How to Calculate and Break Down Labor Costs for Small Businesses

What if your $20-per-hour employee is actually costing you $28?

What about those benefits you offer (like PTO and health insurance)... are they silently shrinking your profit margins?

Do you really know what it costs to run your business when it comes to paying your team?

Most small business owners underestimate their true labor costs, sometimes by 30% or more. They see the hourly wage or annual salary and think that's the whole picture. But wages are only the beginning. The true costs also include taxes, benefits, equipment, and even your time.

At Patrick Accounting, we've helped hundreds of business owners uncover their real labor costs and use that data to price smarter, hire better, and grow stronger.

In this article, you'll learn:

• How to calculate true labor cost per employee
• The difference between direct vs. indirect labor
• Hidden labor costs that eat away at profit
• A step-by-step system to track and control costs

What Does Labor Cost Include?

When most business owners think about labor costs, they think about the number on the paycheck. But that's like looking at an iceberg and only seeing the part above water.

Your true labor costs actually include:

• Base wages or salary (the obvious one)
• Payroll taxes (Social Security, Medicare, unemployment insurance)
• Benefits (health insurance, retirement contributions, paid time off)
• Workers' compensation insurance
• Training and onboarding costs
• Equipment, technology, and workspace expenses
• Overtime and holiday pay
• Recruitment and hiring costs

For example, let’s say you hire someone at $20 per hour. Seems straightforward, right? But add in:

• Your payroll taxes (7.65%)
• Workers' comp (varies by industry, let's say 2%)
• Health insurance ($400/month)
• Two weeks paid vacation (4%)

Suddenly, that $20/hour employee is costing you closer to $28 per hour.

Direct vs. Indirect Labor Costs: Understanding the Difference

Not all labor costs hit your bottom line the same way. You need to understand the difference between direct and indirect labor costs for accurate pricing and profitability analysis.

What Are Direct Labor Costs?

Direct labor costs are wages paid to employees directly involved in delivering your product or service. 

Examples of direct labor costs:

• Restaurant: Cooks, servers, bartenders who serve customers
• Auto repair shop: Mechanics who work on cars
• Law firm: Attorneys who bill clients directly
• Landscaping company: Crew members who mow lawns

These costs should be factored directly into your pricing structure and cost of goods sold (COGS). If it takes three hours of direct labor at $25/hour to complete a landscaping job, you need to charge enough to cover that $75 in labor costs (plus overhead and profit).

What Are Indirect Labor Costs?

Indirect labor costs support your business but are not directly tied to the production of your product or service.

Examples of indirect labor costs:

• Administrative staff (bookkeepers, receptionists, office admin)
• Sales and marketing teams
• Maintenance and cleaning staff
• Your own non-billable time (when you're not directly serving customers/clients)

These costs need to be covered by your overall pricing strategy and built into your overhead calculations.

The Hidden Labor Costs Most Business Owners Miss

Beyond the obvious payroll taxes and benefits, several hidden expenses affect your labor costs as well.

Recruitment and Training Costs

Every time you hire someone, you're not just paying their first paycheck. You're paying for:

• Job postings and advertising
• Time spent interviewing candidates
• Background checks and drug testing
• Training time (both yours and theirs)
• Reduced productivity during the learning curve

Overtime and Schedule Inefficiencies

That labor cost per hour calculation gets expensive fast when you're paying time-and-a-half. But it's more than just premium pay. It's also:

• Increased mistakes from tired or overworked employees
• Higher turnover from burnout
• Scheduling conflicts that require last-minute coverage

Paid Time Off and Holidays

Don't forget to factor in:

• Vacations and holidays
• Personal and sick days
• Bereavement leave

Equipment and Workspace Costs

You also need to consider what your employee needs to do their job:

• Desks, tools, phones, computers, software
• A place to work (rent, utilities, internet, maintenance)
• Uniforms or safety gear

How to Calculate Your True Labor Cost Per Employee

Here's the simple formula:

True Labor Cost = (Annual Salary + Payroll Taxes + Benefits + Other Costs) ÷ Productive Hours

Step-by-Step Example:

Let's say you have an employee making $40,000 per year:

• Base Salary: $40,000

Add:

• Payroll Taxes: $3,060 (7.65% of salary)
• Benefits: $6,000 (health insurance, retirement contribution)
• Workers' comp: $800 (2% of salary)
• Equipment/workspace: $2,000 per year
• Training/recruitment: $500 ($1,500 amortized over 3 years)

Total annual cost: $52,360

Now, divide by productive hours:

• 52 weeks × 40 hours = 2,080 hours
• Minus 120 hours (vacation + sick) = 1,960 productive hours

True hourly cost: $52,360 ÷ 1,960 = $26.71 per hour

That $19.23 per hour employee ($40,000 ÷ 2,080) actually costs you nearly $27 per hour.

Simple Systems to Track and Control Labor Costs

I’m sure you’ve heard the saying, “You can't manage what you don't measure.” So, here are some practical systems to keep labor costs under control:

1. Classify Job Roles Properly

Make sure your payroll system matches your actual organizational structure:

• Separate production vs. administrative roles (direct vs. indirect labor)
• Match pay to skill levels
• Clearly define job descriptions with measurable responsibilities

2. Implement Time Tracking

Whether it's punch cards, apps, or biometric systems, accurate time tracking is essential for:

• Calculating true labor cost per hour
• Identifying overtime patterns
• Measuring productivity
• Ensuring accurate client billing

3. Monitor Key Labor Metrics

Track these numbers monthly:

• Labor cost as a percentage of revenue
• Average labor cost per employee
• Overtime hours and percentage of total labor
• Turnover rate and associated costs

4. Integrate Your Systems

Make sure your payroll data flows into your accounting system in real-time. This will give you actionable labor cost insights for better hiring, pricing, and forecasting.

How to Use Labor Cost Data to Make Better Business Decisions

Once you know your true labor costs, you can make smarter choices in the following areas:

Pricing Your Services

If you know it costs $30/hour for direct labor (including all hidden costs), you can price jobs to ensure profitability. Many service businesses use a 3x multiplier. In other words, if labor costs $30/hour, they charge $90/hour to cover labor, overhead, and profit.

Hiring Decisions

Before adding staff:

• Calculate how much revenue that person needs to generate
• Estimate how long before they ramp up
• Consider whether overtime or subcontracting might be more cost-effective

Efficiency Improvements

Labor cost analysis can reveal:

• Which roles provide the best ROI
• Where training might improve productivity
• Whether automation could reduce costs

Performance Management

When you know exactly what each employee costs, you can:

• Set realistic productivity goals
• Identify your most valuable team members
• Make data-driven decisions about raises and bonuses

Your 4-Week Labor Cost Action Plan

Ready to get control of your small business labor costs? Here's a step-by-step plan to help you get started:

Week 1: Gather Data

• List all employees and their current wages.
• Identify all labor-related expenses (taxes, benefits, equipment).
• Review your payroll and accounting systems.

Week 2: Do the Math

• Use the formula above to calculate total cost per employee.
• Break down direct vs. indirect labor costs.
• Calculate labor as a percentage of total revenue.

Week 3: Analyze and Plan

• Compare your labor costs to industry benchmarks.
• Identify areas for improvement.
• Set targets for labor cost percentages.

Week 4: Implement Systems

• Set up proper tracking and reporting.
• Create monthly labor cost reports and dashboards.
• Establish regular review schedule and processes.

Remember: Labor may be your biggest cost, but it's also your biggest opportunity for impact. Small improvements in efficiency, productivity, or cost control can have huge effects on your bottom line.

Take Control of Your Labor Costs Today

Understanding your true labor costs provides clarity for making informed decisions that help your business thrive. When you know exactly what your team costs, you can price jobs profitably, hire strategically, and build a sustainable business.

The businesses that succeed long-term are the ones that measure what matters and make decisions based on real data, not gut feelings. Your labor costs are too important to guess.

At Patrick Accounting, we help small business owners get clarity on their numbers and build systems that track and control labor costs effectively.

We’ve seen firsthand how this knowledge transforms decision-making and profitability.

Ready to take control of your labor costs?

Let's talk about your numbers and create a system that gives you the clarity you need to build a better business.

Learn more here: “What Business Owners Can Learn from Their Numbers.”