How to Calculate Labor Costs

Labor cost is an essential piece in the profitability puzzle, but calculating it can be tricky. Labor cost, in the simplest terms, is the cost required to employ a worker. Cost of labor, while similar, is somewhat different from labor cost.

What Is the Difference between Cost of Labor and Labor Cost?

Cost of labor and labor cost are similar and often used interchangeably, but there are some differences between the two. The main difference is how detailed the calculation is to determine the cost to employ workers.

Cost  of labor  includes all salary (gross pay), benefits, and payroll taxes paid by employers to employ workers  and can be compared from location to location. The cost of labor is commonly used for determining salary structures and geographic pay. This value is critical when deciding which location a business may decide to operate in since it is easily comparable between locations. ERI’s Geographic Assessor allows a business to compare the cost of labor by looking at geographic differentials between multiple locations.

Labor cost  is a more casual term and includes the expenses used to determine the cost of labor, but it may also be customized based on an organization’s specific definitions. For example, a company that operates and maintains an oil rig would include specific expenses, such as lodging and meals, that would not apply to most other businesses. Labor cost is useful for companies that want to know exactly how much it costs to employ an individual to further calculate profits.

In short, to appreciate the difference between cost of labor and labor cost, remember that cost of labor is a more universal and reproducible calculation that can be compared easily between locations. Labor cost, on the other hand, is a more specific and tailored calculation used to help determine a specific business’ total profitability.

Determining Labor Costs

Before delving into how to calculate labor costs, it is important to understand some key terminology: indirect vs. direct labor costs and fixed vs. variable labor costs.

What Is the Difference between Indirect and Direct Labor Costs?

Direct labor costs  refer to labor that can be correlated directly with an output of goods or services. For example, a Product Assembler hired to construct tables at a factory can make six tables per hour. Each of these tables can be sold for a given amount of money. This employee is a direct labor cost that can be correlated easily with the cost of the goods that they are producing.

Indirect labor costs  refer to labor that cannot be tied directly to the production of goods or services. An example of this would be an IT Support Specialist. This role does not necessarily produce any goods or services directly, but they may help other employees do their jobs effectively.

What Are Fixed and Variable Labor Costs?

Fixed labor costs  refer to labor costs that do not change with the amount of output of a product being manufactured or labor costs that are not expected to change over time. For example, the salary of an exempt employee is not expected to change within a year, so may be considered a fixed labor cost.

Variable labor costs  are costs that can change depending on production output or increased demand. An example would be seasonal shifts in retail when more employees are needed or required to work overtime. This could also relate to the cost of powering machines that workers will be using in a production environment.

How Do You Calculate Direct Labor Cost?

Direct labor cost is an involved calculation, but it is a critical value since it can directly impact a business’s bottom line. Here is an overview of the steps needed to calculate this value:

1. Determine the Employee’s Salary

The first step is determining the total salary for an employee to see how much they would be paid on an annual, weekly, or hourly basis. For this example, let’s calculate the cost of an exempt Front-End Developer in Portland, Oregon. Take their annual salary of $100,000 and divide it by 52 to get their weekly cost. If they work 40 hours a week, we would further divide that number by 40 to get their hourly rate.

Annual salary  = $100,000

$100,000 / 52 = $1,924.08

Weekly salary  = $1,924.08

$1,924.08 / 40

Hourly salary  = $48.08

It’s important to note that this is an exempt employee. For a non-exempt employee, you would have to factor in overtime, as well, to get their total labor cost. Breaking this down into weekly or hourly equivalents allows you to easily work with other types of expenses later.

      2.  Factor in Additional Benefits

Benefits can constitute a significant part of an employee’s overall compensation and must be considered carefully in a labor cost calculation. Determining the cost of benefits is critical to understanding exactly how much it would cost per hour, week, or year to have an employee work on a specific project.

Employer-provided employee benefits may include some of these popular options, though there are many other benefits utilized to attract, retain, and motivate employees in competitive labor markets:

• • Medical insurance
  • Dental insurance
  • Life and disability insurance
  • Retirement plans
  • Paid time off
  • Employee assistance plan (EAP)
  • Executive perquisites
  • Compensated meals
  • Education and training

Let’s say our Front-End Developer receives $2,000 per year for medical insurance, $200 annually for dental insurance, $500 per year towards retirement, and $2,000 of paid time off annually. This employee would cost an additional $4,700 in benefits per year. Keep this in mind as we continue with the next steps.

3.  Factor in Payroll Taxes

The cost of payroll taxes can vary depending on your location, but it should be factored into the total labor cost for an employee. Payroll taxes paid by employers include Social Security tax, Medicare tax, federal unemployment tax, and state unemployment tax, which varies by state. For our Front-End Developer, let’s say it costs $200 per month for payroll taxes. This equates to $2,400 per year in payroll taxes for this employee.

4.  Calculate Annual Cost of Labor

The next step is to combine salary (gross pay) with benefits and payroll taxes. We will use annual values so that we can break them down later for our various needs.

Salary + Benefits + Payroll Taxes = Cost of Labor

In this example:

$100,000 + $4,700 + $2,400 = $107,100

This value will give you a good base for determining labor costs, but there are still some additional steps to determine the exact cost.

5.  Factor in Additional Fixed Labor Costs

Earlier, we mentioned fixed labor costs being a factor in determining total labor costs. An example of this cost would be the software subscriptions that an employee needs to do their job. An employee’s computer, however, would not fall into this category because buying a computer for an employee is not a regular cost. This would be considered a variable labor cost.

Variable labor costs cannot be factored into direct labor costs due to their frequent fluctuations. They should still be considered when deciding on the value and efficacy of projects, but they are not useful for direct labor cost calculations.

For this example, let’s say that the software used by the Front-End Developer will cost an average of $100 each year per license. That means that, with this additional fixed labor cost, the cost of labor would now equal $107,200 per year.

6.  Break Down the Cost of Labor into Digestible Numbers

With all these extra expenses included, you have arrived at your total annual labor cost value. Let’s use the salary pay period calculation that we demonstrated in step one to convert the annual labor cost value into weekly and hourly rates:

As can be seen, an employee’s salary is not everything; there are significant additional costs to consider in the total labor cost to keep an employee working. With these values handy, you will now be able to get a better grasp of your company’s potential profits when it takes on new endeavors or projects.

How Can I Reduce My Cost of Labor?

The most effective way to reduce your cost of labor would be to employ workers in a different location with a lower cost of labor. ERI’s Geographic Assessor helps organizations easily compare the cost of labor in multiple areas by looking at geographic differentials across locations. That said, relocating to an area with a lower cost of labor is not always possible, so managers and owners may need to think of other creative ways to lower the cost of labor, such as adjustments to benefits offered.

How Can I Reduce My Labor Costs?

Now, since labor cost is based on the total cost of all expenses related to employing an individual, there are quite a few different ways to reduce this expense:

1. Hire Temporary Labor During Busy Times

Depending on your industry, there may be predictable busy times and quiet periods. You can save some major labor costs by hiring temporary labor for specific jobs instead of paying overtime.

1. Avoid Turnover

As an employer, you know that the hiring process can be quite expensive. Employee Benefits News (EBN) reported that, according to the Work Institute’s 2017 Retention Report , hiring a replacement can cost employers 33% of an employee’s annual salary. It may even cost more depending on how long the employee was employed before they left. Making employees feel heard and valued with annual check-ins on employee satisfaction coupled with reasonable adjustments based on feedback are great ways to retain and motivate employees.

1. Try to Avoid Scheduling Overtime

Overtime laws for non-exempt employees can turn a profitable project into an unprofitable one. Try to schedule employees so that they are not working overtime regularly. See point number one above about hiring temporary labor during busy periods.

For help estimating FLSA overtime exemptions, turn to ERI’s Occupational Assessor, which includes a module to help subscribers easily estimate overtime exemption status at the state and federal level.

1. Reexamine Your Benefits

Examine your benefits and consider if it would be more cost effective to increase or add additional benefits instead of paying higher salaries. Employer-provided medical benefits, for example, are considerably less expensive than individually funded medical benefits. That said, it is important to ensure that medical benefits are desired by your employees, as opposed to higher salaries; otherwise, you may see increased turnover.

ERI’s Benefits Benchmarking Survey provides an invaluable resource to organizations in the process of building and updating competitive employee benefits packages with a comprehensive analysis of health care benefits, in addition to sections on life and disability insurance, paid time off, retirement, and executive prerequisites. To drill down on actual costs and extensive details on employer-provided employee benefits in today’s competitive marketplace, read ERI’s 2025 Benefits Benchmarking Survey report.

ERI’s Salary Assessor also includes three useful resources for planning and managing employee benefits in your organization:

• • The Benefits page includes current survey data on trends in employee benefits, including benefits offered (medical, dental, vision, prescription drug, paid holidays, paid vacation, paid sick leave, retirement, and telecommuting), health care coverage, and paid time off (PTO). ERI’s employee benefits survey data can be filtered by geographic region, organization size (number of employees), and industry, allowing you to accurately evaluate trends in benefits offerings amongst peers in your market.
  • The Benefits Administration feature in Compensation Management helps you define benefits plan options, including health & wellness benefits, financial & retirement benefits, time-off & leave benefits, mandatory benefits, and additional benefits, to administer in your organization.
  • The Total Rewards Statement is an essential report in Compensation Management that provides a complete breakdown of individual employee pay, including current base, incentive, and long-term compensation, plus benefits, with employee and employer contributions for each benefit option. You can easily download and share this report to evaluate the costs of individual benefits options for each employee.

5.  Consider Part-Time Workers

Part-time employees will be less expensive to hire and maintain than full-time employees since they do not require certain benefits that are provided to full-time workers. It may make more sense to hire two part-time workers than one full-time employee. As always, it depends on your situation.

Knowing how labor cost is calculated and the many factors that affect it is a first step towards optimizing your profits. For a more in-depth analysis of how to manage the cost of labor, use ERI’s Geographic Assessor to analyze geographic differentials and perform cost-of-labor comparisons across various locations in the United States and worldwide.