Companies that routinely track their labour costs stand a much better chance of avoiding their overheads spiralling out of control, which can significantly impact cash flow and output.
This is because when you deliver a product or service, labour takes up a significant proportion of the cost involved. In fact, the cost of labour is often the most expensive of any business cost.
In this article, we'll explain what labour costs include, how to accurately calculate and track your direct and indirect labour costs and detail how using the labour cost per unit formula can help you to optimise your production levels and your gross profits.
What is labour cost and what does it include?
Many people initially think that labour costs only include paying an employee's wage, but it is much more than this, explains Alan Price, CEO of smart HR software company BrightHR. “It’s important to remember that labour cost also takes into consideration the cost of recruitment, induction, training and development, daily management, offboarding and replacement," says Price.
"Employers should ensure that all these components are factored into their overall labour budget."
Labour costs cover the total amount you spend on your workforce. This includes: salaries, tax and pension payments; perks, such as a weekly staff lunch; training; the cost of HR and workforce admin; and staff leave, including sick pay, maternity pay and covering the cost of annual leave.
Miriam Attwood, Director of Edinburgh-based Storytelling PR, which provides PR services for live entertainment events, says that labour costs are the bulk of her business costs and something that she is constantly monitoring.
“As we produce a service, not a product, and basically sell our expertise and time, our labour costs are the bulk of our turnover," she says, adding that 80% of her company's labour costs are direct labour costs.
"As the time leading up to and around the Edinburgh Festival is our busiest time, we assess our labour costs every September and then monitor them throughout the year. There is always a tricky balance when it comes to deciding how much we want to push ourselves and take on new work, which often comes to us, and how much we want to increase our headcount to produce that work. And that’s why managing our labour costs is so crucial to what we do.”
Direct vs indirect labour costs
Both direct and indirect labour costs need to be included when calculating labour cost.
Direct costs are the salaries, taxes and benefits you directly pay each employee who works directly on producing the product or service you supply.
Indirect costs cover the staff and services needed to support your workers, which can include an HR team, cleaners and payroll. They also include those additional costs for supporting your employees, such as bonus payments, benefits and sick and annual leave.
Why calculate labour costs
Companies find it helpful to calculate their labour costs regularly for two key reasons:
1. Control costs
The labour cost calculation helps businesses to set a fair price point for their products and services. It also helps them better manage their margins, cash flows and balance sheet.
“Calculating labour costs in advance helps organisations to understand how much they can allocate to additional resources, such as training budgets, discretionary bonus payments, enhanced benefits, and more,” says Price.
2. Assess the value of the workforce
By determining their direct and indirect labour costs with the labour cost calculation, businesses can see whether they are getting value for money from their workforce. It also helps them to see how important it is to find the right person for the job, adds Price.
“A new hire, especially when it doesn’t work out, is a costly business expense," he says.
"As such, before hiring anyone, employers should take time to consider the gaps in the workforce, why a new person is needed and what specific skills are required to fulfil the particular role. Thorough analysis at the preparation stage can help ensure the right person is hired. It also helps to reduce staff turnover, boost organisational culture and contribute to a positive reputation.”
If you're looking for ways to retain and incentivise your employees, without impacting the cost of labour, you can earn 1 Membership Rewards® point for every £1 spent using the American Express Business® Gold Card. Points can be redeemed with hundreds of retailers on things like travel perks and gift cards, which you could use to reward your employees¹. You can also manage your costs with greater flexibility with up to 54 days to clear your Card balance².
How to calculate labour cost per unit
Labour cost per unit is classified as the average cost of labour per unit of output of a product or service produced. So, if handbags are being manufactured, the labour cost per unit is the labour cost per handbag produced. If the company is offering a mortgage advice service, the labour cost per unit is the labour cost per mortgage advice session. The average cost of labour covers worker productivity, wages and other indirect labour costs connected with the workforce.
Labour cost per unit formula
The formula used to calculate the labour cost-per-unit is:
Total Labour Cost (£) / Total Level of Output (hrs)
Step 1
To calculate labour cost per unit, you first need to add up all of your direct and indirect labour costs. This may include:
- Basic salary
- National insurance
- Pension
- Bonus scheme
- Benefits
- HR, training and admin costs
Step 2
Next, calculate the total level of output as hours. For example, Jim is an employee who works 37.5 hours a week for 48 weeks of the year. This equates to 1800 working hours per year.
Step 3
Imagine the total cost of Jim's labour broken down in step 1 is £75,000 per year. Divide that figure by the total output.
Labour Cost / Total Output
1800 hrs / £75,000 = £41.66 (per unit)
The importance of calculating labour costs correctly
Sticking with the example above, imagine if Jim took two weeks of paid sick leave for one year. The business is obliged to continue paying his salary during this time, but two weeks of labour productivity, equalling 75 hours, has been lost.
If the business failed to subtract this period of two weeks from Jim's total output, their cost of labour per unit figure would be wrong. This then misinforms their price-setting strategy, and if this continued unchecked would lead to significant profit loss.
1. Membership Rewards points are earned on every full £1 spent and charged, per transaction. Terms and conditions apply.
2. The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
