Businesses come with numerous expenses which entrepreneurs must understand for effective management. Learning what to spend money on makes budget allocation a less complicated process and improves accountability. Cost of labor is such an expense.

This cost is what a company spends to recruit, train, and manage employees. Labor costs include the wages, benefits, and taxes that an enterprise pays its workers during a specified period. Many aspects influence the cost of labor because businesses operate differently. Understanding the elements that constitute labor costs is essential for every entrepreneur because companies spend almost 70% of their budgets on it.

What You Should Know: 5 Sides of the Cost of Labor

1. Direct Cost of Labor

These expenses are some of the major components of labor costs. Direct costs are those that a company can track to a specific product or service. For example, a worker who paints cabinets in a furniture making company or a cashier in a retail store generate direct expenses. The costs involved in this category are not just the wages paid to employees. They also include:

  • Medical insurance;
  • Workers compensation;
  • Life insurance;
  • Payroll tax;
  • Pension contribution;
  • Any other benefits the company offers.

Direct cost of labor is an element that companies look at when pricing their products. Together with the direct cost of materials, these expenditures allow you to calculate how much is spent on producing an individual product or delivering a service. You can use different methods to come up with direct labor costs in an enterprise. Employers can use direct labor hours to arrive at the cost of labor. They do this by monitoring the hours an employee spends on a certain job. In instances where workers are responsible for creating goods in large quantities, conversion techniques are necessary to assign equal costs to each product.

2. Indirect Cost of Labor

Costs that cannot tie to a particular production process fall into the indirect cost category. Employees play a lot of supporting roles before a product can reach store shelves:

  • Accounting team puts together the budget for your production processes;
  • Marketers create campaigns to promote the finished goods;
  • Manager supervises a team of workers.

The money spent on these people come as indirect labor cost.

Indirect labor does not have an immediate influence on production. General and administrative positions are some of the areas where indirect labor costs occur. Distinguishing between the direct and indirect cost of labor is not always easy. But it is necessary. Some of the expenditures that a company associates with production or service delivery may appear direct, but there may be no discernible way to trace them.

Take overtime expenses, for instance. In cases where an employee clocks in more hours than necessary because a job was urgent or involved more effort than initially thought, then the overtime pay falls into the indirect labor costs category. Indirect labor costs are considered overhead – ongoing costs of operating an enterprise – and should always be treated as such.

3. Variable Cost of Labor

Another factor that makes up the cost of labor when running a company is the variable expense. Variable labor costs fluctuate with the production process meaning that there is no standard rate. When the production in an organization goes up, these costs rise with them and go down when production is low.

Temporary workers are some of the common determinants of variable cost of labor. Enterprises sometimes hire employees on a short-term basis to complete a project or cut back on expenses. The wages you pay your temporary workers are not constant because they depend on how many people you require for specific projects and how long you need them for. Small business enterprises are fond of variable labor due to its efficiency in meeting the bottom-line.

Overtime wages are other popular variable expenses. From manufacturing to retailing to services, all kinds of companies have some variable labor costs. The simplest way to identify a variable cost of labor in your business is to look for the expenses that go away if you stop operations for a day.

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4. Fixed Cost of Labor

On the flip side, some expenditures remain constant whether your production is at 90% or 60%. So, these qualify as fixed labor costs.

  • Examples of costs that classify into this group are the salaries paid to the management team. CEOs, directors, and managers as a salary that doesn’t change regardless of the output.
  • It doesn’t matter if a supervisor put in 60 hours a week or 50 hours towards the completion of a project, at the end of the month, he/she receives the agreed salary. However, if that same manager works over time, then the wages paid would be variable costs.
  • Fixed cost of labor can also be in terms of contracts with other companies. For example, if another small business has a deal to service your production equipment or upgrade your software, then that is a fixed labor cost.

5. Total Labor Costs

A business has to be able to calculate the total cost of labor for the purpose of efficient budgeting.

  • Firstly, you have to look at the number of hours that an employee works in a particular period.
  • Then you have to group workers into wage rates and job titles.
  • When measuring total labor costs, a company has to factor in the burdened and unburdened labor rates. Burdened rates refer to the expenses you shoulder for your whole workforce including insurance, benefits, and taxes.

Unburdened rates involve the wages only. These include regular salaries, vacation pay, sick pay, overtime, bonuses, severance pay, business expense reimbursements, tips, and commissions. Total labor costs depend on many aspects which is why they vary from one enterprise to the next. For instance, your company may be in a state where it has to pay local payroll tax and carry worker’s compensation, which increases your burdened labor rates.

Wrapping Up

Employees are your biggest investment. This makes the cost of labor your most critical expense especially for a growing enterprise. Any services rendered to your business that you have to pay for fall under different categories of labor costs. As with any other transaction in a company, you must keep an eye on your payroll spending, which requires an understanding of the various costs of labor.

Learning how to break down the cost of labor allows a business to minimize wastage by allocating funds where they are necessary.

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