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How to Calculate Labor Costs: The Small Business Owner’s Guide

A guy sitting at a desk calculating labor cost on his laptop computer

Depending on what line of work you are in, labor costs can eat up a significant portion of your expenses. Many small business owners think of labor costs as the wages or salaries that they pay their employees. While this is partly true, direct wages and salaries are just a fraction of total labor costs.

Business owners looking to stay on budget and maximize profits must accurately account for labor costs. Otherwise, it’s easy to overspend or undercharge, and that’s no way to run a business. Here are some basics about what labor costs really are and how to calculate them.

What are Labor Costs?

Labor costs are the total amount of money a business spends on labor. As mentioned above, direct wages and salaries for work performed during standard working hours make up a good chunk of labor costs, but there is much more to total labor costs. Other payments and benefits to be factored into the total cost of labor include:

  • Overtime wages for non-salaried employees
  • Payroll taxes paid by the employer
  • Bonuses
  • Sick time
  • Vacation days
  • Paid training
  • Employer contributions to retirement accounts
  • Employer-paid health and life insurance

When all these types of compensation are added to standard hourly wages or salaries, the labor cost is much higher.

How to Calculate Labor Cost

Calculating the total cost of labor is a little more complex than simply adding up the total cost of all the payments listed above. The following is a step-by-step guide to calculating the total labor cost of an employee.

  1. Calculate the gross payment: For an hourly employee, the gross payment is simply the number of hours worked multiplied by the hourly rate. For a salaried employee, it is simply the salary he or she draws during a given period.
  2. Calculate the additional labor costs: Add together the costs of each payment or benefit listed above.
  3. Calculate the total labor cost: Add together the gross payment and any additional labor costs to find the total labor cost for each employee.

Depending on what you are doing, you may choose to calculate the total labor cost for a year, a week, or the predicted timeframe of a specific project.

The Importance of Total Labor Costs

Total labor costs have many implications for small businesses and small business owners. Correctly calculating total labor costs can help you budget for upcoming projects and appropriately price your products or services. It can also help you plan ahead for how many employees you can afford to hire, how many projects you should take on, and which projects are worth your time.

If customers pay your small business on a per-project basis, it is critical to use total labor costs when generating estimates. If you only include the gross labor costs in your estimate, you will under budget for labor. When the project is complete, you will need to increase the cost of labor, which may disappoint your customer, or take the additional labor costs out of your profits, which will disappoint you.

Controlling Labor Costs

Once you have learned how to calculate total labor costs, you can use that information to control labor costs and maximize profits. Strictly managing your employees’ schedules is one strategy that can help. Below are some points to consider for scheduling.

  1. Plan schedules in advance. Scheduling employees well in advance gives you time to note scheduling conflicts or planned absences, then adjust the schedule.
  2. Cross-train employees. If you train your employees to perform more than one function, you can shift them between roles as scheduling changes arise. This approach can help you avoid assigning overtime to get the job done.
  3. Monitor overtime. Overtime wages can quickly increase the overall labor costs. Avoid them whenever possible.

Time tracking software is one tool you can use to manage scheduling. It can help you plan your schedules, eliminate coverage gaps, and monitor which employees are approaching overtime hours.

You can learn how to calculate labor costs, or you can outsource that work to accounting professionals. The staff at Expert Payroll LLC handle a variety of payroll services in Carlsbad, CA, for many small businesses. Call us today at (760) 421-5334 to learn how we can help you.

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