Calculating Labor Cost A How-To
One of the top problems for struggling companies is their inability to budget properly and monitor cash flow. Spending too much on large office spaces, fancy computers, or unnecessary advertising will transform a promising organization into one that is barely surviving.
Other organizations scratch their heads when they see how much they've lost per week in profit. Their owners don't overspend on frivolous items, they optimize inventory management, and nor they don't operate lavishly.
For these businesses, reviewing and drilling down into labor expenses may be the quick service solution to their low profit margins and the bottom line.
As case studies have shown that labor fees constitute a large part of revenue, overspending on overtime payments and office benefits will harm long-term profitability. To gain control over cash flow and minimize the labor burden, a small business should calculate labor cost percentage.
How to Calculate True Labor Cost
Labor cost is the totality of employee wages as well as secondary expenses paid by an organization to each staff member. Additional payments are payroll taxes, health insurance, benefits, paid vacation days, supplies, or any other equipment used by employees.
Labor costs are made up of indirect and direct labor costs. Indirect expenses are everything unrelated to producing a product. Direct labor cost is any employee-related costs direct to producing a product or service.
Because labor costs constitute 30-35% of total revenue, it's imperative to know exactly how much they are. While an organization may pay its workers a fixed wage, true labor cost is much higher because there are many other expenses to consider.
Using a formula to identify and add in these other expenses will control labor fees and assist in pricing sales items correctly. It also helps to optimize cash flow management so the company can and maintain profitability.
Here are the best practices to accurately calculate true labor cost
1. Compile All Expenses
Compiling all direct costs and indirect costs is probably the most important step to calculate labor costs, as leaving out items will result in an incorrect total labor cost. Though each company has different types of labor costs, the most common ones include -
- Payroll taxes
- Overtime hours
- Health care costs
- Social security
- Employees' work salary and/or hourly pay rate
- Employee hours paid
- Paid sick time off
- Paid vacation days
- Employee benefits
- Equipment (scheduling software systems, management software, office supplies, computers, etc.)
- Onboarding costs
2. Calculate Total Gross Pay
Next, the owner can use a formula to determine labor gross pay. To gain a better understanding of this process, it's helpful to use an example. In this illustration, a small diner has 5 full-time employees. Each of them has an hourly wage of $35 per hour.
A full-time staff member typically works 2,080 labor hours per year. This example demonstrates the restaurant labor cost of just one of these workers in the organization.
Gross Pay = Hourly Rate x Total Hours Per Year
Gross Pay = $35 x 2,080 Labor Hours
Total Gross Pay = $72,800
3. Calculate Net Hours Worked
Because a business usually calculates the labor cost before the start of a new year, the owner may have to use guesswork and historical evidence to estimate how many days a typical worker takes off. It's important to take all of the paid holidays into account, as well as possible sick days.
For this example, the average employee takes 12 days off per year, factoring in holidays and sick days. The owner can translate the total labor rate not worked into net hours worked by utilizing this formula
Hours Not Worked = 12 days x 8.5 hours
Hours Not Worked = 102
Next, the owner should subtract that number from the total number of hours worked annually to calculate the net hours worked -
Net Hours Worked = Gross Hours Hours Not Worked
Net Hours Worked = 2,080 102 =1,978
Net Hours Worked = 1,978
4. Calculate the Yearly Payroll True Cost of Labor
Now the owner should add in all other indirect expenses that contribute to the true labor prime cost.
This includes overhead fees such as employee computers, office supplies, health insurance, overtime hours, and taxes. Here are the total additional costs for this illustration -
Office Supplies $1,000
Taxes $1,000
Overtime $600
Health Insurance and Other Benefits $2,500
Additional Yearly Expense Total = $5,100
Then, the owner should take the additional yearly expense total and add it to gross pay to discern the yearly payroll true cost of labor
Yearly Payroll True Cost of Labor = Gross Pay + Additional Yearly Expense Total
Yearly Payroll True Cost of Labor = $77,900
5. Calculate True Hourly Cost of Labor
Finally, the owner can calculate how much is truly paid to the worker each hour, factoring in all of the additional expenses -
True Hourly Cost of Labor = Yearly Payroll True Cost of Labor / Net Hours Worked
True Hourly Cost of Labor = $77,900 / 1,978
True Hourly Cost of Labor = $39.38
This true cost of paying one employee each hour is $39.38, which is $4.38 higher than the original hourly rate. If the owner multiplies this number by the total number of employed workers, he can discern the total actual hourly labor fees for all staff members.
Obviously, most employees are not paid exactly the same amount in an organization, but let say for the sake of simplicity they are for this illustration.
For this example, the total cost per all employees would be -
Labor Costs Restaurant = $39.38 times 5 workers, or $196.90.
Key Takeaways
In conclusion, here is what to know about calculating labor cost
- Knowing what the true labor cost is can assist in cash flow management, pricing sales items properly, budgeting, pinpointing wastage, and lower labor cost.
- To properly calculate labor cost, businesses should first compile how much they pay employees, along with any other direct and indirect labor-related expenses.
- Next, the owner can calculate the total gross pay of employees work to determine how much each worker is making per total work hours in one year. He can then calculate the total net hours worked, which is the gross hours minus the hours worked in one year. Next, the owner should add in additional expenses such as health insurance, benefits, and equipment to find the yearly payroll true cost of labor. It can then add this number to the gross pay to calculate the yearly payroll true cost of labor.
- The owner can then divide the yearly payroll true cost of labor by the net hours worked to calculate the true hourly cost of labor. This number can be multiplied by the total number of employees in the organization to receive the true hourly cost of labor for all workers.
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