The direct labor cost formula: How to calculate your labor cost

Understanding direct labor cost is essential for businesses of all sizes, especially small businesses and startups managing tight budgets. Labor is often one of the biggest expenses, and failing to calculate it correctly can lead to pricing mistakes, cash flow issues, and even profit loss.

This is why it’s important to know the direct labor cost formula, which enables you to accurately determine how much your business spends on labor, optimize workforce costs, and set profitable pricing structures.

In this article, we’ll cover everything you need to know about how to calculate labor cost, including step-by-step instructions, real-world examples, and tips for reducing costs without compromising productivity. So let’s begin.

What is direct labor cost?

Direct labor cost refers to the wages and benefits paid to those employees who are directly involved in producing your goods or services. These are the people whose work is essential for delivering your product, such as assembly line workers in a manufacturing firm or software engineers in a SaaS company.

Indirect labor, on the other hand, includes employees whose work supports the business but isn’t directly tied to production, such as administrative staff, HR personnel, or accountants.

Since direct labor costs are directly tied to production, your business must track them accurately to determine unit costs, profitability, and workforce efficiency. To do this, you can use the direct labor cost formula.

What is the direct labor cost formula?

To calculate direct labor cost, use this formula:

Direct labor cost = (hourly wage x hours worked) + payroll taxes + employee benefits

Here’s what each component means:

1. Hourly wage. This is the base pay rate per hour. For salaried employees, convert their salary into an hourly rate.

2. Hours worked. This is the total hours worked, including any overtime if applicable.

3. Payroll taxes. These are your employer-paid taxes like Social Security, Medicare, unemployment tax, and any other mandatory contributions.

4. Employee benefits. This includes any additional compensation like health insurance, retirement plans, and bonuses.

Note that this formula applies whether your employees are hourly or salaried — just adjust the “hourly wage” portion accordingly.

How to calculate direct labor cost

To calculate direct labor cost using the formula, follow these steps for each employee:

Step 1: Determine the hourly wage

For hourly workers, this is simple — just use their base pay rate. If a worker earns $20 per hour, that’s their wage.

For salaried employees, divide their annual salary by the number of working hours per year. To do this, first work out the number of hours worked. If someone works 40 hours per week, this would be:

40 hours x 52 weeks = 2,080 hours

Next, divide the annual salary by the number of hours. If your employee earns $50,000 per year, this would be:

$50,000 / 2,080 hours = $24.04 per hour

Step 2: Calculate the total hours worked

Once you have the hourly wage, multiply it by the total hours worked in the pay period. If relevant, you should include overtime in this.

This will give you the base labor cost.

For example, if an employee earning $20 per hour works 160 hours in a month, the base labor cost is:

$20 x 160 hours = $3,200

If, during this period, they worked 10 extra hours at 1.5x pay, you would need to add this on. As a result, the total would be:

($20 x 1.5) x 10 hours = $300 + $3,200 = $3,500

Step 3: Add payroll taxes and benefits

As mentioned, you must also account for payroll taxes, which typically include:

• Social Security (6.2%)

• Medicare (1.45%)

• Federal and state unemployment taxes (varies by state/country)

For an employee earning $3,500 per month, the payroll taxes (assumed at 7.65%) would be:

$3,500 x 7.65% = $267.75

Employee benefits like health insurance, paid time off, retirement contributions, and bonuses must also be added. If, for instance, your benefits cost you $500 per employee per month, the total labor cost becomes:

$3,500 (base labor cost) + $267.75 (payroll taxes) + $500 (benefits) = $4,267.75

Thus, this employee’s direct labor cost is $4,267.75 per month.

To get your company’s full direct labor cost, you would need to do this for each applicable employee and then sum the total.

Common mistakes in direct labor cost calculation

As mentioned, mistakes in your cost calculations can lead to inaccurate cost projections, unexpected expenses, or even pricing errors that hurt revenue. Here are some of the most common mistakes — and how to avoid them:

1. Ignoring full employment costs

Many businesses focus only on wages when calculating direct labor costs, and forget or ignore the other employment costs listed above, such as payroll taxes, and employee benefits.

To avoid this mistake, ensure you always use the full direct labor cost formula, and track all labor-related expenses, including bonuses, vacation pay, and employer-paid insurance.

This is much easier if you use automated payroll software that calculates and tracks all your payroll costs to the cent.

2. Not accounting for overtime and fluctuating hours

For businesses with hourly employees, overtime can quickly drive up labor costs. Many companies underestimate how often employees work extra hours, leading to surprise expenses.

This is why it’s crucial to track the actual hours worked — including overtime — to get an accurate labor cost picture.

Use workforce management software to forecast scheduling needs and avoid unnecessary overtime, and consider offering flexible scheduling (or redistributing hours) to prevent excessive overtime expenses.

3. Forgetting employee turnover costs

Hiring and training new employees is expensive, yet many businesses don’t factor turnover into their labor costs. The cost of replacing an employee can range from 20% to 150% of their annual salary, depending on the role and industry.

If your business experiences high turnover, direct labor costs will increase due to recruiting fees, training time, and lost productivity.

While this isn’t included in the direct labor cost formula, you should still track employee turnover rates and the costs associated with hiring and training replacements, and use onboarding programs that speed up training and reduce lost productivity when hiring new workers.

4. Misclassifying employees as contractors

Some businesses deliberately misclassify employees as independent contractors to save on payroll taxes and benefits. However, misclassification can lead to hefty fines, tax penalties, and serious legal issues if pursued by the tax authorities.

Contractors are not considered direct labor because they are not on payroll and don’t receive benefits. But if they are treated like employees (e.g., they have set hours, use company equipment, and receive direct oversight), they must be classified as employees and included in your costs.

To avoid misclassification, ensure you correctly classify your workers. It’s a good idea to only use contractors for project-based or specialized work that doesn’t require direct oversight.

How Remote can help

Knowing how to calculate direct labor cost is key to making informed financial decisions, setting fair prices, and ensuring business profitability. By using the direct labor cost formula and following the step-by-step process outlined above, you can gain clarity on your labor expenses and optimize workforce planning.

However, to ensure your calculations are fully accurate, it’s advisable to use an automated payroll system like Remote Payroll. We calculate the full employment cost for your people — including wages, overtime, benefits, and payroll taxes — making it quick and easy to see what exactly you’re spending.

To learn more about how our payroll platform keeps you compliant and saves you time and money, check out our free guide below:

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