How To Easily Calculate Labor Cost For Your Business

How much does an employee on a $41,600 annual salary cost you? If you said $41,600 per year, you’re wrong.

Don’t worry, though; most people get that wrong. While a common mistake, understanding accurate labor costs is so important for running a successful business.

How much an employee costs you and the wages they take home are vastly different numbers based on many factors. Getting this number wrong can lead you to underestimating your business costs, hiring more than you can afford, or pricing products lower than you should.

Here, we’ll explain how much a $41,600 employee costs you, how to calculate actual costs with a step-by-step guide, and why knowing your labor costs is important for your business’s health.

TL;DR—Key Takeaways

• Labor costs are more than just wages. They include benefits, payroll taxes, bonuses, and more.
• Understanding and accurately measuring labor costs helps manage business finances, set prices, and maintain overall profitability.
• There are different ways to calculate labor costs depending on your needs, but generally, add up wages, benefits, and taxes and divide by a specific period. This period could be hourly, daily, monthly, yearly, or seasonally.
• Labor cost percentage is a useful metric for your company’s financial health. It shows how much revenue goes toward labor expenses.
• Time tracking is a great way to accurately measure labor costs by monitoring employee hours and improving cost efficiency.

What are labor costs?

Labor costs are the expenses your business incurs for each staff member, contractor, or casual worker you pay. When you first hear the term “labor costs,” your mind might immediately jump to salaries, though. Surely the labor cost of a designer at $50 per hour is $400 per 8-hour day?

Not quite.

While salaries are part of the puzzle, they aren’t the whole picture.

Labor costs include so much more. Think of them as the total amount a business spends to employ its staff, including wages, taxes, benefits, bonuses, and others we’ll get into later.

There are two main categories of labor costs: direct and indirect labor costs. Adding them together produces your total labor cost.

Direct labor cost

Direct labor is traceable to the creation of products or services. So, direct labor costs show you how much you’re spending on producing a product or service.

For example, a graphic designer creating a brand identity for a new agency client or a backend developer cleaning up the code for an app update would both be classed as direct labor costs.

This category includes:

• Wages for regular working hours
• Wages for overtime hours
• Payroll taxes (social security, FICA, etc.)
• Health insurance
• Life insurance
• Employer retirement contributions
• Paid time off
• Employee expenses, such as travel or meals
• Personal development budget
• Employer-provided equipment, such as laptops
• Other employee benefits

In an artisanal ice cream shop, the person milking the cows, the chef making the ice cream, and the salesperson scooping the finished product are all direct labor costs to the ice cream company.

But this is only half of the equation.

Indirect labor costs

Indirect labor costs have more to do with operational support for the production of your business services and products. This includes anyone who supports the production process but is not directly involved.

In our ice cream example, this would be the truck driver delivering milk to the ice cream factory, the legal and accounting teams keeping the company above board, and the cleaning staff mopping the place after closing.

In other industries, this might include:

• Technicians
• Managers
• Consultants
• Janitors
• HR staff
• Quality control professionals
• Warehouse packers
• …the list goes on!

Why you should care about calculating labor costs correctly

Labor cost math is a must if you want to know exactly how profitable you are. Once you know how to calculate your total labor costs, you can more accurately budget as you grow, price your products more appropriately or even determine if some offers aren’t worth your team’s time.

Having a better grasp on your actual labor costs means you’ll never be caught out when paying your employee wages.

Miscalculating labor costs can leave you short when you least expect it, though. It’s like a freelancer forgetting to set aside taxes all year and then being slapped with a bill at the end of the year. Not a good feeling.

But miscalculations can be more than an embarrassing moment. They can also be really expensive (like…really expensive). They can lead to pricing errors, reduced profit margins, and a more unstable bottom line.

The easiest way to prevent that from happening? Learning how to actually calculate the cost of labor the right way.

Is there a standard labor cost formula to use?

The labor cost formula calculates how much an employee costs a company based on a range of inputs beyond their salary.

There are many ways to calculate labor costs, and the best one to use will depend on the nature of your business. Regardless, the formulas are all made up of the same key ingredients:

• An employee’s hourly wages

• The number of hours they work in a day/week/year
• An employer’s overhead cost per employee
• An employer’s annual taxes

Let’s walk through some examples.

1) Annual Labor Cost = Gross Pay + Annual Costs

This is the most basic formula you can use. To provide some context, here’s a real-world example.

Stephen is a product manager at your company, with an annual salary of $80,000. His annual costs include payroll taxes, benefits, insurance, health care, paid time off, and any other non-salary expenses the company would have to pay for him, totaling $25,000.

Stephen’s annual labor cost would be $80,000 (wages) + $25,000 (annual costs) = $105,000.

2) Hourly Labor Cost = (Gross Pay + Annual Costs)/ Hours Worked

To understand hourly labor costs, divide the previous total by the number of hours worked. This might be useful if you want to get Stephen on specific projects and need to price it accordingly or ensure you’re allocating resources as effectively as possible.

Stephen works 40 hours a week and has four weeks of PTO. This means he works 1,920 hours per year (40 hours * 48 weeks = 1,920 hours per year).

We divide Stephen’s annual labor cost by 1,920 to get his hourly labor cost.

$105,000/1,920 = $54.69 per hour.

3) Daily Labor Cost = (Gross Pay + Annual Costs)/ Days Worked

Suppose Stephen is already at maximum capacity, but you have an important new product release coming up. You decide to bring on Anna, a day-rate consultant, to support this project and give Stephen a hand while controlling costs.

Anna charges $500 daily and will work for you twice weekly for three months. That’s 26 days total, at $500 each.

Since Anna is a consultant, her annual costs are lower than Stephen’s. She doesn’t have your pensions, employee benefits, or healthcare contributions.

• Gross pay: $500 * 26 days = $13,000
• Annual costs: $1,000 (equipment, software subscriptions, ad hoc stipends)
• Days worked: 26

Plugging this into the formula, we get:

Daily labor cost = ($13,000 + $1,000)/26 = $538 per day

Assuming Anna works 8-hour days, her hourly labor cost is $67.31, about 22% higher than Stephen’s.

Realizing this, you decide to hire Melanie instead, who charges $400 per day.

By running her numbers through the formula, you’ll see her hourly labor cost comes to $54.81 — almost the same as Stephen’s.

How to easily calculate labor cost

Ready to level up your workplace mathematics skills? Let’s dig into a clear, step-by-step guide to calculating your labor expenses. By the end of this section, you’ll know how to streamline your staffing by accurately forecasting your labor cost.

You’ll learn how to lower labor costs to remain profitable, whether you need to adjust your employees’ hourly rate, the cost of goods, or your operating costs to further optimize total revenue, and whether you can afford new team members.

As we’ve seen, several methodologies exist, but this is the simplest and most efficient.

Step 1: Determine employee costs for hours worked

Calculating actual labor costs starts with determining an employee’s gross annual wages.

‍Gross annual wage = annual working hours x gross hourly wage

‍Suppose Melissa works full-time. That’s 40 hours per week, 52 weeks per year—or 2,080 hours per year. If she charges $20 per hour, we can calculate her gross annual wage to be:

2,080 hours x $20 per hour = $41,600 per year

However, something is missing from this calculation.

It’s doubtful Melissa works the full 52 weeks. Firstly, she has two weeks of paid time off per year. Let’s say she also uses three sick days in a year. That’s 104 hours per year she’s not working.

We can use the following calculation to amend our working hours and reflect this time off.

Actual hours worked = annual hours worked minus hours not working

In Melissa’s case, this is 2,080 annual hours minus 104 = 1,976 hours actually worked

Step 2: Determine any additional labor costs

As we’ve seen, there are additional costs beyond worker’s compensation. Some of these are fixed costs and easier to predict, like employee benefits and taxes, while others are variable costs you need to stay on top of from month to month, like incentives or bonuses. We’ll explore these in greater detail below.

Benefits

Generally speaking, benefits make up 30% of employer costs and comprise a variety of different costs:

• Health insurance
• Dental, vision, life, or disability insurance
• Pension plan
• Vacation days and sick days
• Company meals and expenses
• Equipment and supplies
• Education, personal development, and training costs

‍To give you a rough idea, if Melissa’s labor hours make her $41,600 per year, you’ll need to add an extra 30% to account for her employee benefits.

This drives her labor cost up to $54,080 per year for her employer.

Bonuses

When calculating bonuses, you’ll need to consider:

• Overtime hours and pay rate (it isn’t uncommon to pay 1.5x the regular wage for overtime, for example)
• Performance bonuses, if relevant (for example, in sales roles)
• Non-performance bonuses (for example, an onboarding bonus or a holiday bonus)

‍Remember that local laws and regulations regarding overtime pay can vary substantially, so it’s always best to double-check FLSA and state guidelines.

Payroll taxes

The last thing to consider in additional costs is payroll taxes, which include:

• FICA taxes = 7.65% (6.2% for Social Security and 1.45% for Medicare taxes)
• FUTA taxes = usually the standard rate of 6%, but not always, so check for exceptions that might apply to your situation
• State unemployment tax = varies significantly from state to state

So what does this mean for Melissa? You should add at least an extra 15% on top of the rate we’ve calculated for her so far, not considering state unemployment tax. We’ll do that in step 3.

Step 3: Calculate the total annual labor cost

That’s all the hard work done; now all that’s left is putting it all together.

Total annual labor cost = gross wage + other annual costs

We’ve established Melissa’s:

• Gross wage = $41,600
• Annual costs:
  • Benefits = 30% of $41,600 = $12,480
  • Bonuses = Let’s say she gets a $2,000 holiday bonus every year
  • Taxes = 15% for FICA and FUTA, plus 2% new employer Arizona state unemployment tax, meaning we need to account for an extra 17% of $41,600 = $7,072

This mean’s Melissa’s total annual labor cost = 41,600 + 12,480 + 2,000 + 7,072 = $63,152

When you divide this final number by the hours Melissa actually worked (1,976, from step 1), you get an actual hourly rate of $31.96 per hour.

💡 Key takeaway: The cost to you is 60% higher than the wages Melissa takes home. She quoted you $20 per hour but it ended up costing about $32 all-in.

Bonus: Use labor costs to guide your decisions

You should use labor cost data to drive your strategic decisions. Doing so will help you allocate resources efficiently, set competitive pricing, and hire within your means. Ultimately, this will enhance profitability and make your operation more efficient.

• Pricing: Using labor cost data to set pricing will ensure you always have enough cash to cover expenses. It also keeps your profit margins healthy because you’ll know exactly how low you can afford to go while remaining viable.
• Hiring: Hiring based on labor costs optimizes workforce efficiency, reduces unnecessary expenses, aligns staffing with demand, and keeps you on budget. You’ll know when you can afford to give raises and when you’ll need to downsize with enough foresight to plan a smooth transition for employees.
• Resource allocation: Allocating resources according to labor cost data drives efficiency and productivity. You can be sure your staffing levels are optimized and aligned to your overall business goals.

What about labor cost percentage?

Labor cost percentage is key to understanding your company’s financial health. It shows you the percentage of revenue that goes to pay back labor.

Labor cost percentage = (total labor cost / total revenue) x 100

For example, if you sell $100,000 of ice cream in a year, and your labor costs are $50,000 per year, your labor cost percentage would be:

($50,000/$100,000) x 100 = 50%

In other words, every other ice cream you sell is going to pay for your labor. The higher your labor cost percentage, the lower your profit margins. This metric is a good one to boost your business efficiency.

Tip: Time tracking can improve labor cost calculations

Time tracking is a powerful way to monitor your real-time labor burden. Using a reliable time tracking solution increases the accuracy of labor cost calculations and gives a clearer picture of your overall financial health and business efficiency.

Software solutions like Toggl Track are designed to slide effortlessly into your life by:

• Easily tracking time with a one-tap start/stop timer
• Offering manual time entry options for clients, projects, and tasks
• Setting flexible billable rates
• Adding labor rates as needed
• Getting project profitability insights for clients and team members

The best part? You can tap into this power for free. Create an account to get started and see the simple way to stay on top of labor costs.