Remembering Shay Litvak Our Co-Founder and CTO

November 1979 - September 2023

How Is Labor Cost Calculated: A Simple Guide

7
August 21, 2023

Whether you’re running a restaurant, a construction company, or another small business with employees, labor costs are some of the biggest expenses you'll need to cover.

That’s why it’s essential to understand what labor costs are and how they are determined. Labor cost does not only mean the hourly rate that you pay a member of your staff. It spans a number of other expenses that you need to account for. Only after factoring them in you can get the actual labor expenses for your company.

How is labor cost calculated, then? Read on to get a clear overview and make the right calculations for your business.

What Is Labor Cost?

The expenses that you pay for each employee equal your labor cost for that particular staff member.

Labor cost includes gross wages for an employee, as well as additional payments on their behalf, like Social Security and Medicare taxes, as well as benefits.

You have to keep tabs on your labor expenses and to constantly compare them to your revenue, so that employee costs don’t harm your bottom-line. This is called labor cost percentage and is the key to solid business management and growth.

How Is Labor Cost Calculated?

In order to calculate the labor cost of an employee per hour, you need to go through a simple process of factoring in all expenses related to their employment.

The simple labor cost per hour formula looks like this:

Labor cost per hour = (gross pay + all annual costs) / actual worked hours per year

Let’s break down each of these calculations into steps.

We’ll use a hypothetical  employee, Maria, as an example. She is an hourly, non-exempt employee, who works full-time in a company in California with more than 26 employees. She gets the minimum wage of \$13.

So, how do you calculate the labor cost for Maria?

#1. Calculate the Gross Pay

The first thing you want figure out is the gross pay of an employee.

Here is the formula:

Gross pay = gross hourly rate x number of hours worked for a pay period

In this case, let’s calculate Maria’s gross pay per year. The total hours that Maria is supposed to work for the period of one year is:

Total number of hours per year = 40 hours per week x 52 weeks = 2080 hours

This means that her gross pay per year is:

\$27,040 = \$13 x 2080 hours

#2. Figure Out the Actual Worked Hours

The total work hours per year are 2080. However, every employee needs to take days off.

Let’s say that Maria did not work 12 days in that year. Here is how to calculate hours not worked:

Hours not worked = 12 days x 8 hours = 96 hours

Then you can easily get the net hours worked:

Actual worked hours = total number of hours per year - hours not worked

This would mean, in this case:

1984 hours = 2080 hours - 96 hours

The actual hours that Maria has worked for a year are 1984 hours.

#3. Determine All Annual Costs Per Employee

Next, you have to take into account all related expenses that you owe for Maria, such as taxes and healthcare. They come on top of her gross pay. Only after you calculate them can you get the actual labor cost per hour for a particular staff member, or the true cost per hour.

Some typical labor costs besides the actual pay to the employee are:

Payroll Taxes:

• FICA taxes (7.65%), of which Social Security is 6.2% and Medicare is 1.45%
• FUTA taxes (standard rate of 6%, but exceptions apply)
• State unemployment taxes
• Local unemployment taxes

Employee Benefits:

• Health insurance
• Additional insurance such as dental, life or disability
• Retirement plans
• Paid time off (sick and vacation days)
• Meals at work
• Education and training

Other Possible Expenses:

In Maria’s case, here is the breakdown of additional labor costs:

• \$2,348.56 annual taxes: 6.2% Social Security is \$1676.48, 1.45% Medicare is \$392.08, 0.6% FUTA on the first \$7,000 is \$42, and California state unemployment insurance is 3.4% on the first \$7,000, which equals \$238
• \$3,120 health insurance
• \$1,200 benefits
• \$500 overtime
• \$500 meals

Thus, the extra annual costs that you have to pay for having Maria in your team are \$7,668.56. Of course, this is just an example and these costs can vary greatly.

#4. Calculate the Total Annual Payroll Cost

You are now ready to determine the actual annual payroll cost for Maria, or the total labor cost for her. Here is how to do that:

Annual payroll cost = gross pay + other annual costs

In this example, the amount is:

\$34,708.56 = \$27,040 + \$7,668.56

This is the total cost of Maria’s work for your business per year.

#5. Calculate the Hourly Labor Cost

At last, you can figure out Maria’s cost of labor per hour.

Her hourly labor rate (wage) is \$13. However, you want to get the total cost per hour. Here is how you can do that:

Hourly labor cost = annual payroll cost / actual hours worked

For Maria, our hourly labor cost calculator comes up with the following:

\$17.50 per hour = \$34,708.56 / 1984 hours

Now you know the actual labor cost per hour for hiring Maria.

Knowing your labor cost expenses per employee is necessary for determining your labor cost percentage, which shows you the relationship between your total revenue for a given period and your labor costs during that time.

The formula is:

Labor cost percentage = labor costs for all employees / total revenue

When you determine your labor cost percentage, you can make a deeper analysis of your employee expenses. That’s how you can figure out if you need to reduce them to increase your overall profit margins

The average labor cost percentage should typically be in the range of 20% to 35% of a company’s gross sales. However, there are variations, depending on your field. It’s not uncommon for restaurants and other service businesses to have a labor cost percentage of up to 50%. In other areas, such as heavy industry, the percentage should not be more than 30% to ensure profitability.

Tips to Reduce Your Labor Costs

Keeping your labor costs under control is a large part of the expense management for your business. This does not mean reducing employee wages and cutting corners when it comes to the extra labor costs. However, it does entail being observant and setting clear rules regarding attendance, overtime and logging of worked hours.

Get Time Tracking Right

One of the most important tips for decreasing your labor expenses is to accurately track employee hours. Mistakes in time tracking can have serious and costly consequences for your business.

With solutions like Hourly, you can be sure that clocking in and out for your employees is seamless, and that you get the most accurate information about their actual worked hours. The platform offers geofencing, which is great for teams on the go, as you can set the physical area in which employees can track time.

Keep an Eye on Overtime Hours

You cannot do much about reducing most of the additional labor costs, such as payroll taxes and benefits.

However, you have control over the scheduling of your team. This means you can regulate the overtime hours that your employees are working. There are situations when you can’t avoid overtime, of course, but try to keep it at a minimum if you want to reduce labor costs.