Skip to main content

«  View All Posts

How to Break Down Labor Costs for Small Business

March 15th, 2024 | 4 min. read

By Mike Shaeffer

Do you really know what it costs to run your business, especially when it comes to paying your team? Many business owners get the big picture but find it tough to figure out exactly what their employees cost them. This lack of clarity can make critical decisions, like pricing and operational improvements, feel like shots in the dark.

So, how do you demystify labor costs for small businesses? At Patrick Accounting, we’re good at making complicated things simple, especially when it comes to understanding what your team costs you. We’ve helped hundreds of business owners get a clear picture of their labor costs, and we’ll show you exactly how to see what your team is costing you to help empower you to make smarter decisions for your business.

What Are My Labor Costs?

It’s a two-part breakdown:

  1. Direct Labor Costs

Direct labor costs are tied directly to producing goods or services – like paying a crew in a lawn care business. For instance, imagine you pay your three crew members $20 an hour and they complete 2 yards per day. This means your direct labor cost per project is $240. Why does this matter? Because it directly impacts your profitability.

If your pricing for a project is under $240, you’re not covering your direct labor costs and end up trimming away at your profits. The money you spend on your crew should be reflected in how you price your services, ensuring each project contributes positively to your business’s prosperity.

  1. Indirect Labor Costs

Indirect labor costs, as you can imagine, are the costs not directly related to producing the goods or services you are selling. Suppose you’ve hired a marketing team to make sure your clients recognize how exceptional your landscaping services are.

If your receptionist is earning $45,000 a year, you’re covering that expense whether you complete one project or a hundred. These wages are indirectly related to the production of your services but are indispensable for keeping your landscaping business thriving.

The Significance of Breaking Down Your Labor Costs

What Does It 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’re like many small business owners, you may not easily know the labor cost that goes into the production of the goods and services you provide.

Start by breaking down the labor for each role in your organization and assigning them to the appropriate department or 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 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.

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.

Why It’s Important

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.

Let’s revisit our lawn care company scenario. Assume you’re the General Manager who is responsible for running a profitable operation. You review the financials and find that your landscaping crew costs $125,000 per year. Your sales and marketing team, which helps bring in the landscaping projects, costs $150,000 annually, and you have an administrative support role costing $45,000 per year. This adds up to a total labor cost of $320,000 annually.

If your company completes 2,000 landscaping projects a year at an average charge of $300 per project, the total annual revenue is $600,000. By comparing the revenue to the labor costs, you notice that labor consumes a significant portion of your income. This prompts you to think: how can we optimize our labor costs or adjust our pricing to maximize profitability?

How It Impacts Your Overall Operation

Understanding these costs helps you make informed decisions about pricing your services and managing your team’s efficiency. It also sheds light on opportunities for restructuring – for instance, performance-based pay for your crew members or tying the sales and marketing team’s compensation to the revenue they generate. Addressing these aspects of labor cost management allows your business to align roles more effectively, enhance performance, and ultimately, increase profitability.

While there are additional factors at play that contribute to potential financial challenges, 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 an area to implement tweaks that can motivate and incentivize the team, propelling them toward the achievement of common goals.

The Importance of Accurate Labor Data

Acquiring accurate labor data can pose a challenge for many small businesses. Why? Imagine managing labor like driving a car: You need to monitor it in real-time, like watching the road ahead, and also review it after the fact, similar to checking the rearview mirror, to ensure it aligns with your financial records.

The challenge comes when different departments like operations, HR, finance, and accounting aren’t well-coordinated, making it hard to gather and analyze labor data efficiently. However, the advantage for small businesses is that these roles are often handled by just one person or a small team, which can simplify data collection and management.

Now, Where to Begin?

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.

Thinking about how much you spend on labor? It might seem complicated, but getting a handle on these costs can really help your business make more money. If you’re wondering what to do next, we’re here to help. Take a look at How Labor Cost Impacts Your Profitability to learn how you can start making smarter choices for your business’s future.