The Employer’s Guide to Calculating Labor Costs

May 09, 2024

Learn the different types of labor costs and expenses organizations see, how to calculate them, and how they can appear in other industries. 

Creating an annual budget that sets your entire business up for financial success is certainly no trivial matter.

And one of the most important financial details every company needs to know is how much it spends on labor. Regardless of whether that company creates complex technology or delivers newspapers, if it has employees, it has labor costs.

The following guide explains the different types of labor costs, how to calculate them, and how this works in different industries.

Key Takeaways

  • Labor costs are the expenses related to maintaining and managing the workforce an organization uses to create its products and/or services.
  • A company’s labor costs are either direct or indirect based on how those costs affect the workforce’s ability to create the products and/or services.
  • The expenses that make up direct and indirect labor costs are either fixed (i.e., remain constant regardless of production levels) or variable (i.e., fluctuate with changes in production or activity levels).

What are Labor Costs?

Labor costs are the amounts a business spends on its workforce, from salaries and wages to benefits like healthcare, paid time off (PTO), and fringe benefits. This also includes taxes and any other related expenses.

Because labor costs affect nearly every part of an organization, keeping a close eye on them is critical for any human capital management strategy.

Direct vs. Indirect Labor Costs

Direct labor costs are those immediately and inherently involved with the production of a service or good. This includes things like an employee’s salary, the cost of raw materials, and any tools or parts required to complete the production process.

For example, the prices a local bakery pays for ingredients and kitchen utensils are inherently involved with each baker’s ability to create pastries.

Indirect labor costs are broader expenses for things that support the production process but aren’t inherently or immediately involved in it. Things like hiring a cleaning staff or a security guard would be indirect costs.

For example, if that same local bakery hired an accountant to process its receipts, bills, and revenue, those accounting services would be indirect labor costs.

Fixed vs. Variable Expenses

Direct and indirect labor costs can each be broken down into fixed and variable expenses:

  • Fixed Expenses: Predictable, stable amounts, that organizations can forecast and plan around. This would include things like an employee’s salary each pay period or the office’s monthly internet bill.
  • Variable Expenses: Fluctuating amounts based on independent and less predictable factors. For example, sales commissions go up or down based on job performance, while office parking lots may need snow plowing in the winter to ensure employees can get into the building.
  Direct Indirect
Fixed Employee Salary Security Guard’s Salary
Variable Performance Incentives Seasonal Administrative Assistants

Table: Examples of how to classify the fixed and variable expenses of direct and indirect labor costs.

How Do You Calculate Labor Costs?

While the formulas used to calculate different labor costs are relatively simple and similar between organizations, there’s no universal standard for how often to perform them or what qualifies as “good” and “bad” results. 

In other words, just like the expenses involved, the best use of the following calculations vary from one company to the next.

Calculate Direct Labor Costs

Approximately 69% of direct labor costs come from each employee’s total gross pay, which makes them easier to estimate than indirect labor costs.

Total Direct Labor Costs = Total Gross Payroll + All Direct, Fixed Expenses + All Direct, Variable Expenses

Calculate Indirect Labor Costs

Unsurprisingly, indirect labor costs vary widely based on each company’s unique situation, location, industry, etc.

Total Indirect Labor Costs = All Indirect, Fixed Expenses + All Indirect, Variable Expenses

Calculate Labor Cost Percentages

With these amounts in mind, it may also be useful for strategic workforce planning to calculate how much of your total gross sales or revenue goes towards covering those labor costs. This is called your “labor cost percentage.” 

Labor Cost Percentage = (Total Direct and Indirect Labor Costs ÷ Total Gross Revenue) x 100

Industry-Based Labor Cost Examples

One industry with particularly fluid labor costs is the restaurant industry. Seasonality, customer reviews, high worker turnover, prices for ingredients — the list of costs goes on.

Even direct costs and fixed expenses are more diverse than in other industries, as restaurants often employ a mix of full-time and part-time employees, many of whom are non-exempt and earn tipped wages instead of standard benefits.

Tackle Today’s Challenges for a Stronger Tomorrow

In the service industry, there never seems to be enough time in the day to manage challenges like tight margins and high turnover. Download our eBook to discover how to leverage modern technology to overcome the top HR challenges facing restaurants.

Another industry with complex labor costs is manufacturing. Specialized equipment and training can create far greater direct costs, and there’s sometimes a heightened risk of injury that demands increased indirect costs, like safety insurance and worker’s compensation.

Also, manufacturers sometimes prefer to calculate labor costs more often while tracking production volume.

Paylocity’s Time and Labor Management Software Saves Time and Resources

Keeping track of your labor costs and related expenses can be both time-consuming and tedious. Just imagine how much less stressful the process would be if you could automate all that legwork. With Paylocity’s time and labor management software, you can:

  • Quickly locate potential ways to reduce labor costs.
  • Make more informed workforce management decisions.
  • Recruit and retain talent more effectively. 

Request a demo today and see how much easier things can be with Paylocity!


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