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How labor cost impacts your profitability

October 7th, 2022 | 4 min. read

By Matt Patrick

Like a number of our clients, we are a service-based business. Our ability to be profitable is based on our knowledge and technology, but most importantly, is tied to our team or labor costs. Almost all service-based businesses fall into this category. Labor costs are the most critical and highest expenses we incur, and are truly not even close to any of the other costs we have. If you are a product-based business like a contractor or a retail store, this may not be the case. But it’s likely that labor is still probably 2nd on your list of highest expenses.  

We often see that many of our clients don’t really know their true labor costs. They know the people they need to get all of the work done. They also know that many costs go into having employees. But knowing their actual labor costs? Not likely. And this uncertainty can lead to business owners feeling like they are guessing in the dark to determine things like price, adjustments, and how to make improvements to their process.   

So how do you go about breaking down your labor cost? Here’s where you should start. 

Get educated on all the items that may or may not be tied to labor costs. 

In general, labor costs can fall into a couple of categories. The first is the actual salary and wages, the second is the cost of having employees (such as payroll taxes and employee benefit costs), and the third is the cost of managing all of the things. Technology, automobile expenses, training, computers, software licenses, overhead, and, and, and…you know, all the things.   

Having employees is expensive. The employees not being productive is even more expensive. When you misunderstand how to separate your labor costs into appropriate categories, it can be difficult to tell where your extra expenses are coming from. Unfortunately, this is not uncommon for business owners. Employee costs are lumped together with payroll taxes, insurance and benefits aren’t always being recorded right, payroll isn’t being accounted for in the same period as the evaluated revenue...  and most of the time, all labor is placed in one category as opposed to separating labor by grouping (we often call them “departments” in our office conversations). This is a problem because it prevents an owner from seeing the different costs associated with their production labor versus administrative labor versus the owner’s labor. Lumping all labor costs together doesn't provide any helpful data that a decision-maker can actually use when evaluating the overall labor costs. In turn, this makes it very difficult to see that each labor category is generating the amount of revenue it should. 

This is why I suggest you begin here. Take the time to understand the roles of everyone on your team and assign them to the appropriate department/category. A good baseline for your categories includes these three buckets: production labor, administrative labor, and owner labor costs. When you do this, make sure the associated costs for each group – like payroll taxes for the people that are in that group and any direct employee expenses – are also appropriately tracked. 

To set yourself up with even better data long-term, you can then break down production labor further as you see fit. For example, a restaurant owner may split their production labor into front of house and back of house. This could be kitchen, bar, hostess, management, etc...  For other businesses, you may want to break down administrative labor. Possible categories for this could look like separating customer support, sales, and marketing teammates. Breaking down sales and marketing labor costs will specifically allow you to understand your cost of revenue acquisition. How much revenue is needed to determine the effectiveness of the sales and marketing team? 

In general, choose categories that matter to you so you can collect data that will accurately match revenue to the people creating or producing it. This will allow you to understand the productivity of your team and the efficiencies that are being created them. Next, it’s time to look at direct costs.  

Determine the direct costs of each team/category of employees.  

Once you have your labor broken down by department, it’s time to dig into the direct costs a little deeper. Let’s take sales & marketing—they may have travel costs, expense reimbursements, and training costs. If we are producing $5 profit for every $1 spent on sales and marketing costs, this may be something we want to put more money into. On the other hand, if it takes us 7 years to make a new customer profitable because our sales and marketing costs are so high, we may need to change how we are selling or, more specifically, we need to change who is selling. We can’t make these type of decisions without data.   

For you to understand the levers you need to pull or push, you have to have the data to give you the insight.  Let’s say you realize, “Hmm… I’m spending $$$ on training for my sales team, but their close rates are so slow that it’s negatively impacting our ROI.” That is a key insight that should inform how you proceed. Are you going to hire more seasoned salesmen or revamp your training process to make it more efficient and cost-effective? Knowing your detailed labor cost data helps you make better decisions for your business. 

Overall Takeaways 

Understanding the true breakdown of your labor costs gives your incredible insight into your business. Start by separating employees into the three simple categories (production labor, administrative labor, and owner’s labor) and then continue to break down the specific costs associated with those employees as needed. In general, you can look to the industry-specific rules of thumb as to how much labor costs should for your business. For a service-based business without a product, I would expect production labor to be 35-40% of my revenue. For a product-based business, labor cost should be closer to 20-25%. If you are especially fast-growing or trying to open a new location, your labor costs may be 100% of revenue growth. This is not a good long-term strategy, but is all the more reason to understand how your costs break down so you can make adjustments as you’re able to. 

There is no perfect answer for every business, but understanding the levers to pull, putting people into the appropriate departments, and evaluating your results is critical to impact your profitability. If you have questions about how to get started with this process, please reach out and book a call with our team.