How to Calculate Your True Labor Costs (And Why It Matters)

Man holding up two scales, one with money and the other with people

Knowing how to calculate labor cost is essential if you want to run a profitable operation, since labor is by far the largest expense most businesses face. Specific costs vary by industry, but in most fields, it accounts for around 60% of total expenses. In March 2020, the average non-government worker cost employers $37.73 per hour worked. For government workers, that number jumps to $52.45 per hour.

If you do not have a reliable labor cost formula, there is no way of knowing how much each additional employee actually costs your organization. Without this intel, it is impossible to accurately project your current and future hiring capabilities. You cannot properly price your goods or services if you do not know the cost of the labor associated with producing them. 

While calculating labor costs may seem straightforward, many businesses take an approach that is too narrow, merely accounting for the cost of employee wages. This is part of the labor cost formula, but your true labor cost includes the full range of expenses associated with attracting, onboarding, training and retaining your employees. This also includes payroll taxes, benefits packages, and the other expenses associated with employees like space and equipment. 

Here, we will talk more about the importance of knowing how to calculate labor cost thoroughly and accurately and give you a reliable breakdown of every expense you should factor.

Why Calculate Labor Cost?

You would not sign a contract for a new office space without doing the math to see if you could afford the monthly rent, right? Likewise, you should not hire a new employee before you fully assess whether the benefits of hiring them will outweigh the financial cost. 

As companies grow, many run into trouble when they overestimate their staffing needs and underestimate the true cost of labor. In the best case scenario, this ends up hurting profits, and in the worst case, results in having to lay people off.

Using a labor cost formula gives you a precise dollar figure for what every hour of labor directly costs your organization. With this number in mind, it is much easier to work out how many full-time and part-time employees you can afford to bring onboard, rather than guessing. 

Knowing your labor costs helps you set optimal prices, which maximizes your profits. If you underestimate your labor costs, you will set prices that are too low and wind up with margins that are not feasible to stay in business. If you overestimate labor costs, you will set prices that are too high and will not be able to compete in the marketplace effectively. Labor costs should be considered alongside the cost of goods sold when you are deciding how much to charge.

Finally, calculating your labor costs help you pinpoint revenue leaks that are eating into your earnings. Some examples include employee cell phone usage, company vehicle mileage and hiring costs. Monitoring spending trends in these areas can also help you flag potential fraud. 

How To Calculate Labor Cost

Now that we have established why getting an accurate read on your labor cost matters, here are six categories of expenses you need to factor into your labor cost formula. 

Recruitment 

You begin accruing labor costs before you even hire your first employee. After all, it costs money to maintain a website, promote job listings, participate in job fairs and conduct other recruiting activities. Some niche roles may cost you more to fill, while other roles like entry-level positions may cost less. The average amount it costs to attract an employee for any role is known as cost-per-hire. 

Recruiting costs are calculated by summing all of your internal and external recruiting expenses. Some common recruiting expenses to include in your calculation are job board fees, background checks, drug testing, career fairs, setup and maintenance of your careers page, and fees paid to recruiters. 

Wages

This is the most obvious employee expense, and it is pretty straightforward. This is the total cost of salaries or hourly wages you pay to all of your employees.

Make sure that whatever unit of time you are using to measure wage costs—typically looking at the cost of employment for a full year is the simplest—you are using the same time frame for all of the other categories outlined here. 

Benefits and Health Insurance

Employee benefits are another major labor-related expense. Of the $37.73 hourly employee cost, we told you about earlier, $11.82 of that was made up of benefits. That is roughly 30%. 

Generally speaking, the more employees you have, the less your benefits will cost per employee. Health insurance premiums, employer retirement contributions, retirement program administrative fees, paid time off, and supplemental pay like overtime should all be included in your benefits calculation. 

Employment Taxes 

For every person you employ, your company bears a tax burden. This is comprised of federal income tax, Social Security and Medicare taxes, and unemployment. Federal income taxes are withheld from the employee’s wages, so we are not including them here (as they are already covered as part of the wages category above). 

Social Security and Medicare taxes are also withheld from employee wages, but the employer is responsible for paying a matching amount on top of that. Federal unemployment taxes are paid strictly by the employer. To calculate your portion of the expense for each of these taxes, use the guidance from the IRS outlined here

Training 

New employees are not typically productive right out of the gate. Rather, you are going to spend some time and money training them, and these costs should be factored into your labor expenses. According to a report by Training magazine, U.S. businesses spend an average of $1,075 per employee on training. 

When adding up your training costs, consider travel, training materials, equipment, software and other digital programs, and payment for outside help. If you want to get super precise, you can also include loss of productivity, i.e. the amount of money you are not making because the employee is not fully productive yet. These figures might be more readily available in some fields, like sales, while they are not as quantifiable in others, like service-based businesses. 

Overhead 

You are probably familiar with overhead expenses like rent and utilities, and you might be thinking these are a separate expense from labor costs. In fact, though, your overhead is directly tied to the number of employees you have. The more people you hire, for example, the more desks you need and the more square footage of space you will require, so it makes the most sense to include overhead as part of labor costs. 

Some items to factor into your overhead costs include the cost of your physical workspace (mortgage or rent), property taxes, utilities, office supplies, equipment, and maintenance. If you provide company vehicles, cell phones, laptops, or other devices for employee use, these should be included as well.  

Additional Costs to Consider

In addition to the regular, recurring costs covered above, do not forget to work in flexible costs, like seasonal or temporary labor, and one-time costs that only come up occasionally, like holiday bonuses.

Also, consider the cost of contractors like freelance graphic designers or consultants, keeping in mind that these expenses might actually go down as you add employees (like if you bring on an in-house graphic designer to eliminate the need for outsourcing). 

Labor Cost Formula

Once you have dealt with all of the categories above, it is time to add them up. 

  1. To calculate your true labor cost, total the expenses in the categories above and divide the sum by the number of employees you have. This will give you the cost per employee per year (or whatever unit of time you settled on). 
  2. Next, you want to break this cost down by hour. To do this, divide the cost per employee from step 1 by the number of hours worked per year. Assuming a 40-hour workweek with two weeks of paid vacation, most employees work about 2,000 hours annually. 
  3. This is your true labor cost per hour. 

Using this figure, you can easily do the math to understand how much each additional full- or part-time employee will add to your expense sheet every year and, in turn, see whether it is a feasible expense. 

Quickbooks offers a great free tool to help you perform this calculation digitally. You can find it here

Get Expert Help Mapping Your Future Staffing Plan

As you can see, there is a lot to consider when you are deciding how many people you need to hire and what roles to prioritize. Failing to properly forecast your staffing needs can result in lost profits and lagging productivity. 4 Corner Resources can help you map a staffing plan that meets your organization’s needs and makes sense for your budget. 

We will help you weigh the benefits of full-time employees against alternative options like part-time, temporary recruiting, and contract staffing to determine the best hiring strategy for your current situation and future growth. We also offer a full suite of payroll services to help you tackle tedious but necessary tasks like insurance and benefit offerings.

Contact us today and let us get started building a hiring strategy tailored to your business.

Stacey Haley

About Stacey Haley

Stacey Haley is the CFO of 4 Corner Resources, a nationally renowned staffing agency. She has eight years of experience in public accounting as well as seventeen years of consulting in the private sector. As a CPA, Stacey works closely with decision-makers and shareholders for small and medium-sized businesses. Her vast experience varies from debt financing, auditing, cash flow management to mergers and acquisitions. In her free time, she enjoys horseback riding and being outdoors!