Get Expert Help Mapping Your Future Staffing Plan

As you can see, there is a lot to consider when you are deciding how many people you need to hire and what roles to prioritize. Failing to forecast your staffing needs properly can result in lost profits and lagging productivity. We can help you map a staffing plan that meets your organization’s needs and makes sense for your budget.

Our staffing experts will help you weigh the benefits of full-time employees against alternative options like part-time, temporary recruiting, and contract staffing to determine the best hiring strategy for your current situation and future growth. We also offer a full suite of payroll services to help you tackle tedious but necessary tasks like insurance and benefit offerings.