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 for employee labor to get the job done. For example, if your employee works on a project for eight hours at $20 per hour pay rate, your labor cost for that employee would be $160 … right?

Not exactly.

The gross wages you pay your employees are a big part of fixed 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 when factoring in overhead expenses.

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 a $20 hourly rate), 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 you will be powering through a project or need to control the overhead costs for the manufacture of a product. (For the latter, this product cost guide with a pricing template and calculator can help you figure out your manufacturing costs, such as assembly line expenses and cost of goods sold, which includes variable costs like direct labor costs and direct materials. It also covers how that all differs from your manufacturing overhead.)

Why you should care about your cost of labor, 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 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 actual 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 them, it could result in you coming up shorter than you expected. When you don’t factor in things like overtime, payroll taxes (e.g., Social Security and Medicare taxes), employee 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 total hours in the upcoming week to manage the campaign launch.

Step 1: Determine employee costs for hours worked

First, for this labor cost example, you’ll need to figure out how much your employee wages will be.

Let’s say your graphic designer and copywriter are full-time 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 gross pay would be their regular rate 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 care coverage, 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 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 total 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.

You can also use your total direct labor costs 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, not to mention you’ll then be able to figure out how to lower labor costs, if needed.

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 fixed costs for for employee hours. 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 certified public accountant (CPA) for further guidance.

You’ll also want to factor in indirect labor costs, which are the costs that aren’t directly related to the production process but support it in some way. For example, if you’re working a client campaign, then administration costs like human resources might be an indirect labor cost unless directly related to that project. Or if you’re in the business of making and selling a specific product, then marketing and advertising could be indirect costs versus if you’re actually in the marketing business working on client campaigns. In that instance, you would then be factoring in those costs as direct labor rates and direct labor hours for the number of employees or freelancers you hire for those marketing projects.

You can use this labor cost calculator to help you figure out and understand your bottom line. Plus, with Gusto’s workforce costing feature, time tracking is easy, too. Employees can log their number of hours worked for projects. 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 Google or Excel spreadsheets).

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