Last Updated On February 06, 2021 / Written By Lauren Christiansen

How to Use the Direct Labor Cost Formula

Running a small business is a costly endeavor in today's global and competitive economy. Every extra dollar is important when razor-thin profit margins are often the norm.

Startups and first-time entrepreneurs may be tempted to say yes to any customer willing to pay, but this isn't always the best decision. Time-consuming projects can cause a loss in profits, particularly if labor-related indirect costs and direct costs aren't accounted for.

Properly calculating labor fees, which constitute a large percentage of revenue, make it easier to know which projects aren't worth the time and resources.

  • 31% of small businesses are non-operational due to COVID-19 based regulations
  • More than 50% of small companies fail within their first year
  • The biggest challenge for small companies is labor quality at 52%
  • 82% cited cash flow management problems as the biggest contributing factor to failure

Tips to Calculate Direct Labor Costs

Most business owners think about employee wages, labor hours, and salaries when they hear the word direct labor cost'. While these are certainly a large part of labor expenses, many other additional fees and overhead costs are included in total labor costs.

Examples of additional direct expenses that are unrelated to wages include insurance payments, direct materials, manufacturing overhead, benefits, paid time off, overtime hours, and sick leave. Adding these costs in with wages and salaries will help to gain a more accurate understanding of how much is spent on each employee.

Properly calculating direct labor cost streamlines cash flow management by pinpointing specific areas where waste is occurring. It allows owners to know exactly how much to price their sales items to maintain profitability and helps to budget properly.

Furthermore, it identifies how much it costs to complete business activities that directly contribute to producing a new product or service.

Direct Labor Cost Formula

In a difficult market where profit margins are shrinking, it's imperative to make every dollar count. Knowing how much is spent on labor costs will help to avoid misleading conclusions by year's end.

Utilizing a set of formulas to accurately calculate labor expenses will also assist in knowing which projects and activities to take on or not.

Here is an example of how to use formulas to determine total direct labor expenses -

1. Calculate Expenses for Hours Worked

First, a business owner must determine how much each worker makes. For example, Sara is a full-time salary staff member who makes $65,000 per year, and Jennifer is a full-time staff member who is hourly. She makes $18 per hour.

The salaried worker would equate to the regular pay rate per week
Sara Wage Costs - $65,000 / 52 weeks = $1,250

The owner will have to factor in any overtime costs for Jennifer, as she is a non-exempt worker. In this circumstance, Jennifer had 5 hours of overtime this week, at 1.5 times the typical hourly rate.

Jennifer Typical Wage Costs - $18 x 40 = $720
Jennifer Overtime Hours - $27 x 5 = $135
Jennifer Wage Costs = $855

2. Pinpoint Additional Expenses

Next, the owner should factor in any supplementary labor expenses such as payroll taxes or health care benefits.

For this illustration, the company pays $500 in payroll expenses each month for Sara and $300 per month for Jennifer, plus $250 in benefits for both of them each month.

First, these expenses should be broken down into weeks rather than by month. The formula to calculate total additional expenses is-

Sara $750 (additional expense total) x 12 months = $9,000 / 52 weeks = $173.07 per week

Jennifer - $550 (additional expense total) x 12 = $6,600 / 52 = $126.92 per week

3. Determine Direct Labor Expenses

Once the owner has the total normal labor expenses and any additional fees for both workers, he can determine how much it costs to pay each worker.

Sara - $1,250 (normal wages) + $173.07 (additional labor fees per week) = $1,423.07
Jennifer - $855 (overtime plus normal wages) + $126.92 = $981.92
Total Labor Cost Per Week = $981.92 + $1423.07 = $2,404.99

4. Use These Numbers to Optimize Decision-Making

Understanding how these insights can assist in decision-making is key to running a successful business.

To illustrate, if an investor is providing a standard rate of $8000 to advertise, the organization would gain $5595.01 in total profit, which would be an acceptable amount to continue doing business with the investor.

However, if the investor offers $3,000 to advertise, the company would only generate $595.01 in profit, which is not worth the work and time it takes to create the campaign.

Direct labor costs also assist in creating budgets for future business activities and customer requirements. Projections for how much a task will cost will be much more accurate, which can assist in managing cash flow and making better decisions.

  • Future Costs - Future expenses that will be incurred as a result of performing a task/project
  • Opportunity Costs - Any cash flows that will be forfeited due to a project/task
  • Cash Expenses - Any money going out of the business could impact a project/task

Key Takeaways

In conclusion, here are the key takeaways to remember about calculating direct labor costs

  • First, the organization needs to compile all of its expenses to find the direct labor rate, including additional expenses that are unrelated to hourly pay and salaries. Then, it should calculate the total expenses for hours worked to show how much both workers are making per week.
  • The company can then find any additional expenses and add them to the total cost in wages. Over time, health insurance, and benefits are included in this amount.
  • Next, the organization can determine the direct labor expenses or the total labor fees per week. This is performed by taking the total normal wages and adding them to the additional labor fees.
  • Utilizing a direct labor cost formula will assist in optimizing decision-making, budgeting, and resource allocation so a company generates more profit.