To run a profitable business, it makes sense to understand labor costs and watch for overspending. After all, labor is often a company’s most significant investment, and it can be tricky to turn a profit if it gets unwieldy.
What you’ll learn
What you’ll learn
Updated: June 5, 2025
Key takeaways
- Most people consider labor costs as the sum of salaries and wages
- To get a clear picture of your total labor costs, you must identify direct, indirect, variable, and fixed labor expenses
- Actual labor costs include salaries and wages, payroll taxes, employee benefits, time off, sick days, and other expenses
- Miscalculating your labor costs makes it challenging to craft an effective business strategy
On average, labor costs can make up to 20-35% of gross sales, so keeping tabs on workforce expenses can be a difference-maker for profitability. In this guide, we’ll explain what makes up labor costs, how they affect your business, and how to make more informed decisions to put a positive stamp on profit margins.
What is labor cost?
In simplest terms, labor cost is the amount your business spends on employees to run your company. While many people view labor costs as money spent on paychecks, other expenses also contribute to them.
Components of labor cost
When calculating your labor cost, you should factor in every component to capture all expenses so everything is accounted for.
Direct labor costs
Direct labor cost refers to the salaries and wages your business pays employees personally involved in providing services or producing goods. These workers perform roles directly related to a specific task. Here are some examples of direct labor:
- An employee assembling products on the manufacturing line
- A chef preparing meals in the restaurant kitchen
- A laborer building houses
Calculating direct labor costs and their impact on the profit margin is easy, as you can directly tie them to products or projects.
Indirect labor costs
indirect labor cost refers to the amount you pay to employees who work on tasks that contribute to your business performance but do not directly produce products or services. Indirect labor includes work done by administrative staff, accountants, maintenance workers, and quality control inspectors. Calculating indirect labor costs can be challenging because work done by indirect staff isn’t tied to a specific output.
Fixed labor costs
Fixed labor costs don’t change regardless of how much your workforce produces. Compensation for salaried employees is a good example. Since fixed labor expenses are stable, you can easily predict them and include them in your budget. They are also simple to calculate as they change less frequently.
Variable labor costs
Variable labor costs change with your business needs. Part-time workers, hourly staff, and seasonal employees fall into this category. Providing overtime pay or commission-based incentives because of fluctuating workloads is also a variable that can increase your labor cost.
Now that we better understand the common types of labor expenses, let’s find out more about how the numbers come together.
How to calculate labor cost
To calculate your total labor cost, start by determining your gross pay.
Steps to calculate gross pay
Follow the steps below to figure out your gross pay:
- Categorize your employees into salaried and hourly groups.
- Multiply the hourly wages by the total hours worked to get regular pay for
hourly employees.- Regular pay = Hourly wages × total worked hours
- Calculate the overtime pay if applicable. Multiply the overtime hours by the overtime rate, usually 1.5 times the regular rate.
- Overtime pay = (1.5 × hourly wage) × overtime hours
- Add bonuses, commissions, incentives, and any additional earnings, along with salaries for salaried employees.
- To get the gross pay, use the following formula:
- Gross pay = (hourly wage × regular hours) + (overtime hours × overtime rate) + (bonuses + commissions + other incentives) + agreed salaries before deductions
If you only have salaried employees, use this formula:
- Gross pay = sum of agreed salaries before deductions
Estimating absenteeism impact
The direct cost of absenteeism is lost productivity, which reduces profits and revenue. Employees can’t contribute to your company’s success when they can’t work. Other costs include increased overtime and reduced efficiency.
To calculate the impact on your business, consider several costs:
Lost productivity
- Lost productivity cost = Average hourly wage × hours of absence
Overtime or temporary replacement costs
- Replacement cost = (Overtime rate × overtime hours) + (Temporary worker wage × hours worked)
Reduced efficiency
- Efficiency loss = Lost productivity cost × estimated efficiency reduction percentage
- Total absenteeism cost = Lost productivity cost + replacement cost + reduced efficiency
While you can estimate the cost of absenteeism, some costs like quality loss might be harder to quantify.
Additional costs in hourly labor rate
Beyond base wages and absentee costs, several other expenses contribute to an employee’s actual hourly labor rate. Consider:
- Payroll taxes, including Social Security, Medicare, unemployment taxes, and workers’ compensation insurance
- Employee benefits like health insurance, retirement contributions, and paid time off
- Overhead costs such as training and onboarding
- Overtime and shift differentials
To calculate total hourly labor cost:
- Total hourly labor cost = (Wages + payroll taxes + benefits + overhead costs) / Total hours worked
Labor cost formulas
To track and manage your business labor costs, you need to understand them in relation to total sales and operating expenses. With a clear cost perspective, you can set competitive prices and optimize workforce efficiency to maintain profitability.
Labor cost percentage of total sales
The total sales labor cost percentage determines how much of your revenue goes toward workforce expenses. You can use it to establish whether labor expenses are sustainable compared to revenue.
- Labor cost percentage = (Total labor cost / total sales) x 100
A high percentage may indicate inefficiency in your workforce, while a too-low percentage could signal underinvestment in staffing.
Labor cost relative to operating costs
This formula compares labor expenses to total operating costs. It gives insights on how to:
- Adjust budgets
- Control overhead costs
- Approach salary rise percentage strategically
- Improve financial planning.
- Labor cost to operating cost ratio = (Total labor cost / total operating costs) x 100
With an overview of how these figures come together, let’s explore some ways employers can keep them from becoming too much of a burden.
Strategies to reduce labor costs
Here are some employee cost reduction strategies that won’t require cutting headcounts.
Address absenteeism
Unplanned absenteeism costs you productivity and overtime expenses. Typically, the law requires you to compensate overtime at 150% the normal employee pay rate. Also, the increased employee rate means more payroll taxes. To minimize absenteeism, implement an attendance tracking system to help you identify absenteeism patterns. You can then implement strategic work planning and flexible scheduling to reduce absenteeism by improving workplace engagement and morale.
Leverage remote work opportunities
Remote work can decrease your company’s employee costs by reducing expenses for utilities, real estate, office equipment, and cleaning services. To maximize your savings, identify roles that employees can execute offsite. Then, find the appropriate collaboration tools to maintain productivity.
Use workforce analytics
Using workforce analytics can help you make data-driven staffing decisions. You can get accurate insights into employee productivity and staffing inefficiencies to improve scheduling and resource allocation. Similarly, you can use payroll report software to analyze your labor costs in real time, identify areas for cost reductions without affecting productivity, and maintain compliance with wage law and overtime regulations.
Understand labor expenses for long-term success
Since labor costs can be one of the larger costs associated with running a business, having a process to track and optimize labor expenses should be at the top of every employer’s to-do list. If you rely on manual labor cost management processes, which can be prone to human error, it could be time to take a different approach. Most payroll software can make it simple to automate employee time and labor cost tracking, automate tax calculations, and generate detailed payroll reports – so you can get the bigger picture.
As your company grows, we hope you have success finding top talent to keep your business moving forward while managing your labor costs.
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Jon Davis is the Sr. Content Marketing Manager at OnPay. He has over 15 years of experience writing for small and growing businesses. Jon lives and works in Atlanta.