What is labor cost? Definition and how to calculate it

A business is a complex machine. When tracking costs and budgeting, some nuts and bolts are easier to count than others. The cost of labor is more than the sum of salary and wages. Every type of labor cost—direct, indirect, fixed, and variable—plays a distinct role in your financial framework. Each requires specific cost formulas and careful management to maximize your labor strategies. 

In this guide, we’ll break down what labor cost is and provide helpful definitions and equations. You’ll have the insights and tools to build a well-oiled machine that drives productivity. 

What is labor cost?

Labor cost refers to the total expense of maintaining a workforce, which includes salaries, wages, bonuses, commissions, employee benefits, and payroll taxes. Typically, labor costs are the most expensive line item on an organization’s budget. They weigh enormously on an organization’s overall profitability and financial planning, either pushing it into the red or setting it up for impressive profits.

Accurate calculations and projections of labor costs help with more than just balancing budgets. They allow companies to plan for growth, build effective hiring strategies, and remain competitive when pricing their products and services. 

Direct labor vs. indirect labor costs

There are two types of labor: indirect and direct labor. All organizations utilize both types. Your team should know how much each employee costs to ensure precise budgeting, financial planning, and hiring strategies.

Direct labor costs

Direct labor refers to workers who are personally involved in producing goods or providing services. Common examples include the following:

• Manufacturing workers on an assembly line
• Service providers in client-facing positions, including dentists, customer service representatives, and lawyers
• Laborers, carpenters, electricians, and plumbers who execute construction projects

Direct labor costs are wages and employee benefits provided to these workers. The profit margin of these costs is easy to calculate because they are directly tied to quantifiable projects or products.

Indirect labor costs

Indirect labor is associated with employees who support the production process without directly contributing to creating goods and services. Examples of indirect labor positions include:

• Administrative staff involved in general office management, including secretaries, payroll administrators, and human resources personnel
• IT support technicians who maintain and support computer systems, networks, and software
• Maintenance workers who repair and maintain equipment and facilities

Indirect labor costs are often more challenging to calculate because they aren’t tied to specific outputs.

Fixed costs vs. variable costs

Labor costs can also be divided into fixed and variable costs. Fixed costs are predictable, whereas variable costs fluctuate. Understanding these differences will help you effectively manage financial goals and operational strategies.

Fixed labor costs

Fixed labor costs are constant regardless of production or business activity level. Their stable expense structure makes them easy to forecast and integrate into long-term budgets. 

Imagine a car manufacturer. Salaries paid to full-time employees or long-term contracts don’t fluctuate with changes in production levels. Whether the company produces 10,000 units or zero, this payroll expense remains the same. Predictability simplifies budgeting processes, letting companies confidently divvy resources and prepare for future expenses. 

Variable labor costs

Variable labor costs are directly connected to production levels and fluctuate accordingly. Due to their dependence on the volume of work, these costs can be more challenging to predict and manage. 

Imagine the same car manufacturer. Wages paid to hourly workers or temporary contractors vary depending on their hours worked, which can change with production demands. Similarly, overtime pay and tax contributions may rise during peak periods and fall during slower production schedules. Companies must continuously monitor production and labor to manage variable budgets.

How much does labor cost? 

The average cost of an employee depends on the industry and job role, with adjustments for the local cost of living. The cost of hiring in the United States will differ significantly from hiring costs in Spain.

Although specific paychecks fluctuate, the total compensation for labor encompasses a predictable range of components. Every company’s total compensation strategy is different, but most organizations generally budget for the following costs: 

• Wages or salaries: Regular payments made to workers based on their role and hours worked.
• Payroll taxes: Contributions required by law, such as Social Security taxes, Medicare taxes, and federal and state unemployment taxes. 
• Bonuses: Additional compensation provided to incentivize or reward performance. 
• Leave: Costs associated with paid time off, including vacation days, sick leave, and personal days. 
• Perks: Expenses for employee benefits like health insurance, retirement plans, and life insurance contributions. This may also include optional nonmonetary benefits that contribute to a strong company culture or work-life balance (e.g., gym memberships, catering, or commuting subsidies). 
• Training and development: Costs related to enhancing employee skills through professional development, tuition reimbursement, mentorships, and training programs. 

How to calculate labor cost

The following examples provide a framework for calculating labor costs generally, accounting for gross pay, absenteeism, and employee benefits, among other costs. You can also use Oyster’s employee cost calculator for a more comprehensive estimate of labor costs.  

1. Calculate gross pay

For workers paid an hourly rate, the cost formula is the hourly rate multiplied by the projected annual hours worked. 

For example, if an employee earns $18 per hour and works 35 hours each week (1,820 hours per year), the cost formula for gross pay would be 18 x 1,820 = $32,760. 

Salaried employee costs are easy to calculate since they have a fixed annual salary and aren’t typically eligible for overtime pay. For an exempt salaried worker with a yearly salary of $85,000, their gross pay is simply $85,000. 

2. Estimate absenteeism

Workers need holidays and sick days. Historical company data can determine how sick time and holidays should factor into your labor cost estimate.

Using the example above, imagine your workforce takes 12 days of vacation and holiday time, totaling 96 hours. Subtract this sum from the total hours worked annually. The hours per year formula looks like this: 1,820 – 96 = 1,724 hours per year, making gross pay $18 x 1,724 = $31,032. 

Since salaried employees aren’t paid by the hour, absenteeism doesn’t directly impact their labor costs.

3. Add additional costs 

Now, you can personalize the calculation based on your company’s total compensation policy by adding additional expenses and employee benefits. For example, between payroll taxes, training, and paid time off, let’s assume an additional annual cost of $6,000. 

Assuming your hourly and salaried employees get the same benefits, the annual cost of your hourly wage worker is now $37,032, and the cost of your salaried worker is $91,000. 

4. Calculate the hourly labor rate

For hourly wage workers, it’s helpful to calculate the actual hourly labor cost. The cost formula is the annual labor cost divided by hours worked per year. The calculation would look like this: $37,032 ÷ 1,724 = $21.48. 

Percentage formulas for determining labor costs

You can easily learn how to calculate labor costs with a labor cost percentage formula. There are two primary formulas: percentage of sales and percentage of operating costs. Here’s why each one is important and how you can calculate them:

Total sales percentage formula

This calculation determines what portion of sales revenue is consumed by labor costs. It helps you set competitive pricing strategies and evaluate how labor expenses impact profit. Companies that clearly understand total sales percentages can adjust pricing and sales strategies to ensure profitability.

To calculate the percentage of sales allocated to labor costs, divide the total labor cost by the total sales. Then, multiply by 100.

Total operating costs percentage formula

This calculation provides a broad view of how labor costs fit within overall operational expenditures. It’s useful for budget management and cost control, helping businesses improve efficiency and better leverage their workforce. 

To calculate the percentage of operating costs that go toward labor, divide the total labor cost by operating costs. Then, multiply by 100. 

Reducing labor costs 

If direct and indirect labor costs take up a significant chunk of your budget, it’s wise to strategize new payroll efficiencies. Here are three ideas to consider:

Tackle chronic absenteeism

Absenteeism can occur for numerous reasons, including personal health issues, family needs, or poor job satisfaction. First, determine the cause and develop strategies to tackle the problem directly. For personal issues, remote or hybrid work arrangements can alleviate the situation, whereas poor job satisfaction indicates the need to strengthen company culture. 

Set up remote and hybrid work opportunities

No matter the size of your business, traditional office spaces incur overhead costs. From rent and utility costs to office supplies and maintenance, physical spaces chip away at your budget. Remote work setups lower overhead costs and can boost profitability in other ways (e.g., enhanced employee satisfaction and productivity, reduced turnover, and reduced recruitment costs).

Use workforce analytics

Data-driven analytical tools monitor performance and productivity to help you understand employee output, scheduling, and workload. Organizational knowledge contributes to various improvement efforts, whether optimizing labor resources, developing new hiring strategies, or identifying budgetary pain points.

Get expert support to manage labor costs

Your workforce is your greatest asset. With expert collaborators, you can ensure it’s not an undue cost. Oyster’s automated solutions give you detailed insights into every aspect of labor expenses, allowing you to manage your workforce expenses with precision. Learn more about Oyster’s EOR services to find out how it can transform your talent strategy.

About Oyster

Oyster is a global employment platform designed to enable visionary HR leaders to find, engage, pay, manage, develop, and take care of a thriving distributed workforce. Oyster lets growing companies give valued international team members the experience they deserve, without the usual headaches and expense.

Oyster enables hiring anywhere in the world—with reliable, compliant payroll, and great local benefits and perks.