how to calculate labor costs

Understanding how to calculate labor costs is important, no matter the type of business you are running whether it’s a small business or construction firm with staff employed, calculating labor expenditures is among your highest outlays.

It is a general fact that business owners whether large or small will normally hire staff to execute or perform certain tasks which are usually essential and critical to the growth and success of the company.  

Business owners must manage a range of key operational expenditures, depending on the sector, including rent, inventory, labor cost estimates, and a few others.

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Meaning of Labor cost

Humanitarian activities in the provision of goods or services both physically and mentally are referred to as labor.

The sum of all employee salaries, benefits, and payroll taxes is referred to as the labor cost. Direct and indirect labor expenses are the two elements that make up this cost.

The salary and wages provided to workers who are directly involved in the production of a particular good or in rendering service are referred to as direct labor.

It is important to have an understanding that your labor costs for each employee are equivalent to the expenses you incur for them.

The cost of labor comprises an employee’s total salary as well as any additional amounts made on their behalfs, such as Social Security and Medicare taxes and benefits.

It can be further explained as the total funds spent on paying employees of your company either hourly or monthly, taxes are not left out as well.  

Calculating labor costs is a critical part of small-business operations. It might also include anything that has to do with financial compensation.

Labor costs are payable through monetary benefits either immediately ( monthly, or hourly) or sometimes in the future. Benefits paid immediately can include salary and wages and a production bonus or incentive. 

Benefits that may come in the future are not necessarily monetary, they include subsidized food, housing, insurance, training, or even hospital facilities.

Classification of Labor Cost

Classifying labor costs is a great way to help companies make the calculation of labor costs easy and faster.

There are four categories of cost of labor.

  1. Direct Labor
  2. Indirect Labor
  3. Fixed Labor
  4. Variable Labor

Direct Labor

These are the labor expenses paid to the workers who are directly involved in producing the goods; their effort is readily apparent during the process of turning the raw resources into completed goods.

In contrast to indirect labor, direct labor refers to the expenses related to each consumer item or service that a firm produces as part of labor cost estimates.

Put simply, The expenses that may be directly connected to production are known as direct labor costs.

When the question of how to calculate labor costs specifically direct labor is asked, it is safe to say that it involves all employees in charge of producing a company’s goods or services.

Direct labor includes, for instance, production managers, assembly line workers, delivery truck drivers, and quality control engineers.

Indirect Labor

These are the labor costs spent by indirect workers who, while not directly involved in the conversion process, still contribute to it through monitoring, maintenance, and material transportation.

Making a clear instance for a better understanding, employees who act as security guards for the plant or warehouse are indirect laborers and their labor cost is indirect as well, this is because the cost cannot be traced directly to the production process.  

Other examples may include office managers, accountants, sales representatives, maintenance workers, and administrative assistants.

Fixed Labor

Set fees for long-term service contracts may be included in fixed labor expenses.

Calculations of fixed labor costs are constantly independent irrecspective of a company’s output level. 

Calculating fixed labor costs gives a clear illustration of how employers and employees receive a constant salary regardless of the number of hours they work.

A business may establish a fixed-price contract with an outside provider to handle equipment repair and maintenance. For example your cleaning staff, including routine restaurant hood cleaning and all other services.

A great advantage of labor cost that is constant is that payment of overtime to managers is avoided.  

Therefore, regardless of the amount of income you generate, fixed labor expenses are the labor you will pay.

Variable Labor

Put simply it can we will use an instance where variable labor expenditures are the additional servers you require for a busy Friday lunch shift.

As the name indicates, variable labor costs vary based on the total volume of manufacturing output. The most common type of variable labor used by small businesses to calculate labor costs is hourly workers.

How to calculate labor cost

To get an employee’s labor cost per hour, add their gross salary to any associated costs (such as yearly overhead and payroll taxes) and divide by the number of hours they work annually. This will assist in calculating the cost of an employee to their employer per hour.

Additionally, one can use a labor cost calculator.

In calculating labor costs there are certain steps to take, first 

  1. Calculate the Actual Worked Hours 

Not all employees work every day, it is important to determine the number of hours an employee has worked following the number of days he is missed work.

For instance, an employee is expected to work 7 hours a day and has missed going to work for 10 days.

Hours not worked = 10 days x 7hours = 70 hours


Actual worked hours = total annual hours worked – hours not worked

With this, it is easy to calculate labor costs.

  1. Calculate the Gross pay

The gross pay for an employee that works hourly for instance is the calculation that determines the number of hours worked multiplied by the company’s hourly rate.  

Let’s take for instance, where an employee earns $20 per hour, and has worked 2000 hours that year, gross pay will be 2000 * 20 = $40,000  per year.  

Put simply Gross pay = Gross hours * Company’s pay rate per hour.

Therefore, it is basically the salary received by an employee within a certain period of time which mostly is yearly. 

  1. Determine the additional labor expenses

They are in addition to an employee’s base salary. You cannot determine a staff member’s actual labor cost per hour or genuine cost per hour unless you have calculated all of these factors.

When calculating the direct labor cost, one must include the expenses of benefits, overtime pay for non-salaried workers, payroll taxes paid by the employer, bonuses,  life insurance, paid training, employer contributions to retirement plans, and employer-provided health.

In addition to the employee’s real wage, common labor expenses include:

Employee Benefits:

  • Local unemployment taxes 
  • Health insurance
  • Additional insurance such as dental, life, or disability
  • Retirement plans
  • Education and training 
  • Overtime pay
  • Workers’ compensation insurance
  • Work supplies
  • FICA taxes with Medicare is 1.45% and Social Security is 6.2%
  • FUTA taxes 
  • State unemployment taxes
  1. Calculate the overall cost of labor

Labor costs = Gross pay + additional labor cost

Using the direct labor cost method, combine the gross salary and any supplementary labor cost estimates to determine each employee’s total labor cost.

Total labor cost estimations are based on gross pay plus extra labor expenditures. 

Depending on how you may want to do it as a company, after knowing how to calculate labor costs, you can calculate the total labor cost either monthly, yearly, or weekly.

The benefit of calculating labor cost

  1. It prevents businesses from running into financial problems caused by overestimation and underestimating the power of accurate labor cost calculations.
  1. Having calculated labor costs, it is simpler and easier to calculate how many full-time and part-time employees you can afford to hire than making a mere estimation.
  1. Having an idea of how to calculate labor costs and knowing the result of your expenses on labor will increase your income and will help you in deciding the best and most competitive price for your products. 
  1.  Knowing how to calculate labor costs will aid recruitment control, you shouldn’t recruit a new worker unless you’ve carefully considered if the advantages of doing so exceed the costs.
  1. The detection of potential fraud can also be aided by keeping an eye on labor costs.
  1. In order to find revenue leakage that is reducing firm profitability, you could find it helpful to review your labor cost figures.

How to Control Labor Costs

A key component of your company’s account management is keeping your labor costs in check.

This doesn’t entail reducing employee pay or taking short corners with higher labor costs.

Labor seems to be the most sensitive aspect of the cost that has to be secured to prevent expense that is not balanced by productive efforts.

 Here are a few measures that can be put in place;

  • Make adequate records by tracking staff hours accurately 
  • Set up a special department for wages 
  • Make accurate Analysis of idle time and Pay attention to overtime hours 
  • Labor turnover


The amount you pay on labor costs, which comprise the entire cost of goods sold plus other expenditures, affects your business’s prime cost if you run a production or manufacturing business.

The amount you pay on labor costs, which comprise the entire cost of goods sold plus other expenditures, affects your business’s prime cost if you run a production or manufacturing business.

To calculate your labor cost percentage, which illustrates the link between your total income for a particular period and your labor expenditures during that period, you must know your labor cost expenses per employee.

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