Demystifying the Labour Costs of Employees

The cost of labour is used by companies to calculate how to price products and predict future profits. But what is and isn’t included in the labour cost, and what’s the difference between direct, indirect, fixed, and variable labour costs? 

This article will break down everything you need to know about labour costs. 

What are labour costs?

The labour cost or cost of labour is simply the amount of money that an organisation spends on its employees. This includes the total amount of money from all the wages paid to employees combined with the cost of employee benefits, and also payroll taxes. 

Labour cost = total wages paid + benefits + payroll taxes

Types of labour costs

Labour costs are categorised into different categories: direct labour costs, indirect labour costs, and fixed or variable labour costs. 

Direct labour costs

These are the costs of wages for employees whose labour directly produces a product. For example, the wages for employees who work on an assembly line are considered part of the direct cost of labour. Delivery drivers and logistical employees are also included in this category because they are a necessary part of the process of getting a product into the customer’s hands.

In short, the salaries and benefits for the employees directly involved in the supply chain are considered direct labour costs. 

Indirect labour costs

Overhead or indirect costs include the wages for the employees who support the efficiency of the business but don’t work specifically on production.

For example, this includes employees who are involved in the maintenance of equipment on the assembly line, security staff, or employees who are in supervisory or administrative positions. HR employees will be considered in the overhead category. These employees’ roles are still important but are not involved directly in the supply chain.

Fixed labour costs

These are the predictable costs that are unlikely to change in the near future – for example the salary of a worker or the rent payments for a warehouse. Fixed costs can also be direct or indirect costs. 

Variable labour costs

As the name suggests, variable costs are dependent on different variables such as production demand. This means that they can change frequently.

One example might be a business that experiences increased demand around Christmas and Valentines day and needs to hire additional staff or expect hourly waged workers to work longer shifts during these periods. Variable costs can also include the cost of contract workers who do emergency repairs on manufacturing equipment, which is hard to predict in advance. 

Variable costs may also be direct or indirect labour costs. 

What is included in labour costs?

When accounting for labour costs, there are many different costs you need to factor into calculations. 

Wages

The wages or salaries of all employees are one of the key types of employee compensation included in labour costs, and also one of the biggest expenses for an organisation. 

Overtime

Overtime payments and time off in lieu expenses need to be factored into labour cost calculations. 

Bonuses

Accounting for bonuses (annual or one-time payments in addition to a worker’s salary or wage) is a key part of labour cost calculations. Bonuses may be considered as variable costs if they are performance related bonuses, or fixed if they are guaranteed. 

Sick days

Sick days taken by workers are factored into the total cost of labour — they need to be subtracted from the gross number of days worked. 

Paid time off

PTO is also included in labour cost calculations. This is the number of days that an employee is on their annual leave while still getting compensation from their employer. 

Payroll taxes

Taxes paid by the employer on payroll is another expense factored into the cost of labour. This includes national insurance contributions for employees. 

Benefits

Any employee benefits offered by the company are also included into labour cost calculations. For example, the cost of health insurance or company cars may be included. 

Training

The price of training employees must be factored into calculations of labour costs. These would be classed as indirect labour costs as training does not directly contribute to the supply chain. 

Supplies

The price of essential supplies, such as office supplies, is also included in labour costs. 

How do I calculate labour costs?

There are several steps involved in the calculation of labour costs.

    1. Calculate the gross pay for all employees

First, you’ll need to calculate the gross pay received by employees in a year. The gross pay is the pay rate multiplied by the gross hours. 

2. Estimate how many hours are actually worked

The next step is to estimate how many of these hours are worked. This involves accounting for paid time off and sick days taken by employees. Then, all you need to do is calculate the net number of hours worked by subtracting the hours lost to PTO and sick days from the gross hours worked.

3. Calculate the additional costs

Now, add up all the other expenses. This includes totalling the cost of taxes, insurance, overtime, benefits, and supplies. 

4. Calculate the annual payroll labour cost

Then, add gross pay to the other annual additional costs to get the rate for the annual payroll labour cost.  

5. Find the actual hourly labour cost

Divide the annual payroll labour cost by the net hours worked to find out the actual hourly labour cost. 

6. Find the labour cost percentage

Divide your annual payroll labour cost by the total revenue of the business to find out the labour cost percentage. This provides a useful metric that makes it easier to understand how much labour is costing the business.

7. Analyse and compare

You may want to compare this percentage to industry norms for labour costs. For example, a service-based industry business might expect a labour cost percentage of 50% or higher, while restaurant businesses often see a labour cost percentage of 25-40%. 

Cost of labour vs cost of living

The cost of labour and the cost of living are two different metrics that are often compared. The cost of living equates to the minimum amount of money that an individual requires to enjoy a basic standard of living in a particular area. It includes the cost of housing, food, transportation, healthcare, and other essentials. It’s a term that is often in the news at the moment due to the UK’s major cost of living crisis and record inflation levels.

The cost of labour and the cost of living are different metrics that should not be confused. However, they can be used together by human resources professionals to check that the organisation is offering salaries and wages that are competitive in the geographical area and industry. 

Payroll software and labour costs

Calculating labour costs is a complex process so it’s no wonder that many UK organisations are using payroll software to automate the process. Payroll and HR software can help you get to grips with labour costs easily and efficiently by simplifying the calculations and providing a more detailed and granular perspective. 

With a payroll solution that automates labour cost calculations, your team can gain better visibility and make informed decisions about compensation and benefits. Providing key information about payroll and labour costs at a glance, HR and payroll software allows teams to identify opportunities to control labour costs and increase revenue.

Moreover, a powerful payroll and HR software eliminates the risk of human error in calculations, creating a single and accurate source of truth for your organisation. This makes budgeting and forecasting a breeze. Self-service capabilities in a payroll software also make payroll more accessible and transparent to all. 

Want to see for yourself how Payroll and HR software can streamline calculations and boost productivity for your team? Book a demo of our powerful software today.