How To Calculate Labor Cost Percentage

Imagine finding extra profit hidden within your existing operations. This isn't just a daydream — it's a tangible benefit for business owners who learn the nuances of managing their labor cost percentage effectively.

Labor typically represents the largest expenditure in most businesses, sometimes devouring 35% or more of total revenue. In industries where manual labor is a major component, (such as construction or retail) this percentage can be even higher. No matter how you split it, labor has a significant impact on any organization’s profitability.

Many businesses, in their quest to control costs, resort to “easy” strategies like reducing hours or cutting wages. But, these approaches can lead to decreased employee engagement and productivity, ultimately harming the business more than helping it.

Understanding and managing the labor cost percentage goes beyond cutting costs — to optimizing spending and developing processes that enhance efficiency in the right ways. Effective management of this crucial metric can boost profit margins and foster an engaged and productive workforce.

So, what's the secret to mastering your biggest expense? The first step is understanding it. Let’s take a look at how to calculate labor cost percentage and strategies you can use to keep this key metric under control according to industry standards.

What Is Labor Cost?

Labor cost, essentially, is the amount of money required to pay for labor to run your organization. When most people think of labor costs, they think of wages (hourly or salary — the literal money earned on a paycheck). However, labor costs encompass more than wages. Other parts include:

Social Security Tax: Employers must contribute to Social Security, a mandatory federal program.
Benefits: These can include health insurance, retirement plans, and other perks that contribute to an employee’s total compensation.
Vacation Time/PTO: Paid time off for holidays, vacation, or illness also represents a cost to the company.
Equipment and Training: While not a direct part of labor costs, investing in employee training and necessary equipment can also be considered when calculating total labor investment.

Labor Cost Percentage Formula

To understand the efficiency of labor spending, businesses use the labor cost percentage formula:

Labor Cost Percentage = (Total Labor Cost / Total Sales) × 100

Ideally, the resulting percentage should range between 25% and 35% to ensure profitability without undermining the effectiveness of your workforce. However, in certain industries or business models, this may be higher or lower.

At first glance, this formula may seem simple, but the challenge comes in understanding the total labor cost itself. Here are a few important factors to consider to understand that cost:

Fixed vs. Variable Cost

Labor costs take various forms. To make it simple, we can categorize them into fixed and variable expenses. Each will impact budgeting and financial planning differently.

Fixed costs, such as salaries, are mostly consistent when overtime is managed effectively. Costs like this provide a stable framework for forecasting expenses. These are most common in white-collar industries, where positions are often assigned static salaries. This kind of compensation model can make labor costs a bit easier to calculate since change is less frequent.
Variable costs are less predictable and may include overtime, and payments to independent contractors or seasonal workers. They may also include discretionary bonuses given at various times. Variable costs are most common in industries like retail and hospitality, where a large percentage of employees make hourly wages that can change weekly.

In any industry, you’re bound to have a mix of both fixed and variable labor costs. The better you can determine the general financial model for these costs, the better you’ll be able to calculate the true labor cost percentage.

Average Variable Cost

Depending on your industry, total labor costs can fluctuate daily. But without a relatively solid figure, planning for labor costs at scale can be difficult. Average variable cost is one metric organizations use to better understand the total labor cost in direct relation to production.

While not the most common way to understand labor cost percentage, it is helpful to think backward from what actually produces revenue.

Step 1: Identify Variable Labor Costs

Variable labor costs are expenses that fluctuate based on the level of production or business activity. Examples include:

Overtime Pay: Extra wages paid for work beyond the standard 40 hours. Rules for calculating overtime may vary slightly by state along with the minimum wage.
Seasonal Worker Pay: Wages paid to temporary employees hired during peak times.
Bonuses and Incentives: Performance-based, or discretionary payments that vary.
Freelancers/Contractors: Payments to independent contractors hired for specific projects or periods.

Step 2: Calculate Total Variable Labor Costs

Add up all the variable labor costs for a specific period (e.g., monthly). For example:

Overtime Pay: $10,000
Seasonal Worker Pay: $8,000
Bonuses: $5,000
Freelancers/Contractors: $7,000

Total Variable Labor Costs = $10,000 + $8,000 + $5,000 + $7,000 = $30,000 in a month.

Step 3: Determine the Total Output

Identify the total output during a given period, such as the number of units produced or services provided. For instance, if a manufacturing company produces 1,000 units in a month, the total output is 1,000 units.

For service-based businesses like restaurants or creative agencies, output can be quantified by the hours of adequate work performed. In that, it’s important to define what constitutes "adequate" work. This will make it easier to calculate the cost of each service hour later on. In a busy restaurant during lunchtime, adequate staffing requires multiple employees to maintain service levels. However, during an after-hours shift there is lower demand, meaning you won’t need as many employees to provide adequate service. Determining the adequate service level is a key metric for calculating total output in these cases.

For example, you might discover that one successful day of adequate service level at your restaurant requires 72 billable hours of work (across all employees). You could consider your total output (which would be about 2160 averaged over 30 days). However, this gets more complicated as service levels may be different for each day of the week. You may also bolster this with other metrics like projects completed, people served, services sold, etc.

Step 4: Calculate Average Variable Cost

Divide the total variable labor costs by the total output to find the average variable cost per unit.

Average Variable Cost (AVC) = Total Variable Labor Costs / Total Output

Using the example numbers: AVC = $30,000 / 1,000 units = $30 per unit

The average variable cost for the value you produce as a company is $30 per unit. This metric is useful for understanding how individual position salaries affect labor cost percentage on a larger scale. If you control the average variable labor cost for individuals, you can better control the total labor cost without large impersonal actions aimed at forcibly lowering expenses (i.e. layoffs, pay cuts, etc.).

Understanding Total Labor Cost Percentage

Now, let's connect this to the labor cost percentage for a clearer picture of company financials.

Step 1: Calculate Total Labor Cost

Add fixed and variable labor costs to get total labor costs. For instance:

Fixed Salaries: $50,000
Total Variable Labor Costs: $30,000

Total Labor Cost = Fixed Salaries + Total Variable Labor Costs = $50,000 + $30,000 = $80,000

Step 2: Determine Total Sales

Identify the total sales revenue for the same period. For example, let’s say the total sales revenue is $300,000.

Step 3: Calculate Labor Cost Percentage

Finally, use the labor cost percentage formula to find the proportion of revenue spent on labor.

Labor Cost Percentage = (Total Labor Cost / Total Sales) × 100
Using the example numbers: Labor Cost Percentage = ($80,000 / $300,000) × 100 = 26.67%

Why Is Labor Cost Percentage Important?

Calculating labor cost percentage is crucial for many reasons. Here are a few to consider:

Labor Is Expensive: Labor costs are a pivotal aspect of your business's financial health. In most organizations, labor represents the most significant expense. Managing these costs effectively helps maximize the value of your biggest investment (within reasonable limits). It’s the first step to assessing employee utilization, engagement, and several other workforce-related analytics.
Labor Determines Profit: This metric directly influences profitability. Accurate labor cost management can mean the difference between a struggling or a thriving business. It’s a fundamental indicator of success, impacting various operational aspects and strategic decisions.
Labor Cost Percentage Is a Strategic Metric: Labor cost analysis is crucial for human capital management. It provides the visibility needed to make informed decisions and better plan for future expenses. Given that labor costs fluctuate, detailed insights allow for more precise forecasting and adjustment, ensuring that labor investments contribute positively to your organization's goals. In other words, when you can accurately measure this metric, you can make strategic decisions around improving it.

Calculating Labor Cost Percentage

Understanding labor cost percentage is critical for assessing the financial health of your business. Here are three calculation examples:

Example 1 (Probably Too High)

Total Sales: $500,000
Total Labor Costs: $200,000
Calculation: (500,000 / 200,000) × 100 = 40%

A 40% labor cost percentage is often indicative of excessive spending relative to revenue. It may suggest inefficiencies in labor use, depending on your industry and business model. However, in many service-based industries (where the service itself is the profit-driving output), 40% may be normal.

Example 2 (Abnormally Low)

Total Sales: $1,000,000
Total Labor Costs: $100,000
Calculation: (1,000,000 / 100,000) x 100 = 10%

While a 10% labor cost percentage might signal a highly efficient business model or superior sales strategy, it could also mean you’re underpaying your employees. If your labor costs are this low, it warrants further analysis. Look at other metrics around turnover or engagement for a clearer picture.

Example 3 (Just Right)

Total Sales: $700,000
Total Labor Costs: $180,000
Calculation: (700,000 / 180,000) x 100 = 25.7%

A labor cost percentage of around 25.7% is typically optimal. This balances cost control with sufficient investment in your workforce to maintain ethical practices, effective motivation, and engagement.

How To Keep Labor Cost Percentage Down

Managing labor costs effectively is crucial for maintaining a profitable business. However, reducing these costs goes beyond cutting hours or wages. In fact, using strategic methods to keep labor costs down (without compromising the efficiency or morale of your workforce) is often more effective than “obvious” solutions.

What NOT To Do

When companies try to reduce labor cost percentage, it’s tempting to do one of the following:

Reduce Hours Across the Board: Cutting hours can seem straightforward, but this can easily lead to inefficiency and underutilization of employees. At the same time, if productivity remains unaffected by fewer hours, it might indicate existing inefficiencies that need to be addressed (rather than across-the-board cuts).
Pay Lower Wages: If you can do this without breaking any wage laws, it may reduce costs in the short term. However, this “strategy” is fraught with potential downsides that often outweigh the immediate financial benefits. Lowering wages can severely harm employee morale and engagement, leading to higher turnover and less productivity from the few employees who stick around after the cut. What’s worse, this problem often has a compounding effect, making it challenging to attract and retain great talent to run your business at all.

These are often the “obvious” solutions to a high labor cost percentage issue. Now, let’s look at a few alternative strategies for controlling this metric that can actually work.

Analyze Labor/Scheduling Needs

Before you make any changes, you need to establish a good baseline. Start by generating and analyzing a variety of labor reports to learn how effectively your workforce is being utilized. These insights can help you make informed decisions about scheduling, workflows, and much more. You might also be able to reduce hours in overstaffed areas and boost staffing in busier zones to optimize labor allocation.

From there, you can adjust staffing based on demand. Accurate analysis may reveal the need to reallocate employees from underutilized shifts to busier periods, ensuring labor costs align more closely with actual productivity demands.

Hire More Employees

This may appear counterproductive at first. After all, wouldn’t hiring additional staff increase costs? Yes, but it can actually be more cost-effective. If you have fewer employees to cover the same work, some of those employees are bound to work overtime, which costs more than regular wages (most often 1.5x the regular rate of pay). Instead, hiring more people to cover that extra work can reduce your labor cost per hour.

Track Time

Tracking time and labor can significantly reduce labor costs by improving productivity and accountability. While process improvements for tracked/utilized labor can yield decent returns, it’s often more effective to reduce lost time (or time that isn’t directly attributed to production).

For instance, consider a retail business. Making a production-related process more efficient (e.g. streamlining a checkout process) can produce a decent ROI. However, consider how much time it takes to close up the store, file paperwork, or process payroll for employees. These do not directly drive profit. It’s better to improve the use of time overall and reduce these sorts of admin tasks so that more of that paid time goes toward profit-driving production. Comprehensive time-tracking systems provide the visibility needed to identify and eliminate wasteful tasks, leading to significant labor cost reductions.

Develop Training To Improve Utilization

Many organizations overuse key employees (while not relying enough on others). This means that for any shift requiring a special skill, you have fewer employees you can schedule. Similar to the understaffing problem, greater dependency on fewer individuals usually means paying overtime, which is more expensive than regular wages. It may also lead to burnout or resignations — putting the team in a worse position than before.

By broadening the skill set of your workforce, you can reduce dependency on key individuals, which helps evenly distribute workloads. The more people you can assign to any task, the more flexibility you have in scheduling to avoid overtime.

To do this, you’ll need to invest in training, lower the barrier to participate in that training, and incentivize employees to learn new skills. Building comprehensive training programs is a great first step, but it's also a good idea to invest in a software platform that makes it easy to access that training virtually, where possible. The less managerial oversight here, the better. To incentivize participation, you might also create career frameworks to show how training can lead to a promotion or create a reward structure for learning new skills. You can easily see how the broader human capital management strategy is already beginning to form here.

Labor Cost Allocation: How To Connect Work to Financials

Labor cost percentage is a very important metric, but it’s only part of the larger portrait of data analytics you need to manage your workforce effectively. Understanding the full implications of labor costs requires meticulous allocation to specific projects for enhanced financial tracking. This is vital for several reasons:

Detailed Cost Analysis: Financial teams need to grasp the fully burdened cost of each employee, which includes wages, benefits, and other compensations.
Wage Variability: Employees across different departments and positions earn varied wages and benefits. Recognizing the cost implications of these variances is crucial for accurate budgeting and forecasting.
Project and Location Variables: Allocating costs to projects includes accounting for variables like location, which may affect costs due to differing union wages, tax rates, and other regional expenses.

However, reporting on such detailed data across multiple dimensions of your business is often too much for any one platform to handle. Most workforce management platforms don’t integrate payroll, project management, and financial data effectively. You will likely need to adopt separate platforms for different aspects of financial management — but then, how do you connect all the databases to generate accurate reports?

To address these challenges, Criterion HCM offers an open API to connect your HR, scheduling, payroll, and talent management data to your ERP and project management platforms (as well as many others). In fact, we’ve already developed integrations with popular solutions like Microsoft Dynamics, Sage Intacct, Procore, Acumatica, TrackTik, Unanet, and many others, allowing organizations to develop unique custom reports about virtually any field in any system. All of this enables greater visibility and insights which lead to better strategic decisions.

Final Thoughts

Labor cost percentage is a critical metric that impacts the proportion of your revenue that becomes profit. While eliminating labor costs entirely isn’t possible (or advisable), strategic human capital management can keep these costs under control, making sure your business continues to grow and profit.

At the same time, managing labor cost percentage is incredibly challenging without the right tools. Modern businesses that excel in this area leverage advanced workforce management technology to make informed, data-driven decisions that optimize labor at several points.

Criterion HCM is designed to enhance workforce management by streamlining essential business tasks. Our platform empowers your business to tackle your most significant labor challenges by:

Automating complex payroll processes
Streamlining administrative workflows
Managing comprehensive employee and HR data
Creating engaging employee experiences
Developing custom training and onboarding programs
And much more

Ready to achieve better control over your labor and other key HR metrics? Book a Criterion Demo to discover how our HCM solution can help your business improve in virtually every way.