How to Manage High Labor Costs

Labor costs are on the rise. Unfortunately, if not carefully managed, these rising costs can hurt a business’s bottom line. However, with a careful understanding and management of how to manage high labor costs, this doesn’t have to be the case, and businesses can still thrive while competing in today’s markets. 

What are labor costs?

Labor costs are all the costs associated with an employee. For example, this would include the employee’s wages and benefits and payroll taxes. Generally, wages and salaries account for around 70% of compensation, and benefits and taxes make up about 30% of compensation. This is important to know because if you hired someone and offered them a starting salary of $100,000, that would only account for 70% of their compensation, and your business would actually be paying out just under $143,000 total for that employee ($100,000 in wages and $42,857 in taxes and benefits).  

Why is labor cost important?

In addition to solving customers’ problems, one of the main goals of a business is to make a profit. Labor plays an important role in every business because it helps businesses provide products and services to their customers. Labor costs are important to understand and manage because they affect a business’s bottom line.

For example, understanding labor costs can help you make critical business decisions such as establishing and updating your pricing. If labor costs go up, you may want to consider increasing the price of your products or services. If you don’t, there’s a chance that your profit will go down. 

What is the average labor cost?

According to the Bureau of Labor Statistics, the average cost of employee compensation in the US averaged $38.07 per hour worked as of December 2021. Wages and salaries accounted for 70.5% of the costs, while benefits accounted for 29.5%. However, averages did vary by geographic location. For example, the Northeast had the highest labor cost averages, and the South had the lowest labor cost averages. 

What should labor costs be for a business?

Labor costs vary by industry. However, a general rule of thumb is that labor costs should be around 20-35% of gross sales. 

How to determine labor costs

Labor costs are the total salary or wages for an employee plus the cost of their benefits plus their taxes. This formula may be helpful for visualizing: labor costs = wage (W) + taxes (T) + benefits (B).

How to calculate unit labor costs

If you sell a physical item, it may be helpful to calculate unit labor costs which is the cost of labor per unit. In its simplest form, your unit labor cost is the total labor costs divided by the number of units produced over a period. For example, if you manufactured 1,000 products (also known as units) in a month, and your labor costs were $10,000 for that month, your unit labor cost would be $10 ($10,000/1,000).

Why are labor costs rising?

Many factors contribute to the rising labor costs. One is that many people left the workforce during the pandemic to care for children and to avoid the health risks they were exposed to while working. Government assistance helped fuel this “great resignation,” as many people could survive with the unemployment benefits they were receiving and didn’t need to work. Now, there’s a mismatch between the supply and demand of jobs. For example, there are more open positions in certain industries than there are people looking for jobs. For employers to compete for the few workers willing to fill these open positions, they are enticing potential employees with higher compensation which helps fuel the rising labor costs. 

How to Reduce Labor Costs

Now that you understand labor costs, you’re probably wondering how to reduce them. Here are five tips on reducing labor costs without cutting your workforce.

1. Carefully Track Employee Hours

One of the easiest ways to reduce labor costs is to carefully track your employee hours since mistakes in time tracking can add up and negatively impact your bottom line. When you use manual timesheets, it’s easy to add or leave off hours worked accidentally. A physical time clock or application with location stamping is generally better as employees won’t get paid automatically for hours they didn’t work if they showed up late or left early. You’ll also make sure employees don’t go underpaid for forgetting to fill in a timesheet manually.

2. Avoid overtime

As much as we wish we could reduce the costs of taxes, that is something we have little control over. However, you can avoid employees working overtime with careful management and scheduling. Keeping overtime to a minimum can help reduce costs.

3. Strategically Schedule Employees

If you often have too many employees and not enough customers, it may be time for you to look for ways to schedule employees more strategically. For example, you can review your company’s data to see if you can predict days when you will be busy (and need more staff) and days when you will be slow (and can understaff and save on costs).

4. Leverage Incentives

Incentives like bonuses are a great way to incentivize employees to do their best work. It’s recommended to base bonus plans on measurable performance metrics like profitability to make them work for you. When your goals and your employees goals are aligned, the result can be higher profitability and lower costs.

5. Reduce Employee Turnover

Often the highest employee costs come at the beginning of the employment relationship when you first hire someone. New employees need training before they can work independently, which can incur a high cost. If you find yourself hiring and training new people often these costs can begin to add up. Therefore, to reduce training costs, work to keep your employees engaged and happy. It can help to have management pull together data on employee retention and then work to increase the average months or years each employee stays at your company. 

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