Ever feel like you're running your business blind when it comes to knowing your true labor costs?
It’s one of the most common pain points I hear from small business owners.
You may feel confident about your workforce and payroll in general. But when it comes to calculating and understanding what employees actually cost the business, that’s where those blind spots show up.
This uncertainty often leaves you feeling like you’re playing a guessing game, especially when it comes to pricing, staffing, and process improvements.
And without a clear view of what you’re really spending on your team, it’s next to impossible to make smart decisions about hiring, pricing, and profitability.
In this article, we'll walk through what you need to know about labor costs. You’ll learn the difference between direct and indirect costs, how to organize and track your data, and practical steps you can take to start making better business decisions today.
What Labor Costs Really Mean
Labor costs fall into two main categories that every small business owner needs to understand: direct labor costs and indirect labor costs.
Direct labor costs are tied to production
Direct labor is the cost of wages for employees who directly produce your goods or provide your services.
Think of a baker in a bakery. Their time spent mixing dough and baking cookies is a direct cost of cookie production.
If that baker earns $20 per hour and makes 100 cookies in that hour, your direct labor cost per cookie is $0.20. Understanding this is crucial because if you're only charging $0.15 per cookie, you're losing money on every sale.
Indirect labor costs support your operations
Indirect labor costs are wages for employees who support your business but don't directly create your product or deliver your service.
Using our bakery example, if the bakery has a marketing manager earning $75,000 per year, that is an indirect labor cost. You pay them whether you sell one cookie or 1,000.
These employee expenses are just as important to track because they impact your overall profitability, even though they're not tied to specific production or delivery.
How to Categorize and Organize Labor Costs in Your Business
Knowing the two main types of labor costs is a good start. But to really use this information, you need to organize your workforce into meaningful categories.
The Three Basic Labor Categories
Start by sorting each role in your organization into one of these three buckets:
- Production Roles. These are the employees directly responsible for creating your product or delivering your service. Include all associated costs like wages, payroll taxes, and benefits.
- Administrative Roles. These team members keep things running and support operations, but they don't directly generate revenue (HR, finance, office managers).
- Owner Compensation. Include your own compensation, whether as salary, distributions, or reinvestment into the business.
Advanced Categorization for Better Insights
Once you have the basics organized, you can refine your categories based on your business type. Here are two examples:
Restaurant Example
- Front-of-house production labor (servers, hosts)
- Back-of-house production labor (kitchen staff, bar)
- Management
- Administrative support
Service Business Example
- Client-facing employees
- Sales and marketing (helps you track cost of acquiring revenue)
- Customer support
- Operations and administration
Choose categories that matter to your business and that reflect the way your business actually works so you can accurately connect the right costs to the right activities. This will help you understand where adjustments may need to be made.
Why Understanding Labor Costs Matters for Your Bottom Line
Let's revisit our bakery scenario with real numbers that demonstrate why labor cost tracking is critical.
Annual Labor Costs:
- Three bakers: $150,000
- Sales and marketing team: $150,000
- Administrative support: $45,000
- Total labor costs: $345,000
Revenue:
- 100,000 cookies per year at $3 each = $300,000
I’m guessing you see the problem?
Your labor costs ($345,000) are eating up more than your entire revenue ($300,000). Without this visibility, you'd never know why your business is struggling to be profitable.
When you understand your labor costs, you can:
- Identify where labor distribution might be unbalanced
- Explore pay structures like performance bonuses or commission
- Make better decisions about hiring, pricing, and capacity
- Align the right roles to the right outcomes to increase profits
For most small businesses, employees represent your largest expense. This makes it both your biggest challenge and your greatest opportunity for improvement.
How to Make Your Labor Cost Data Accurate
Think of managing labor costs like driving a car. To stay on course, you need to watch both the windshield and the rearview mirror. But you can’t drive well if you’re only looking at one.
Scheduling and staffing decisions happen in real time, right in front of you. That’s your windshield view. You’re adjusting as you go to meet the day’s needs.
But your labor costs don’t fully show up until payroll is processed and financial statements are ready. That’s your rearview mirror. By then, the decisions that drove those numbers are already behind you.
To avoid blind spots, you have to connect both views: Watch what’s happening now while also learning from what’s already behind you.
This can be challenging when operations, HR, payroll, and accounting aren’t synced up to give you a 360-degree view. Fortunately, for most small businesses, the same one or two people wear all those hats, which means you can get everyone aligned more easily than you might think.
4 Practical Steps to Start Tracking Labor Costs Better
Step 1: Review your roles
Make a complete list of every job title in your company and make sure they’re set up properly in your payroll system. That way, you can see costs by job type.
Step 2: Connect your systems
Set up your payroll and accounting systems to talk to each other so labor costs feed directly into your financial reports.
Step 3: Share your data
Give managers access to labor cost information so they can make smarter day-to-day staffing decisions.
Step 4: Check your numbers regularly
Schedule monthly reviews to compare labor costs to revenue and look for trends and opportunities for improvement.
Start Taking Control of Your Labor Costs
Understanding and managing your labor costs isn’t just about tracking expenses. It’s also about getting the insights you need to build a profitable, sustainable business.
When you have clear visibility into your team’s costs, you can make smarter business decisions with confidence. Your business may not have come with an owner's manual, but tracking your labor costs is the next best thing.
However, that’s only part of the equation. The bigger question is: How are those labor costs actually impacting your bottom line?
To learn how to connect the dots between labor data and the financial health of your business (and what steps to take next), check out our article, “How Labor Cost Impacts Your Profitability.”
And if you’d like help getting a handle on your labor costs today, schedule a quick 15-minute chat with our team. We’ll help you uncover where your biggest opportunities lie.
