Finances and Taxes

How to Calculate Labor Costs: The Small Business Owner’s Guide

Deanna deBara Freelance writer and journalist 
How Do I Calculate My Labor Costs - Gusto

When you think of labor costs, what’s the first thing that comes to mind? Chances are, it’s the salary or hourly wage you pay your employees to get the job done. For example, if your employee works on a project for eight hours at $20 per hour, your labor cost for that employee would be $160… right?

Not exactly.

The regular wages you pay your employees are a big part of labor costs. But if you’re pricing out your projects solely based on wages paid for working hours, you’re not getting a complete picture of your total labor costs, which can make it hard to create accurate budgets or financial projections.

And that’s where direct labor cost comes in.

What is direct labor cost?

Direct labor cost is a formula that gives you a big-picture view of how much you’re actually spending on labor. In addition to wages paid for regular working hours (for example, employee A gets paid $20 per hour), direct labor cost takes into account all the other labor costs associated with employing your team, including:

  • Overtime hours
  • Payroll taxes
  • Company benefits, like health insurance, life insurance, and employer retirement contributions

From there, you can calculate how much in total labor costs you’ll spend to complete a specific task, whether that’s powering through a project or manufacturing a new product.

Why you should care about your labor costs—especially now

Getting deeper insights into your total labor costs always plays an important role in sustaining your business; those insights allow you to more accurately budget for projects, price your products or services appropriately, and ensure your business is profitable.

But while understanding direct labor cost is always important, it’s especially important now, as the world navigates the post-COVID landscape.

For many small business owners, business has slowed down significantly as a result of COVID-19 and the related restrictions and shut downs. When business is slow, less revenue is flowing into the business, which means profit margins are slim and every dollar counts.

When you understand how to find your direct labor cost, you can create more accurate labor budgets. It can help you determine if you need to adjust your pricing or eliminate certain products or services that aren’t driving a profit. Having a more in-depth idea of your labor costs also protects your cash flow and ensures you have enough cash on hand to pay your team—and keep your business up, running, and moving forward in the process.

In other words, when you don’t calculate labor costs or miscalculate late them, it could result in you coming up shorter than you expected. When you don’t factor in things like overtime, payroll taxes, benefits, and so on, you may come to misleading conclusions about where your business is actually at financially.

Want to see how your labor costs are impacting your cash flow? Try out our free cash flow forecasting tool.

How to calculate direct labor cost, step-by-step

Clearly, understanding how to calculate direct labor cost is a must for your business. But what does the direct labor cost formula look like in action?

Let’s say you own a marketing agency and you’re trying to calculate your direct labor costs for an upcoming client campaign. You plan to put a graphic designer, a copywriter, and a coordinator onto the project—and because it’s a big project, you want each member of the team to dedicate 50 hours in the upcoming week to manage the campaign launch.

Step 1: Determine costs for hours worked

First, you’ll need to determine how much you’ll pay your team in wages.

Let’s say your graphic designer and copywriter are salaried employees who each make $75,000 per year, while your coordinator is a non-exempt employee who’s paid $20 per hour.

Because the graphic designer and copywriter are exempt employees, their wages would be their regular rate of pay for the week.

Graphic designer wage costs: $75,000 / 52 weeks = $1,442.31

Copywriter wage costs: $75,000 / 52 weeks = $1,442.31

Because the coordinator is a non-exempt employee, you’ll also have to factor in overtime costs for any hours worked over 40 hours in a week—so, in this case, 10 hours of overtime (at 1.5 times their regular rate of pay).

Coordinator regular wage costs: $20 x 40 hours = $800

Coordinator overtime wage costs: $30 x 10 hours = $300

Coordinator total wage costs: $1,100

Step 2: Determine additional labor costs

Once you’ve determined the cost of wages, it’s time to factor in additional labor costs, including payroll taxes, insurance, and other benefits.

Let’s say you pay $600 in payroll taxes each month for your graphic designer and copywriter, $350 each month for your coordinator, and $300 in benefits for each employee each month (which includes health insurance, life insurance, and a retirement contribution). 

To calculate the costs for this project, you would need to break down each of those monthly costs into a weekly cost (since the project is slated to last a week):

Graphic designer and copywriter: $900 (payroll taxes plus benefits) x 12 months = $10,800 / 52 weeks = $207.69 per week

Coordinator: $650 (payroll taxes plus benefits) x 12 months = $7,800 / 52 weeks = $150 per week

Step 3: Calculate direct labor cost

Once you have both the regular labor costs and additional labor costs for each employee, you can calculate the direct labor cost for the project.

Graphic designer: $1,442.31 (regular wages) + $207.69 (additional labor costs) = $1,650

Copywriter: $1,442.31 (regular wages) + $207.69 (additional labor costs) = $1,650

Coordinator: $1,100 (regular and overtime wages) + $150 (additional labor costs) = $1,250

Direct labor cost for the project: $1,650 + $1,650 + $1,250 = $4,550

Step 4: Use direct labor costs to guide your decisions

Once you have your direct labor costs, you can use those insights to guide your business decisions. 

For example, let’s say your client is offering you $10,000 to launch the campaign. That would mean your business would generate $5,500 in profit for a week-long project—and would likely mean you’d want to continue working on similar projects with that client moving forward. But if your client is offering $4,000 for the launch, you’d take a loss of $550—which would mean it likely wouldn’t be a project you’d want to tackle.

Once you have your direct labor costs, you can also use them to create budgets for future projects. For example, if you know you’re going to be launching a similar campaign at $10,000 per project every quarter, you can use these numbers to create financial projections for the rest of the year. And because direct labor costs take all labor costs into account (not just wages), those projections will be more accurate and you’ll be able to better manage your annual budget, profits, and cash flow.

Calculate your way to deeper insights into your labor costs

As a small business owner, it’s important to keep your finger on the pulse of what’s happening financially with your business—and that includes your labor costs. And now that you understand how to calculate direct labor costs, you have a jumping off point to calculate your way to deeper insights into your labor expenses, cash flow, and revenue.

Just keep in mind that calculating direct labor cost is only helpful to your business if those calculations are accurate—so if there is any uncertainty around your labor costs (including how much you’re paying in benefits or taxes), make sure to talk to your accountant for further guidance.

With Gusto’s workforce costing feature, employees can easily track their hours to projects worked. Once payroll is run, Gusto will do the heavy lifting and automatically calculate these costs for you on a per-project basis, so you can make informed decisions for your business (without a mess of spreadsheets).

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Deanna deBara
Deanna deBara Deanna deBara is a freelance writer and journalist based in Portland, Oregon.

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