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Understanding Your Labor Costs 

December 15th, 2023 | 4 min. read

By Mike Shaeffer

Ever felt like you're running a business blindfolded when it comes to knowing your real labor costs? You're not alone. Many of our clients have a handle on their workforce and the general employee expenses, but drawing the line at actual labor costs? Not so much. This fog of uncertainty often leaves business owners feeling like they're playing a guessing game in the dark, especially when it comes to pricing, adjustments, and process improvements.  

So, the question is how do you go about unraveling the mystery of your labor costs? Well, that's precisely where we aim to shed some light. Let’s start by breaking down your labor costs, which not only provides clarity but also the empowerment to make informed decisions that can significantly impact your business's bottom line. 

What Are My Labor Costs?  

It's a two-part breakdown: Direct and Indirect.  

Direct labor costs are tied directly to producing goods or services – like paying a baker in a bakery. For instance, if a baker makes 100 cookies at $20 per hour, that's a direct labor cost of $0.20 per cookie. You can see the importance of understanding this because if I’m only charging $.15 per cookie, I’m losing money! The cost I’m paying for that baker is directly attributed to the cost of the cookie being produced. 

Indirect labor costs, as you can imagine, are the costs indirectly related to producing the goods or services you are selling. To continue the bakery example, if I hire a marketing team to let my potential buyers know how awesome my cookies are, I have to pay my marketing team regardless of the production of my cookies. If my marketing manager is making $75,000 per year, I have to pay that person regardless of whether I make 1 cookie or 1000 cookies! The wages I’m paying my marketing manager are indirectly related to the production of my cookies. 

What Does It All Mean?  

While the principle holds true, the example above is an oversimplification of understanding real-life labor costs but does present a great place to start! If you are like many small business leaders, you may not easily know the labor cost that goes into the production of the goods and services you provide. 

I would encourage you to start by breaking down the labor for each role in your organization and assigning 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 be 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 by them. Once you have an idea of your direct and indirect labor, you can dive into pricing, profitability, margins, capacity, and the myriad challenges associated with labor. 

Why It’s Important 

Now, let's revisit our bakery scenario. Imagine you've assumed the role of General Manager and are responsible for running a profitable operation. In looking into the financials, you discover three bakers costing $150,000 per year, a sales and marketing team with an annual expense of $150,000, and an administrative support role at $45,000 per year – summing up to a total labor cost of $345,000 annually. With the bakery churning out 100,000 cookies a year at $3 per cookie, it becomes apparent that the numbers don't add up. You ask yourself; how do we fix it? 

Understanding your labor costs provides a roadmap to pinpoint where the labor distribution might be unbalanced. It also offers insights into potential restructuring – for example paying bakers based on production volume or shifting the sales and marketing team to a percentage-of-sales compensation model. By addressing these nuances in labor cost management, businesses can strategically align roles, optimize performance, and ultimately boost their overall profitability.  

While there are additional factors at play contributing to the financial challenges in my bakery, it's worth noting that, in most businesses, personnel costs represent a substantial portion of overall expenses. If you want to find out how much hiring a new employee actually costs, we’ve got some answers for you here. This category not only commands a substantial portion of your budget but also offers a prime opportunity for strategic adjustments. It serves as a key area to implement tweaks that can motivate and incentivize the team, propelling them toward the achievement of common goals.  

Making Sure Your Data is Accurate  

Now, let's take a step back. Acquiring accurate labor data can pose a challenge for many small businesses. Why? Picture labor as something best managed in real-time during scheduling (like looking through a windshield) and reviewed retrospectively during payroll processing (like glancing in the rearview mirror), ultimately surfacing in your financial statements. The difficulty arises when operations, HR, finance, and accounting aren't synchronized—getting accurate, timely labor data becomes a cumbersome task. Fortunately, in small businesses, all these functions typically rest in the hands of one person or a small team, streamlining the process.  

Where to Actually Start 

First, grab a coffee and make a list of all the job titles in your organization, and make sure those same job titles are appropriately set up within your payroll systems. This alignment allows for the precise tracking of labor costs on a per-job basis within these systems.  

Now, with your coffee-fueled list in hand, the next step is to make sure the labor data in your payroll system flows seamlessly into your accounting system, ideally in as close to real-time as possible. Lastly, make sure the people responsible for your operations have access to all this data so that they can make informed decisions on a daily or weekly basis that can impact the overall goals of your organization. 

Your business may not have come with an owner's manual, but we're here to provide the next best thing. If you’re grappling to understand the intricate details of your labor costs, then schedule a 15-minute call with our team so we can help you turn those complexities into opportunities for your business success.