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 you make smarter decisions for your business.
What Are My Labor Costs?
Labor costs boil down into two key categories: direct labor costs and indirect labor costs.
1. Direct Labor Costs
These are the costs directly tied to producing your product or service. Think about the crew in a landscaping business. If you’re paying three workers $20 an hour, and they complete two yards per day, your labor cost per project is $240.
Why does this matter? Because it directly impacts your profitability.
If you're charging less than $240 per project,$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, so that each project contributes positively to your business’s prosperity.
2. 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, but are still essential to running a profitable business. Suppose you’ve hired a marketing team to make sure your clients recognize how exceptional your landscaping services are.
If your marketer is earning $45,000 a year, you’re covering that expense whether you complete one landscaping project or a hundred. These wages are indirectly related to the production of your services but are indispensable for keeping your business running smoothly.
How To Turn This Data Into Something Useful
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. Here’s how to start...
Categorize Roles
Break down your workforce into three main buckets:
- Production Labor: Those directly involved in delivering your service or product.
- Administrative Labor: People managing the back office, like HR or finance.
- Owner Labor: Your own contribution to the business.
Within each bucket, track associated costs like payroll taxes and employee benefits. If you’re a restaurant owner, you might split production labor into front-of-house (servers, bartenders) and back-of-house (chefs, dishwashers). In other businesses, administrative labor might be broken into customer support, sales, and marketing roles.
Match Costs to Revenue
Once you’ve categorized your labor, align these costs with the revenue they generate. This allows you to measure productivity, identify inefficiencies, and make adjustments to optimize your team’s performance.
How Labor Costs Impact Your Business
Tracking labor data is like driving a car—you need to keep your eyes on the road (real-time data) while also checking your rearview mirror (historical data) to ensure everything aligns.
However, many small businesses struggle with this. Why? Often, operations, HR, and accounting systems don’t communicate well, making it hard to collect and analyze labor data efficiently. But in small businesses, where one person or a small team often wears multiple hats, this process can be simplified.
Let’s look at an example:
Imagine you manage a landscaping business.
- Your landscaping crew costs $125,000 a year.
- Your sales and marketing team costs $150,000.
- Your administrative team costs $45,000.
That’s a total annual labor cost of $320,000.
Now let’s say you complete 2,000 projects a year at an average charge of $300 per project, generating $600,000 in revenue. Labor alone eats up more than half your income. 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.
What can you do?
- Optimize Efficiency: Look for ways to make your team more productive without overworking them.
- Adjust Pricing: Are you charging enough to cover your costs and still turn a profit?
- Restructure Compensation: Consider performance-based pay or linking bonuses to revenue targets.
By analyzing your labor costs, you can make adjustments that boost profitability and keeps your business growing.
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.
Labor may be your biggest cost—but it’s also one of the areas where you can create the most impact.
By understanding both direct and indirect labor costs, you can make smarter decisions about pricing, improve team efficiency,
and set your business up for long-term success. If you’re wondering what to do next, take a look at How Labor Cost Impacts Your Profitability to learn how you can start making smarter choices for your business’s future.
Topics:
