The cost of employees is typically a company’s biggest expense. This is especially true for the hospitality industry. The percentage of total costs attributable to labor is a crucial indicator. That’s because a high ratio of labor to profit reflects well on your company. The more skillfully you perform it, the more competent you will be. The more proficient your company is at making money, the better. The higher your company’s standing among top executives and investors. Read on to learn about types of labor cost along with its formula.
What is a Labor Cost?
The analysis of the labor cost is very important for finance and accounting workers because it helps them figure out exactly what a company’s direct and indirect costs are related to its employees. The direct labor cost includes both wages and benefits for workers who work directly on making the product or service. Indirect labor costs are the costs of paying workers who help make a product but aren’t directly involved in making it.
When figuring out how to price their goods in the best way, businesses need to have a full understanding of how much labor costs. That is to say, without a clear understanding of both direct and indirect costs, it may be hard for companies to figure out how much their things really cost. In today’s changing economy, it’s more important than ever to have a deep understanding of labor costs and how to use them most effectively. This is a key factor in promoting economic growth and success.
Labor Cost Formula
When it comes to calculating labor costs, there are two main methods that businesses commonly employ. It can be calculated: as a percentage of sales or as a percentage of total operating expenses.
First, before you are able to calculate the labor cost as a percentage of sales, you’ll need to add up all of the organization’s labor costs. Total cost of work for a certain amount of time, including both direct and indirect costs.
Next, use the POS system or the inventory system as its standard to find out how much money the organization made in total. Here’s the bottom line. You have to take out all of your money before taxes and other costs.
Lastly, multiply the cost of labor by the company’s total sales to get a percentage. The amount of money from sales that will go toward paying your workers.
Labor Cost = (Total Labor Cost / Total Sales) x 100
In general, it is attainable to determine how much of the overall operating cost is attributable to labor. Like before, you’ll start by figuring out how much it costs your business to hire people. The next thing to do is add up all of your operating costs. All other costs, like food, drink, rent, overhead, and promotion, are subtracted from the income.
Divide the result of dividing the cost of workers by the total cost of running the business by 100. The formula to determine the proportion of operational expenses attributable to labor is as follows:
Labor Cost Percentage = (Total Labor Cost / Total Operating Costs) x 100
Why Calculate Labor Cost?
You wouldn’t commit to a new place of business without first determining whether or not you could afford the lease, right? Similarly, you shouldn’t bring on a new worker without first figuring out if they’re worth the investment. When a company expands, it often makes the mistake of hiring more people than it needs and paying them less than they’re actually worth. This has a negative impact on profitability at best and can lead to layoffs at worst.
You can calculate the direct cost of an employee’s time with pinpoint accuracy using a labor cost formula. Knowing this figure eliminates the need for educated guesswork when deciding how many full- and part-time workers to hire. In addition, if you know how much your labor is costing you, you can set prices that will bring in the most money. Underestimating labor expenses might lead to pricing that is too low, leaving you with unsustainable profit margins. Also, if you overestimate the amount of time and money spent on labor, your prices will be uncompetitive. When setting prices, it’s important to factor in not only the cost of items sold but also the cost of labor.
Last but not least, understanding how much you spend on labor could help you find places where money is being lost. Consider the expenditures associated with things like staff cell phone use, vehicle mileage, and recruitment efforts. Monitoring expenditure patterns in various areas can detect fraud.
Types of Labor Cost
The types of labor cost include the following:
#1. Direct Labor Cost
The direct labor cost is how much money the business spends to pay the skilled workers who make the goods directly. On a per-unit basis, it’s easy and accurate to get measurements. Direct worker cost is a key factor that is easy to find and assign to a particular job, process, or product. This cost includes the pay and benefits paid to the workers directly involved in making something.
Businesses can learn much about how much it really costs to make goods or provide services if they correctly track and assign direct labor costs. Companies can use this knowledge to make smart decisions about pricing, how to use their resources, and how to make the most money overall. The total calculation of the prime cost includes this particular element as an important part. The hardworking people who build dams, make beautiful tables and print books receive direct labor costs as their payment. These cases show how much it costs to produce the skilled workers who are responsible for making these projects happen.
#2. Indirect Labor Cost
Indirect labor cost is the amount of money a business spends on workers who are not directly involved in the manufacturing process. These workers, while not directly engaged in production activities, play a crucial role in supporting the overall operations of the factory.
In addition, an indirect labor cost encompasses the expenditures associated with compensating those invaluable workers who support and collaborate with the direct labor force to successfully carry out the various stages of the manufacturing processes. Accurate identification and measurement on a per-unit-of-output basis pose significant challenges. The allocation of costs is undertaken to maximize the advantages of various cost centers. This particular expense is included as part of the overall overhead costs. Indirect labor costs encompass various forms of compensation provided to individuals fulfilling essential roles such as sweepers, watchmen, cleaners, supervisors, and accounting personnel. Indirect labor expenses encompass these payments, which are not directly tied to the production process.
#3. Variable
Variable labor costs, as the very name implies, exhibit variations based on the level of output. In the realm of small businesses, the prevailing mode of flexible labor often takes the form of hourly wages. Consider the various establishments where you frequently engage in retail therapy or indulge in delectable culinary experiences. As the demand for these establishments experiences fluctuations, so too does the corresponding labor cost.
#4. Fixed
According to the Small Business Administration (SBA), fixed labor costs remain constant irrespective of any variations in a business’s production output. Employers and owners who receive constant pay regardless of how much time they work illustrate labor costs.
One notable benefit associated with this type of labor cost is the ability of business owners to circumvent the financial burden of overtime pay for their supervisory and managerial staff. Reducing fixed labor costs while maintaining optimal efficiency and effectiveness within the business operation can often pose a significant challenge.
You may want to see: INDIRECT COST: Meaning, Rate, Grant & Difference
Ways to Reduce Labor Costs
If you have analyzed the facts and are genuinely surprised by your labor costs, now is the time to take action. Here are some potential options.
#1. Boost Efficiency
It goes without saying that you should give your employees the resources they need to maximize their output while on the job. The goal is to reduce the number of steps required to execute the operation; hence, automation and streamlining are key. As you analyze your processes, you may discover that you can do away with certain steps altogether without compromising the quality of your final deliverable. All of these can help you save money by reducing the number of man-hours you need to put into a project.
#2. Manage Your Overtime Hours
The second step is to take a serious look at the amount of overtime your workers are putting in. Many businesses have a warped view of overtime, allowing workers to clock it with little to no scrutiny. Employees should only work overtime when necessary to complete a demanding job. Also, limit employees’ exposure to overtime by instituting policies like mandatory manager approval for shifts lasting longer than a predetermined threshold. Bonuses and other incentives for working a standard 40-hour week are another option.
#3. Complement Your Existing Staff
Our prior breakdown shows that there are additional expenses associated with hiring and retaining employees beyond their hourly wages. Contract or temporary workers can help if you can’t afford full-time perks and taxes.
#4. Put Sick Time and Holiday Time Together
While most companies still keep sick days and vacation days distinct, others are becoming inventive in order to save money. Say, for instance, that you normally offer two weeks of paid vacation and ten days of paid sick leave. Instead, combine three weeks of vacation time into a pot for employees to use. This gives workers five vacation days and more time control.
#5. Strategic Staffing
When done correctly, increasing the number of full-time employees hired can result in a positive net benefit. Let’s imagine you’re in the construction industry, which frequently calls for estimates. If your estimator is too busy to deliver quotes in two weeks, try adding a second estimator. As such, a well-thought-out strategy for hiring and deploying personnel is crucial.
What Is Full Labor Cost?
The cost of labor encompasses the total amount of gross wages paid to each employee, along with any additional expenses incurred per employee. In addition to the core operational costs, businesses must also account for various ancillary expenses. These encompass payroll taxes, employee benefits, insurance coverage, paid time off, the provision of meals, as well as the procurement of essential equipment and supplies.
What Factors Affect Labor Costs?
A variety of factors affect the overall labor cost percentage for a business. These factors encompass the nature of the business, the industry it operates in, the unit, the geographical location, and the size of the workforce. The nature of the work and the going wage rates can also have an impact on the total labor cost percentage for workers.
What Is the Difference Between Direct and Indirect Labor Costs?
Understanding direct labor cost is a simple idea that is easy to understand. Employee project costs encompass various expenses associated with the workforce engaged in project-specific tasks. These costs primarily comprise wages and additional benefits provided to employees directly involved in project-related activities, such as laborers, riggers, foremen, and pipefitters. Indirect labor refers to an organization’s devoted staff that performs non-construction duties. These employees play a crucial role in supporting the overall functioning of the company, contributing their skills and expertise to various operational aspects that facilitate the smooth operation of the organization.
What Is the Difference Between Labor Cost and Labor Rate?
In instances where these two factors appear to be on average, it is not uncommon for the prevailing misconceptions surrounding labor costs to align as well. However, it is important to note that labor rates and labor costs are not synonymous. The calculation of a labor rate involves dividing a person’s total pay by the number of hours they have worked. However, labor costs—the expenses expended in relation to a workforce’s output—are closely linked to productivity. By considering productivity, labor costs provide a comprehensive perspective on the financial implications of human resources.
References
- home.binwise.com
- indeed.com
- mbaknol.com
- khatabook.com
- 4cornerresources.com
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