Skip to main content

September 3, 2021 | Time and Attendance | Posted by Ascentis Thought Leadership

How to Calculate Labor Costs

Labor costs are not only the largest overall expense for most businesses, but they are also one of the most difficult to control. According to the U.S. Bureau of Labor Statistics, the combination of wages and salaries with health insurance and other benefits costs employers between $36 and $52 per hour, depending on the industry. The percentage of total costs represented by labor varies widely between industries, but in many cases anywhere from 20% to 40% is considered reasonable. In the healthcare industry, labor costs routinely account for more than half of an employer’s operating expenses. With those kinds of figures involved, it makes sense for employers to take every action possible to manage labor costs prudently. 

Throughout this post, we’ll go over how to calculate labor costs, with tips on how to reduce labor costs to help protect your bottom line. Continue reading for an in-depth look at how to compute labor costs, or use the links below to jump to a section of your choice.

What is the cost of labor?

The cost of labor goes beyond looking at how much you’re paying an employee to figure out the true hourly cost of each employee. Using labor tracking software and analytics, you can get a better picture of how much each hour is costing you so you can make informed decisions about product or service pricing, material costs, and labor. 

There are two different types of labor costs: direct labor costs and indirect labor costs. A direct labor cost is something that’s directly related to a product or service, such as the wage you pay service or manufacturing employees. Indirect labor costs are costs that aren’t directly related to creating a product or providing a service, such as administrative costs. Both of these labor costs are an important part of running your business, so they’re both equally important to understand. 

Labor costs include the total wages, payroll taxes, and benefits paid to all employees involved in producing a product or service.

In order to understand the true cost of labor, you have to look at factors such as the cost of recruiting software, wages, benefits, health insurance, employment taxes, training costs, the overhead for each employee, and more. After all, employees don’t come from thin air and they certainly don’t know how to do the job on their very first day. By considering all these costs, you can make sure you’re not spending so much on labor costs that your business isn’t making any profit.

There may also be temporary labor costs to consider depending on your situation. If your business needs to find temporary workers to fill in for a lost employee, that should count toward your labor costs. Understanding how much you’re spending on labor costs each week, month, and year helps you understand how much you should charge for products and services if you want your business to be profitable.

Labor cost formula

To determine how much you spend on labor, you can use a labor cost formula. Here’s how to calculate labor costs with the labor cost formula in relation to your total sales:

Labor Cost Percentage = (Total Labor Costs / Total Sales) x 100

Labor cost formula

Labor cost example

The labor cost formula can be a little confusing. It’s easier to understand how to calculate labor costs and why you need labor tracking hardware when you have examples of labor costs. 

As we know, there are direct and indirect labor costs to account for. As far as direct labor costs go, you’re talking about the money you spend directly to produce and distribute a product or provide a service. One example of this would be the wages you’re paying employees who are responsible for manufacturing a product, which are considered direct labor costs. Direct labor costs can even be in the form of money you pay a company to distribute your product to locations across the country. 

An example of an indirect labor cost would be the wages of an HR manager, an accountant, or a quality assurance worker. These wages are considered an indirect labor cost because these workers don’t directly manufacture the product but help facilitate the process. While these employees aren’t directly responsible for the creation of your product, they play important roles in making sure your business runs smoothly. Chief financial officers (CFOs) and other high-level employees are also an example of an indirect labor cost. Keeping track of these wages with payroll software is a good way to stay on top of labor costs.

You also have to consider the difference between fixed and variable costs when it comes to how to compute labor costs. If you have a team of employees who manufacture a product and are paid a salary, that’s a fixed labor cost you can expect to pay each month. An example of manufacturing costs could be a manufacturing employee being paid one rate for spending the first part of their workday working on the line, while the second half of their day operating a forklift.

Calculating your labor costs 

Before you can begin to manage your business’s labor costs, you need a clear understanding of what they are. In general terms, labor costs cover a wide range of expenditures, including: 
  • Employee wages (both hourly and salary) 
  • Overtime pay 
  • Paid time off (both sick leave and vacation time) 
  • Training and education 
  • Payroll tax 
  • Health insurance 
  • Employee wellness programs 
  • Supplies and technology 
  • Any other benefits 
Labor cost expenditure examples include employee wages, overtime pay, paid time off, training, payroll taxes, health insurance, employee wellness programs, and any other benefits.

The specifics of calculating these costs will vary from business to business and industry to industry. For example, one simple formula for calculating labor costs in the manufacturing and construction industries involves multiplying a workers’ hourly rate by the time that worker takes to complete production of a single unit of work (a manufacturer’s product or a construction task, for instance), resulting in a per-unit labor cost.  

A more elaborate calculation frequently used in industries like healthcare, hospitality, and retail involves adding up the total cost of all the expenses listed above, then dividing that total by the employee’s total hours worked, resulting in an accurate cost-per-hour. There are many different labor cost calculators available for many different kinds of employers, many of them adjustable to reflect the specifics of your organization and industry.

The Department of Commerce labor costs resource makes it easy to find out more about why labor costs are important for businesses and how to figure labor costs. This includes information on labor costs and productivity, how rising wages affect the bottom line of a business, and how turnover plays a role in labor costs. If you want to learn more about labor costs and how they affect the bottom line of your business, this resource is an excellent place to find more information.  

How to reduce labor costs 

The most obvious method for reducing labor costs is to employ less labor, but layoffs are seldom the most desirable outcome for an employer. Fortunately, there are a number of other useful approaches to keeping labor spending in check. As a bonus, most of these methods have the added benefit of improving productivity or streamlining existing practices. 

To reduce labor costs, review your best practices, take advantage of your learning management system, get a handle on overtime, and institute flexible scheduling

Review your best practices 

Taking regular stock of your organization’s policies and best practices is just a good idea all around, and it can be especially useful for reducing labor costs. If your business is relying on outdated practices like manual data entry, or using multiple platforms to manage employee hours and scheduling, there is a greater chance of human error leading to problems like overscheduling, unnecessary overtime, and time fraud. Upgrading your workforce management software and automating time and attendance functions are excellent steps toward more effective labor cost management. 

Take advantage of your learning management system 

The old workforce adage about it being more expensive to hire new talent than it is to keep the talent you have holds true. Diversifying your workforce’s skillsets is a reliable way to cut labor costs without taking drastic measures. Rather than hiring new employees to fill new roles or operate new equipment or technology, retraining existing employees can not only reduce labor spending but also increase their engagement and empowerment. A strong, customizable learning management system can help your workers evolve their skills to keep pace with your industry.  

Get a handle on overtime 

Overtime pay represents a minefield for many employers. Not only is it one of the most expensive aspects of payroll, but it is also one of the most heavily regulated. Keeping a close eye on overtime hours is essential to preventing both overspending and potential fines and sanctions from federal, state, and local authorities. An automated, customizable time and attendance software with an easily accessible, one-stop dashboard can go a long way toward reducing unnecessary overtime while maintaining compliance across your organization. 

Institute flexible scheduling 

The past year has forced a lot of employers to re-evaluate the ways they approach scheduling employees. In industries such as manufacturing, construction, and healthcare that have less possibility for remote work, many employers have compromised by instituting flexible scheduling options and adding shifts. Those lessons can be used to control labor costs beyond the pandemic. Using scheduling software to have larger or smaller volumes of workers onsite depending on the volume of work and the specific jobs that need doing not only reduces labor costs but can also boost productivity and efficiency across the board. 

Ready to start working toward lower labor costs for your organization? Learn more about the many ways Ascentis time and attendance solutions can help you manage your employees in a more efficient, effective, and compliant way.

With more than 35 years of experience in providing Software as a Service (SaaS) solutions, Ascentis thought leaders have become a respected source for insights, tips, and innovations in the Human Capital Management (HCM) space.