Labor Cost: Definition, Calculation, And Expert Tips

calculating labor cost on a laptop

With many expenses to consider, the cost of labor is one that businesses tend to invest quite a bit in. At its simplest, labor costs are the sum totals paid to an employee for their services.

This includes not only their hourly wage but also the benefits they receive, payroll taxes, any training or equipment provided, and more.

The better you, as an employer, understand these costs and how to calculate them, the better you are able to balance company profits with a healthy workforce.

The Different Types Of Labor Costs

Employees calculating labor cost

To best understand how money is being allocated, labor costs can be placed into multiple categories. Depending on the type, these costs can range from a known factor to unpredictable, but each one is designed to benefit your company in one way or another.

Direct Labor Costs

The first type of labor cost is usually the one that comes to mind when thinking about a typical employee-employer relationship. These are known as direct labor costs and account for the wages that an employee receives for the work they perform.

An example of direct labor is a steel industry employee working with iron ore to create a final product that the company markets to consumers. The worker is directly involved in the production of what the company makes, so their payment is considered a direct labor cost.

In many instances, separating the direct labor costs from the other types is important to help determine product costs.

Indirect Labor Costs

Indirect labor costs play another significant role in the wellbeing of a company, but these costs do not directly affect production. Instead, they include payment to those who assure the company can produce their goods (without actually taking part in making them).

At a steel company, for example, a human resource manager is not melting, molding, or forming the steel to be sold. But without them, the company would run into issues that would prevent seamless operation and harm profits.

Similarly, the cleaning crew makes sure that the production floor is up to code each day to avoid anything from accidents to code violations. Mechanics maintain the functionality of production equipment.

All of these workers are essential to supporting the people who are directly making the company’s product.

Variable Labor Costs

Man doing a job that has Variable Labor Costs

Within direct and indirect labor costs are the costs that are either subject to change or likely to stay the same.

The first, known as variable labor cost, is exactly how it sounds. These costs might increase or decrease depending on a list of production-related factors, and though they’re not easy to predict, they are important to take into account.

A common example of variable labor cost is the wage paid to an hourly worker. Unlike salary employees, hourly workers are paid depending on varying hours and overtime.

Workers who perform their duties case-by-case rather than on a fixed schedule are also considered variable labor costs.

For instance, if a heater suddenly stops working in an apartment complex, it can be difficult if not impossible for the landlord to predict this would be an issue. Although calling someone to fix the heater is going to cost money, it’s a critical part of keeping tenants satisfied.

Fixed Labor Costs

Opposite to variable labor costs, fixed labor costs are unlikely to change for a certain time and are paid regardless of a company’s earnings.

While certain variable costs might have to be pushed off due to a lack of business, fixed labor costs are often vital to keeping a business running.

These costs can be better controlled by an employer, such as the annual salary of an employee. The salary might increase slightly, but employers ultimately know and can project what this cost will be over time.

Calculating Labor Costs

Calculating labor costs

Understanding the differences between labor costs is helpful when calculating the total cost of labor for an individual.

We know that the cost of labor is more than just an hourly wage; it includes a list of expenses, some predictable and others not so much. Below are the items to take into consideration when calculating this cost.

Gross Wages

All of the hours worked by an employee (including overtime) go into figuring out their gross wage. Essentially, this is all the money they’ve earned before payroll deductions (like taxes) come into play.

Benefits

Benefits are a major part of what draws job-seekers to specific roles. The better the benefits, the more people are likely to apply for the position.

The significance of this in calculating labor cost is pretty straightforward: benefits cost money, and this cost goes into calculating the total cost of labor.

Health and dental, PTO, 401(k), and even onboarding for new employees are all going to eat into company profits to make sure employees are fairly compensated.

Taxes

The taxes most employers are likely to pay are Medicare, Social Security, and State Unemployment Tax. It’s best to work with an accountant to assure that these calculations are done correctly and any additional taxes are taken into account.

Field Labor Burden

Field labor burden is the cost of payroll-specific expenses that go beyond the gross earnings of an employee.

Payroll tax contributions and workers’ compensation are commonly put in this category, but field labor burden will also vary depending on the location of the company.

For example, if you live in a state that requires mandatory vacation pay, this would fall into the category of field labor burden. The total of these expenses will be your burden cost.

An important thing to keep in mind is that it can only be considered a field labor burden if it relates to all the workers of a company. If a single employee is receiving a specific perk, this wouldn’t qualify.

Calculating The Cost

After determining the numbers in each category above, the equation for calculating labor costs is found by adding all of these direct and indirect costs and then dividing by the annual number of hours worked.

Let’s say a worker’s gross wage earnings is $87,000. The benefits they receive from their employer totals $18,500. The employer pays $5,600 for taxes, and the cost for additional equipment and resources totals $9,000. Added together, these equal $120,100.

If an employee works the U.S. average of 1,801 hours per year, the true cost of their labor is $66.69 — about $23 more than their calculated hourly wage.

Tips For Lowering Labor Costs

Management discussing ways to Lower Labor Costs

The best part about knowing your annual labor costs is now you can figure out the best way to reduce some of them.

From holding on to good employees to reevaluating who is doing certain tasks within the company, there are several ways to reduce the amount being spent on overall labor.

Reduce Employee Turnover

The first way to lower labor costs is to keep the labor you have for as long as you can. Normal turnover is bound to happen — things like retirement and relocation are a natural part of life.

But when employees are leaving left and right, it can start to get expensive. Treating employees fairly by providing them with fair wages and benefits will help avoid a high turnover rate and eliminate the unnecessary cost of having to hire and train worker after worker.

Additionally, investing in the right task management technology — like that offered by Inch — can boost team efficiency, increase communication, and highlight the real value in the tasks they perform. The result? Less employee turnover.

Invest In Training

Again, spending money to save money might sound counterproductive, but investing more in the knowledge of employees is a great way to save down the road.

Throughout the training process, the employee receives a better understanding of their task and the goals of the company.

Good training also ties back into reducing employee turnover. An estimated 40% of workers who receive poor training or are neglected training will begin looking for a new job within one year of being hired.

Training is the perfect opportunity to not only help the employee understand what is needed but to also show them what the company is willing to offer them in return for their hard work.

Hire Freelancers

If your company has a set of tasks that don’t necessarily have to be done by an employed worker, contracting the job out to someone who doesn’t work for the company can be beneficial.

Freelancers are usually not part of costly expenses such as onboarding or employee benefits. But if the individual you hire does an exceptional job and you want them for future freelancing needs, it’s best to offer some type of incentive for their skills and dedication.

An annual payment increase for their continued services is a common way to retain the best freelancers.

Turning Knowledge Into Profit

Two employees discussing labor cost

Knowing the true cost of direct and indirect labor your company is paying and how to lower these costs is, in a sense, a reorganization that leads to higher profit.

Whether it’s reconsidering certain tasks to be freelanced or surveying employees on the benefits they use, finding out what works best for your company is the ideal way to turn an understanding of labor costs into a more efficient — and cost-effective — organization.

If you’re looking to better associate costs with tasks while maintaining a successful and purpose-driven team, Inch is the answer.

As a voice-operated workforce management software, Inch seamlessly combines communication, task management, and time tracking to ensure the most efficient and enjoyable work environment.

To learn more about growing your business, save countless hours each week managing your employees, and streamline internal communication, visit tryinch.com today.

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