What are labour costs and how do you calculate them?

Start-up businesses that understand their labour costs may be better able to control costs, forecast future financial performance, and ensure enough working capital to pay salaries.

Labour costs can be unpredictable as they include far more than employee salaries, such as training, recruitment, and equipment – and if you’re not careful, workforce-related overheads can soar.

Any time you change your organisation, whether hiring new staff or expanding your operations, it could be a good idea to calculate your labour costs.

What are labour costs?

Labour costs are the expenses that a business spends on its employees, contractors, and casual workers.

A start-up’s biggest labour costs are likely direct employee salaries – the amount your employees receive for their work – but there are many more expenses to consider.

You can consider your costs in terms of direct and indirect labour.

• direct labour costs are the expenses related to employees who help produce goods or deliver services – for example, a retailer’s direct labour costs include wages for staff that assist customers on the sales floor
• indirect labour costs relate to operations and expenses that help the business run smoothly – such as human resources – as well as ‘on costs’ such as workplace pensions, training, expenses, and employee benefits.

You can also consider labour costs in terms of fixed and variable expenditure.

• fixed costs are regular expenses that are not likely to change in a given period, such as employees with a set salary that is paid monthly or weekly
• variable costs are expenses that fluctuate depending on your business activity – such as start-ups with shift work and that pay their employees hourly – including costs such as contractors, as well as sales bonuses and other benefits that are based on performance.

Types of labour cost

There are many different types of labour costs, and they fall into several categories.

Salary and wages

These expenses are the core of your labour costs and apply to all employees, whether they work on a salaried, hourly, or fixed-term basis.

Recruiting costs

Replacing employees or creating a new job role can be costly.

You might have to pay to advertise the vacancy, while the hiring team and HR will have to take time out of their day to conduct interviews.

Plus, someone in your team will have to cover the work that has been left vacant.

Equipment

Employees may need equipment to do their job properly.

This could include a computer, chair, and desk, but employees may need other industry-specific tools, clothing, and equipment in some roles.

This could include personal protective equipment (PPE) if working in construction or a uniform in retail or catering.

Training

A new employee might need to receive training to ensure they perform their job safely and effectively.

You might also have a legal or contractual requirement to perform regular staff awareness training courses on occupational health and safety or data privacy.

Pension

You might be required to contribute towards your employees’ pension scheme.

In the UK, organisations are subject to automatic enrolment legislation, which requires them to identify eligible staff and contribute at least 3% of their qualifying earnings into their pension scheme.

Employer’s National Insurance contribution (NIC)

NIC payments are mandatory deductions made from an employee’s gross earnings.

Your start-up is responsible for identifying qualifying employees and passing the correct NICs to the government.

Expenses

You might be required to reimburse employees for additional expenses they incur as part of their job, such as travel costs or hotel stays.

Benefits, bonuses, and commissions

When you hire an employee, you might offer them perks, such as private medical coverage, additional paid leave, and employee discounts.

Likewise, you might offer performance-based bonuses or commissions.

Absences

Your labour costs will increase when an employee isn’t at work, such as on annual or sick leave.

This might be because you are less productive or because someone will be required to cover their tasks.

You may need to hire contractors or additional cover for staff absences, which can add additional overheads.

How to calculate labour costs

You can calculate labour costs by adding together all the expenses associated with your workforce.

You can determine each of these figures on an annual, monthly, or hourly basis.

Annual or monthly labour costs are ideal for organisations with steady operations, such as those keeping regular office or retail hours.

By contrast, hourly labour costs can be helpful for start-ups with irregular operating hours, such as those that incorporate shift work.

What factors affect labour costs?

The most significant factor affecting labour costs is the number of employees and how much they are paid.

As your start-up takes on more staff, you will increase wages and salaries, which will increase costs related to NICs, pensions, and benefits.

Government legislation, such as the national minimum wage and living wage, might affect your salaries and wages.

You might also consider benchmarking your wages against your competitors and local market.

Another factor to consider is your desire to expand as a business.

Higher salaries are more likely to attract employees with greater skills and experience, which could boost productivity and help increase your revenue – and this will allow you to increase your labour costs.

Having more employees can lead to economies of scale.

This means certain costs, such as training or purchasing supplies, can be more cost-effective.

Why you should manage labour costs

It’s essential that you manage labour costs because they’re probably one of your biggest expenditures and will directly impact your revenue.

By measuring your labour costs, you can know if you’ve hired an appropriate number of employees and are giving them sufficient support.

You can also use these figures to help you set the prices of your goods and services.

You want to ensure that you profit from the goods and services you provide, so you might have to increase your prices to account for increased labour costs.

Tips for managing labour costs as a start-up

If you’re looking to reduce your start-up’s labour costs, the good news is that there are plenty of options to explore, such as:

• benchmarking your labour costs against industry standards
• prioritising employee retention to avoid high turnover expenses
• identifying and upskilling top-performing employees to enhance efficiency
• boosting morale with performance-based bonuses to encourage greater productivity
• reducing overtime and, if necessary, increasing regular staff hours
• introducing flexible work arrangements, such as remote work and flexi-time, to optimise scheduling and reduce overheads
• conducting performance reviews to give and receive feedback and highlight opportunities for improvement.