How to Calculate Labor Costs By Year, Day, Hour, & More

Let’s say you have an employee who earns a salary of $50,000 a year. What’s the annual labor cost of keeping that team member?

If your answer is $50,000, you might be misunderstanding (and underestimating) labor costs. That miscalculation affects how you evaluate what each team member you have employed actually costs your business — a financial factor that impacts your expenses, pricing, and services rendered. 

Properly calculating labor costs is key to maximizing profitability for long-term success. 

In this post, we’re going to equip you with everything you need to properly calculate any employee’s labor costs. By the end, you’ll gain a greater understanding of your business’s financial situation, and you’ll be able to grow your business more efficiently. 

Salary vs. labor costs

There’s a difference between the annual salary of an employee and the annual labor cost of an employee. Salary is the agreed-upon amount of money that you will pay someone employed by your business. Labor cost includes salary and other indirect expenses.

Some business owners neglect to consider these indirect expenses when trying to weigh how much each employee costs their business on an annual basis. 

Direct labor costs are immediately tied to the function of your business, such as employees’ salaries, taxes, and benefits. Indirect labor costs are the costs of services or supplies that contribute to your business’s labor and production but are not directly tied to it, such as a human resources department.

What direct and indirect costs are factored into labor costs?

So what are some of these costs that contribute to the overall labor cost of an employee? These two lists cover some of the most common types of costs, though there are still others that may be relevant for your company depending on your business model.

Direct costs

• Working wages
• Overtime pay
• Payroll taxes
• Social security
• Medicare
• Insurance (employer contributions to health, vision, dental Workers’ Comp, etc.)
• Retirement plan contributions
• Onboarding and training costs

Indirect costs 

• Human resources
• Legal advisors
• Accountants
• Quality control
• Advertising and marketing 
• Janitorial 
• Office supplies 

Why aren’t HR teams considered a direct cost? 

Because labor costs are defined as being directly related to the creation of commodities or the delivery of a service, what you pay human resources or legal advisors is not a direct labor cost but an indirect labor cost. Both types of labor cost fall under the category of an expense, but the distinction between the two matters.

A business can function with solely direct labor costs. A business with solely indirect labor costs has no way to produce a product or service to make a profit, and therefore can hardly be considered a business. And just to be clear, a business with both direct and indirect labor costs is better equipped to function at a higher level in the long term.

Step-by-step guide to calculating annual labor costs

Now that we’ve differentiated between the two types of labor costs, let’s get into how to calculate what your employees are costing you.

At its simplest, if not necessarily its most descriptive, the annual labor cost formula can be written as follows:

Annual Labor Cost = Gross Annual Pay + Annual Costs

Let’s break this down using an example employee named Bill.

Step 1: Take an employee’s gross annual pay

Gross annual pay is the salary you’re paying an employee. In the example of Bill who was hired at $50,000 per year, his annual gross pay is just that: $50,000.

Step 2: Add up the other direct and indirect costs that apply to that employee

Next, you have to account for the annual costs of keeping him on the payroll. These annual costs include things like his insurance, training, employee benefits, and other incentives. 

Now’s the time when any records you’ve been keeping of your employee expenses will come in handy. If you use payroll software, you can probably grab these numbers — already calculated for you — quickly from that application.

Let’s add a few known direct costs to our calculations. These are a few of the federal tax rates that employers are expected to pay, which remain static state-by-state.

• Social Security Tax: 6.2% of employee compensation = $3100
• Medicare Tax: 1.45% for employers = $725
• FUTA tax rate: 6.0% times the employee’s taxable wages up to the first $7,000, offset by a credit of up to 5.4% (depending on state) =.006 X $7,000 = $42.00

As well as some direct costs that vary far more depending on your business. For the sake of a little more specificity, we’ll say your business is two years old and located in Michigan.

• Health Insurance: $15,000 annually 
• Employer-Provided Meals: $400
• Bonus: $1,000
• Michigan Unemployment Insurance Tax: = 2.7% in the first two years of a business’s liability (except for construction which is higher) = $1350

Calculating all of this, your total additional annual direct and indirect annual costs are $21,617.

There are many more related expenses and variable costs that can factor into a given business, such as any tax incentives that your business qualifies for, but we’ll run with this example for now.

Step 3: Add annual pay and annual costs together to calculate annual labor cost

Bill’s annual pay is $50,000, and a look at your data reveals that your annual costs for employing him add up to $21,617. This means that Bill’s annual labor cost is $50,000 + $21,617 = $71,617.

The average annual labor cost of an employee tends to be 1.25 to 1.4 times their salary, according to the U.S. Small Business Association (SBA) – meaning this example figure is just about the high end of that range. 

If you thought your annual labor cost of Bill was equivalent to only the wage you pay him, you would have been underestimating that his annual labor costs are 143% of his salary.

How to calculate labor cost per hour

You can go further than just looking at the annual labor costs, and we’d advise you to do so — looking at your labor costs on a smaller scale can help you make informed decisions on how you want employees to optimize their time spent while on the clock.

Let’s go back to Bill. His annual labor cost, as revealed above, is $71,617.

How do we break that down to figure out the cost of labor per hour?

The first question you have to ask is how many labor hours an employee works per week. In Bill’s case, this calculation is simple. He’s a full-time employee, so he works 40 hours per week.  

The average full-time employee works 2,080 hours a year (52 weeks per year, 8 hours per weekday, 40 hours per workweek. 40 x 52 = 2,080). That means that to find out how much an employee’s labor cost per hour is, you can divide their total annual labor cost by the average number of hours they work. 

Labor Cost Per Hour = Gross Annual Pay / Annual Hours Worked

 $71,617 / 2,080 = $34.43 (rounded down) 

That means that Bill’s labor cost per hour is $34.43. This is a contrast to looking at salary alone, which would have his hourly wage at $50,000 / 2,080 = $24.04. 

Figures like this are useful to determine what price to set your cost of goods at. The hourly rate of your labor cost, set against the number of goods you sell at a certain price point per hour, paints a picture of how your finances look over time (days, weeks, months.)

How to calculate labor cost per day

How about figuring out how much Bill is costing you per day?

There are two ways to calculate this number:

1. Starting with having identified the annual labor cost
2. Starting with having identified the labor cost per hour

We’ll show you how to do both.

The average full-time worker is in the office or on the job for 260 days a year, when you consider a standard 5-day work week.

With Bill’s annual labor cost known ($71,617) we can calculate his labor cost per day with the equation:

Labor cost per day = Annual labor cost / Working days in a year

$71,617 / 260 = $275.45.

$275 is how much it costs you to employ Bill per day, all labor costs considered.

Working instead from knowing his hourly job cost of $34.43 per hour, we can reach this same number with multiplication rather than division. 

Labor Cost per day = Labor cost per hour x Total working hours

$34.43 x 8 hours (full-time workday) = $275.44

How to calculate labor cost percentage

One more calculation that’s useful to check is the labor cost percentage. This helps small business owners see what percentage of their business’s total revenue is attributable to their employees in order to determine their profit margin. 

Naturally, this figure can help optimize the efficiency of your labor spending, and help you grow your business in a more scalable way.

The formula used here is:

Labor cost percentage = (Total labor cost / Total gross sales) X 100

Let’s say your business’s total sales equaled $700,000 last year. Let’s see what the labor cost percentage is when you take not just Bob’s annual labor cost, but your entire team’s. 

In this scenario, you have three total employees all making the same amount as Bob ($50k salary).

Your total actual labor cost across your business would be 3 x $71,617 = $214,851

Now we plug that into the formula.

($214,851 / $700,000) = 0.3069

0.3069 x 100 = 30.69%

This means your business’s labor cost percentage is 30.69%, which is a solid number to work with when taking into account other operating costs. The actual number you want to aim for varies widely due to changing overhead costs between industries, but 20-35% is considered an average labor cost percentage across the board. 

Pro Tip: Successful business owners advise that “your profit margin is your mistakes margin.” Keeping your labor cost percentage reasonably low effectively increases your profit margin, which allows for additional marketing and sales budget to grow revenue and leaves room for any potential incidentals that may come up. 

Using software to lower your labor costs

Now that we’ve covered various labor cost calculations and examples, it’s time to get into how you can lower labor costs in your business. 

Many of the labor costs we detailed above are fairly “fixed” costs that you don’t necessarily control (e.g. federal taxes and the going rate for a skilled employee). But what about the labor costs you can control? 

Using employee time clock software is the most efficient way to get a handle on your labor costs, and we’re going to show you how software tools like Buddy Punch counter specific issues and help reduce unexpected overheads.

Labor cost issue #1: Time theft

Time theft is any act that results in an employee falsifying their worked hours and still being paid for it. This can include acts such as buddy punching, lying about the time they clocked in or clocked out, taking longer lunch breaks or smoke breaks than allotted, and more. 

The worst part about time theft is that it can often be invisible to business owners and administrators, especially if you’re relying on manual methods of timekeeping. 

Spreadsheets, paper timesheets, and physical card readers — these are all systems that can be gamed and prevent you from seeing the additional costs accumulated due to these stolen minutes. 

If Bill is clocking into work 10 minutes late every day but writing down that he was on time, after six days he’s stolen a full hour from your business at $34.43. That means a full year of Bill getting away with this would be the equivalent of him taking $1,491.97 straight out of your wallet.

Buddy Punch comes with numerous automatic time and attendance options that help ensure employees are working when and where they’re paid to be.

GPS tracking

Buddy Punch’s GPS tracking provides real-time location data while your employees are on the clock. You can always check to ensure that employees at remote locations — such as at construction sites or remote retail branches — are actively working when and where they’re meant to be. 

Once they clock out, Buddy Punch protects their privacy by ceasing all location tracking.

Geofencing

This automatic anti-time theft feature allows you to create a radius, called a geofence, anywhere you want on an interactive map. When employees are outside of this radius, they’ll be unable to clock in or clock out, preventing them from lying or exaggerating about their presence on site. 

Once they’re in the designated area, they can clock in and clock out as normal. 

Facial recognition

This feature is one of the strongest options business owners have to ensure team members aren’t clocking in for their friends to commit time theft. Through this option, Buddy Punch uses FaceID to check an employee’s face as they clock in against the saved picture on file. 

The only person who can sign in for Bill’s shift is Bill (or Bill’s identical twin). 

Labor cost issue #2: Inefficient scheduling

Another issue that can have an impact on your labor costs is how you handle scheduling. How you schedule your employees (the frequency they work, the amount of time they work, who they work with) can have a positive or negative impact on company morale, changing how productive your team members are.

Additionally, while staffing you want to take a closer look at your team members’ strengths. Are you aware of which of your employees are most efficient when it comes to certain tasks? For business owners relying on manual methods of timekeeping, it may be impossible to really tell. 

Maybe Jake feels to you like the most efficient loader and unloader of heavy materials on construction sites, but in reality, he’s just the most effective communicator, and it’s Sal who has him beat in the efficiency department. 

Unless you’re monitoring your team members throughout the day, how would you know? Do you know how long it takes your employees to complete certain tasks, and can you measure that against others to better optimize your scheduling?

Buddy Punch addresses the high-level issue of how to schedule your employees and gives you a more detailed look at what your employees achieve while they’re on the schedule.

Drag-and-drop scheduling

Buddy Punch makes it easy to visualize and verify employee schedules through a customizable interface. Simply click on an empty cell to create a new shift, then drag and drop it anywhere on the schedule to build out your workweek. 

Job codes

Once it’s time for employees to clock in, enabling the job codes feature will allow you to take a closer look at how efficient they are at their tasks. 

Simply create a code name for certain jobs (for example “stocking” or “sales floor”) and your employees will be able to sign in to them as they clock in. They can also swap between different job codes throughout the workday. 

The result is you having a record of exactly how long employees take to finish each task, which you can use to understand their habits and productivity to optimize your scheduling in the future.

Customizable reports

Whenever you’re ready to get a deeper insight into your employees’ work habits, you can access Buddy Punch’s customizable reports to review data on scheduling, tasks completed, and more. These can be exported as Excel, CSV, or Adobe PDF files at will.

Labor cost issue #3: Subpar communication

Do your employees know when they’re supposed to be working next? Is there enough open communication in your work environment that they feel comfortable expressing when they’re sick, stressed, or feeling burned out so they can take PTO rather than coming to work and being inefficient? 

Opening the lines for communication with and between your team members is a subtle way to lower your employee labor costs.

Buddy Punch comes with several features that improve communication not just between you and your employees, but between your employees as well.

Notifications

Buddy Punch has a built-in notification feature that will ensure team members are aware of many specifics when it comes to time tracking and attendance. 

For example, Buddy Punch’s drag-and-drop scheduler comes with a built-in option for notifying all scheduled employees of their working time. 

This helps ensure that issues with no-shows or late arrivals on shift are stamped down. It also gives employees enough advanced notice to let you know when they’re unable to work a shift due to illness or emergencies. 

Shift trades and covers

In the case of an employee being unable to work for any reason (from emergencies to sick days), Buddy Punch allows them to exert some control over finding a replacement. 

If you enable it, the shift trades and covers feature can be used for a team member to find another employee whom they can swap shifts with. 

In addition to helping with employee turnover and retention, this option allows you to be more hands-off when it comes to making shift adjustments.  If Jake wants to chaperone his daughter’s museum field trip, he can ask Bill to take over his shift. You’ll only be alerted when it’s time to approve or deny this change. 

Labor cost issue #4: Overtime

Overtime notifications

Paying time and a half times the regular rate of pay is obviously a huge factor when it comes to labor costs. If you have rampant issues with overtime due to employees going over their intended work hours, Buddy Punch can help you drastically get your workforce under control.

Under the umbrella of Buddy Punch’s useful notification features is an option to send you an alert whenever an employee is approaching overtime. This allows you to adjust schedules to ensure you’re not paying unintended overtime costs.

Overtime calculations

If overtime is an unavoidable aspect of your business, or if you want to better visualize how it’s impacting your labor costs, the overtime calculations feature will help you quickly get a sense of the overtime hours in your company. 

Choose from 12+ different overtime types to determine how pay will be calculated. This visualization of the impact of overtime on your business’s financials can be the jolt you need to optimize employee hours and workloads.

This covers how Buddy Punch deals with the most common issues when it comes to labor costs, but our employee management tool has many more features available including (but not limited to):

• PTO tracking
• IP address locking
• Text to punch
• Job locations
• Built-in payroll processing
• And more

Buddy Punch can be used on Windows or Apple Desktops, can be accessed via the web or as a native app on iOS and Android smartphones, and also functions on tablets — meaning you can track employees and cut down labor costs on any device with an internet connection.

Click here to start a 14-day free trial, risk-free, and see how Buddy Punch can help streamline and reduce your labor costs. 

Reducing your labor costs

Reducing labor costs is a critical endeavor for any business looking to optimize its operations. Knowledge of both how to calculate labor costs and the hidden factors impacting them is the first step. Then, through the use of software like Buddy Punch, you can master your workforce finances and build your small business toward greater heights.