As a business owner, you need to keep tabs on your cash flow to make informed financial decisions.
However, that’s easier said than done. With product, marketing, and payroll costs, you might often feel like you’re biting off more than you can chew.
So, what’s the solution? You’ve got to break down that big bite into smaller chunks—or think of one expense category at a time.
And since payroll is often the cost that’s hardest to handle with rising living costs and employee turnover, let’s start with payroll.
We’ll start by answering the burning question.
What Percentage of Expenses Should Payroll Be?
As a business owner, you should allocate 15-30% of your revenue to paying your employees. However, where your business falls in this range varies depending on your industry.
In construction, you usually have a payroll percentage of 20% because you rely on skilled workers that require safety training. In addition, you might also need to cover their per diem travel expenses.
Meanwhile, in the retail industry, payroll is more like 8% of your revenue since wages are lower than other sectors and shops tend to rely on part-time employees.
Payroll to Revenue Ratio
Typically, as part of figuring out what percentage of expenses should payroll be, you use a metric called payroll to revenue ratio. It helps you understand how much you’re spending on payroll costs.
You calculate the payroll to revenue ratio as:
Payroll to revenue ratio = (Payroll costs / Gross revenue) x 100
You can use the payroll to revenue ratio to compare your business against the standard for your industry and see if the money is slipping through the cracks in your payroll system.
Let’s check out payroll to revenue ratio benchmarks for different industries.
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Payroll Allocation by Industry
While your business's ideal payroll to revenue ratio might depend on multiple factors, you can use these allocation benchmarks to compare your labor costs.
|Average Payroll Ratio
|Additional needs for safety training and may require travel
|Lowered by automation equipment that increases productivity
|Food and beverage
|Increased by heavy reliance on labor and high employee turnover
|Heavy reliance on labor that is seasonal in nature, often requiring overtime or double time during busy seasons
|In spite of high turnover, lower pay rates and a reliance on part-time labor keep percentages lower.
While these are the benchmarks for common industries, your business's payroll to revenue ratio could be above the respective figure. If that’s the case, let’s explore what payroll expenses include and how to control them.
What Makes Up Payroll Costs?
Payroll costs are expenses you bear while paying your employees. They typically include the salary or wage you pay employees, employment taxes you submit to the IRS, and other benefits, such as workers’ compensation insurance, you offer your workforce.
Base Wages and Salaries for Employees
Base wages and salaries refer to the regular pay you offer your team members—as stated in their employment contracts. The amount typically depends on your industry and location. However, if you want to hire talented individuals who know their stuff, you must at least offer competitive pay.
To get a read on competitive pay for a position, look up the wage estimates for relevant jobs compiled by The Bureau of Labor Statistics. For instance, here’s wage estimation data that might come in handy if you own a construction business:
|Average Hourly Pay
|Residential Building Construction
|Building Finishing Contractors
|Nonresidential Building Construction
|Foundation, Structure, and Building Exterior Contractors
Besides national wage estimates, you must also consider the minimum wage laws. While the federal minimum wage is $7.25 per hour in most cases, some states and locations have a higher minimum wage. Check out the minimum wage by state to see which rate applies to you.
Overtime Pay and Holiday Pay
Besides the base pay, you might need to pay your employees extra if they meet certain conditions. For instance, the federal government’s Fair Labor Standards Act (FLSA) requires you to pay non-exempt employees 1.5 times their base rate for any hours worked over 40 hours in a workweek.
And wait, there’s more. Your state may have its own laws surrounding overtime. For example, in California, non-exempt California employees are due overtime for any hours they work more than eight hours in a day. And for hours beyond 12 hours in a day, you must pay them twice their regular pay rate.
Similarly, if you operate in a state with holiday pay requirements or have a defined holiday pay policy, you may have to also account for holiday labor costs. For example, you must pay 1.5 times the regular rate to non-exempt employees in Rhode Island for any hours they work on Sunday or a Rhode Island state holiday.
As an employer, you’re also responsible for payroll, or workforce, taxes due to the federal and state governments.
On the federal side, you must pay:
- Federal Insurance Contributions Act (FICA) taxes: Social Security tax (6.2% of the base pay) and Medicare tax (1.45% of the base pay)
- Federal Unemployment Tax Act (FUTA) tax: 6% tax on the first $7,000 you pay any employee who makes more than $1,500 in a quarter or works more than 20 weeks in a year.
On the state side, workforce taxes vary from state to state. Most states have their own state unemployment taxes, and you can review state payroll taxes by going to your state’s labor website.
For example, in California, the employer portion of payroll taxes includes Unemployment Insurance (UI) tax and Employment Training Tax (ETT) on the first $7,000 you pay an employee. ETT’s rate is 0.1%, and UI’s rate varies from 1.5-6.2% (determined by California Employment Development Department).
Let’s consider a California employee paid gross wages of $40,000 to see how much payroll taxes skew your personnel costs.
|FICA taxes (combined 7.65%)
|FUTA tax (6% on the first $7,000)
|UI tax (Maximum of 6.2% on the first $7,000)
|ETT (0.1% on the first $7,000)
|Total payroll taxes
|Total personnel costs
To see the percentage of payroll costs you’re paying in taxes, use this formula:
Tax portion of personnel costs = Payroll taxes / Personnel costs
So for this example, we’d do the following:
Tax portion of personnel costs = $3,921 / $43,921 = 0.089 or 8.9%
So, if you have an employee with gross wages of $40,000, you pay almost 9% of payroll costs in payroll taxation.
What Percentage Should I Budget for Payroll Taxes?
You should typically budget around 10% of small business payroll costs for payroll taxes. The exact percentage for your business might vary depending on the number of employees you employ, their gross pay, and your employee benefits.
You may offer several sweet extras to your employees so you can stay competitive in the job market or comply with relevant state laws.
For instance, if your state requires workers’ compensation insurance, disability insurance, sick pay, health insurance, or paid time off, you must include those costs in payroll expenses.
Besides the state-mandated benefits, you may also offer incentives such as 401(k) plans, life insurance, and dental care that add to your payroll budget.
Payroll Associated Costs
The payroll process also involves transferring money and tracking payments. While these tasks might appear minor, the associated costs can pile up. For instance, while electronic payments cost about 15 cents, printing paychecks might cost you $2-4 per check.
Besides that, if you use payroll software to simplify your bookkeeping, you must also account for its subscription fees.
Best Practices to Control Payroll Expenses
Let’s see how to reduce your spending on payroll to avoid putting on a dent in your bottom line.
Track Your Workforce Expenses
To reduce a business expense, you need to track it. The same is true for payroll expenses. Keep tabs on how much you pay each employee—base pay and overtime pay.
If you're a small business owner, keeping an eye on a bunch of employees with different schedules can be like pulling teeth. But you can avoid that DIY dentistry with Hourly. Hourly’s payroll platform helps you track employees and their tasks and calculates workers’ compensation premiums and payroll taxes for you.
Compare Your Labor-Related Expenses with Your Industry
One of the best ways to control labor costs is to compare your payroll cost to your industry’s figures. You can quickly check these numbers. Here’s how:
- Visit the United States Census Bureau’s website.
- Look up the average annual figures for payroll and revenue in your industry in the Economic Census.
- Use the payroll to revenue ratio formula.
- Compare the industry standard to your ratio. How are you doing?
While recruitment costs are typically not included in payroll costs, employee turnover reduces your team’s productivity and revenue. Advertising, interviewing, and training costs add up quickly. And instead of doing their work, your experienced employees have to play tour guide for new employees.
Importance of Navigating Payroll Expenses
While the average business spends about 15 to 30% of its revenue on payroll, this figure can vary based on your industry.
Regardless, it’s an important number to keep tabs on so you can make sure you have the cash flow to pay your team on time and budget for extra things, like bonuses, or make some cuts to control costs.
Now that you’ve learned how much revenue to spend on labor costs, all that’s left to do? See how much you spend on labor costs, compare it with your industry, and figure out if you need to make any changes.