Labor Cost | 11 mins read

What Labor Cost' Really Means

what labor cost really means
Lauren Christiansen

By Lauren Christiansen

What is Labor Cost?

Labor cost includes the totality of gross wages paid to all workers along with payroll tax expenses and the cost of benefits. The cost of labor depends on the number of direct expenses, indirect expenses, and any other additional costs.

While direct expenses include the employee wages related to manufacturing a product, indirect or overhead costs are unrelated to labor, equipment, and manufacturing. Leaving out any of these expenses when pricing a product or service will result in a much lower profit.

Labor costs are also impacted by market demand, the economy, or the competition. If the economy enters a recession or if market demand declines, an organization must cut labor expenses to maintain profitability. Options include cutting back on the number of workers, minimizing the manufacturing of goods, or demanding a greater efficiency.

Accurately calculating and minimizing labor costs while still paying workers a fair wage is essential for a business owner to achieve success and maintain employee morale.

  • Lumber and building material stores at $15.7 billion
  • Painters at $12 billion
  • Truck dealers at $7 billion
  • Wood framing at $5.8 billion
  • Business coaching at $4.08 billion

Direct vs. Indirect Costs

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When an operation determines how to price a product or service, it must consider both indirect and direct labor costs.

For example, if a restaurant incorrectly administers or calculates its indirect and direct labor costs, the price of menu items may be too high or too low. Over time, this can impact the bottom line and confuse the company as to the true worth of its deliverables.

Further insight into direct and indirect labor costs is required to understand how the cost of labor is calculated -

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Direct Labor Cost

Direct labor includes all manufacturing-related expenses and is a portion of the expense of products sold. This may include any equipment or raw materials required to create a product.

To illustrate, if a restaurant is determining how to price its menu items, direct costs may include wages and benefits paid to cooks, food delivery expenses, and wholesale food costs from the supplier. In a factory, direct labor costs include anyone who operates a piece of equipment or performs work by hand.

Direct labor is also known as a variable expense because it can change depending on how many products are produced. Because it is more time-consuming and labor-intensive to generate six products than it does three products, so the cost of direct labor increases as the number of products increases.

This may even out once production rapidly increases, as cost savings occurs once there is a large increase in production. This cost advantage phenomenon is referred to as economy of scale, which occurs when expenses are spread out over a greater quantity of products.

Indirect Labor Cost

Indirect labor costs refer to any worker payroll hours that are not entirely related to manufacturing a product.

Referring back to the restaurant example, an owner calculating the sales price of menu items would consider indirect expenses within their estimations. This may include the wages of management, servers, and HR expenditures, as none of these items are directly responsible for producing any food items.

While direct labor is variable, indirect labor costs are fixed. They typically do not change regardless of how many products are sold. A restaurant must maintain its servers even if few chicken dinners are sold, and it must continue to pay HR regardless of whether 500 or 100 meals were sold in a week.

As a consequence, the indirect expenses per product produced tends to decrease once the volume of products generated increases, as the fixed expense is spread out among a larger quantity of produced products.

Other Examples of Labor Costs

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Every small and large organization must factor in the price of labor when determining sales price so it can achieve profitability. Each business model must consider how every new department and worker will contribute to increasing the bottom line.

Over-hiring, under-hiring, or having too many overhead expenses will disrupt this equilibrium and hurt the company's potential for growth. Knowing every type of labor expense is required to accurately calculate sales price and ensure the company is not overspending. Examples of other important labor costs to know include

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1. Variable Labor Costs

Variable labor expenses depend on how many products are produced and sold. Many small businesses employ hourly workers, who are a type of variable labor cost. This helps to decrease total labor expenses so the organization can remain profitable. The price of goods at a retail outlet also fluctuates as market demand for these products ebbs and flows.

Companies choose to hire hourly workers because it's one of the most cost-effective options. Unfortunately, they can't always guarantee a certain number of hours for their variable employees because they may have to cut back on hours if there is low market demand.

2. Fixed Labor Costs

Fixed labor expenses rarely change even when output increases or decreases. Examples of fixed labor expenses may include salaried employees and high-level executives at an organization. These individuals receive their wages regardless of how many products are produced and sold.

While the company does not guarantee these individuals permanent employment, the cost of their salary while employed stays consistent (unless they receive a pay raise or pay decrease). A benefit to fixed labor expenses is that owners don't have to pay overtime costs. A downside is that it is hard to decrease pay or salary without impacting productivity and morale.

How to Calculate Labor Cost

Labor costs are one of the most expensive incurred costs an organization has to cope with. They constitute roughly 30-35% of all profit, which can be very taxing on smaller businesses. They are also very important when calculating the total cost of sold products and labor expenses, which is used as an indicator of operational effectiveness.

Calculating labor expenses properly is required for organizations to determine whether revenue is enough to outweigh expenses. Here are the best practices for calculating labor costs

  • Cancelled meal breaks
  • Overly generous rounding rules when clocking in
  • Labor-intensive and time-consuming manual processes
  • Too few sales employees
  • Inefficient and timely workflows

Labor Cost Formula

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First, the company must list its total indirect and direct expenses, along with any additional overhead. This can include payroll taxes, health insurance benefits, overtime hours, sick and vacation days, health insurance, meals, equipment, materials, and any onboarding expenses.

As a rule of thumb, it's better to include anything and everything directly or indirectly related to labor. Though it's preferable to be as accurate as possible, it's better to overestimate than underestimate costs.
To illustrate, a company has 8 workers. Each worker is hourly, full-time, and makes $20 per hour. As a note, the cost of one of these employees is used in this example, rather than all employees.

A full-time hourly employee works approximately 2,080 hours per year. The equation to calculate the gross pay of one worker is as follows -

Gross Pay = Wage Rate x Gross Hours
Gross Pay = $20/hour x 2,080 hours
Total Gross Pay = $41,600

Next, the employer needs to estimate how many hours the worker was or will be absent. This will probably be difficult to gauge for new hires, but it can help to look at other past worker records for a rough estimation. If the employer has estimated that one worker loses an average of 8 days per year due to vacation and sick time off, he/she can use this formula to determine net hours worked -

Non-Worked Hours = 8 days x 8 hours
Non-Worked Hours = 64

Then, subtract the total hours not worked from total hours per year, or 2,080

Net Hours Worked = Gross Hours Non-Worked Hours
Net Hours Worked = 2,080 64 = 2,016

Then, it's time to add in all other labor-related expenses. For example

Health Insurance - $400
Taxes - $400
Overtime Hours - $800
Benefits - $1000
Supplies - $300

Total additional expenses are $2,900. This number should be added to the worker's gross pay to calculate the total yearly payroll labor expenses.

Annual Payroll Labor Expenses = Gross Pay + Additional Yearly Expenses
Annual Payroll Labor Expenses = $41,600 + $2,900 = $44,500

Finally, it's time to calculate the total real annual labor expenses by utilizing the following equation-

Actual Hourly Labor Expenses = Annual Payroll Labor Expenses / Net Hours Worked
Actual Hourly Labor Expenses = $44,500 / $2,016 = $22.07

When all factors are considered, one worker is costing the company $22.07 per real work performed. The owner can multiply this number by the total number of employees (8) to calculate the total labor expenses for all workers, which is $176.56.

How to Lower Labor Cost

Because labor costs constitute such a large portion of total revenue, companies must do everything possible to lower them. Rather than decreasing hourly workers' pay or firing employees, businesses can find cost savings opportunities in other areas.

As a result of lowering labor costs, an organization will increase its overall profit and still maintain the efficiency and morale needed to run a successful enterprise. Best practices to reduce labor costs include

1. Plan Ahead

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Planning employee schedules a month ahead of time can provide the opportunity to revisit and revise hours worked to decrease labor expenses and still ensure there are enough employees to cover work duties.

Planning also provides ample time for all employees to find coworkers to cover the hours they are unavailable, which ensures the company won't have a shortage of employees for each shift.

2. Calculate Costs While Scheduling

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Calculating labor costs is a time-consuming, meticulous task. This is particularly true if an organization employs hundreds of full-time, part-time, temporary, and hourly workers. If employers plan their schedule without calculating labor costs, there's a possibility that a circumstance may arise that alters the schedule, which further impacts estimated labor expenses.

Businesses should instead calculate labor costs during scheduling to estimate how much money is spent on labor in real-time. An optimized software scheduling system can assist in streamlining this process by automatically creating a direct labor cost report each month.

3. Cross-Train Workers

Training employees to understand how to perform other roles will streamline operations while minimizing labor costs.

For example, an owner may train a part-time server how to prepare food, then schedule him/her to perform the food prep role if the usual food prep worker is approaching overtime. This way, the owner minimizes overtime hours and has a worker who can fill in for another employee in case he/she is ever sick or needs time off.

4. Minimize Overtime Hours

State regulations typically require overtime pay to be hourly wage and a half per hour worked. This can quickly become expensive if there are a lot of hourly employees who work overtime.

Employers should set strict guidelines regarding overtime and enforce them by using an optimized software scheduling system. Notifications are sent as soon as an employee is approaching overtime, so the manager can address excessive overtime before it turns into a very expensive problem.

5. Establish Punch-In Rules

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Managers should make certain that workers clock in no earlier than 3 minutes before or after their shift begins to avoid additional labor costs. Certain circumstances may warrant allowing an employee to clock in ahead of time, but it should require prior approval.

6. Minimize Absenteeism and Turnover

Absenteeism and turnover are costly, hurt morale, and negatively impact productivity. The HR team should implement strict policies regarding sick days and vacation time to ensure workers are not taking advantage of the company.

It's also important to improve onboarding hiring practices and ensure the best workers are hired to avoid a high turnover rate. Promoting connectivity, enhancing work-life balance, improving communication, performing regular reviews, and adjusting leadership styles can all assist in decreasing the turnover rate.

Key Takeaways

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In conclusion, here are the key takeaways to remember about labor cost

  • Direct and indirect costs are the total expenses that constitute labor costs. Direct costs are anything related to producing a product, while indirect costs include any overhead.
  • Variable costs can fluctuate depending on the outcome of deliverables, while fixed costs cannot fluctuate regardless of how many products are produced.
  • Calculating the total labor costs is essential to make sure sales pricing is accurate and to maintain profitability. To do this, an employer must compile all indirect and direct costs and then use a set of formulas to break down the total labor cost per worker.
  • Best practices to decrease labor costs include planning, calculating while scheduling, cross-training workers, minimizing overtime hours, establishing clock-in rules, and minimizing absenteeism and turnover rates.

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