What Small Businesses Need to Know About Labor Costs

What Small Businesses Need to Know About Labor Costs

Payroll is expensive, perhaps more so than the average small business owner realizes. Depending upon the industry, wages and associated compensation paid to employees range from 10 percent to 30 percent of revenue. That’s a chunk. It’s imperative that entrepreneurs understand exactly both the obvious and hidden costs of maintaining a staff of workers. The trick is to find that fine balance of exactly enough employees to maximize profit but not have people standing around looking for things to do. Here’s what every small business owner needs to know about labor costs. It could be the difference between success and failure.

Know Your Industry

As we’ve already alluded to, labor cost as a percentage of revenue varies wildly among industries. For example, manufacturing tends to have a lower percentage of labor costs than industries like restaurants, theme parks, or retail, and trucking carries the highest of all at close to 60 percent of total cost. The first thing to do is figure out what is the standard for your industry and see where your payroll falls on the spectrum. If you’re out of whack to the high side, better figure out why. If your labor costs come in low, you still need to figure out what you’re doing and make sure you keep doing it.

Know the Math

Any small business owner with a basic calculator can figure out what his/her labor cost is by percentage. Let’s say you had a gross revenue to $500,000 last year and spent $100,000 on payroll. Divide the revenue number by the payroll number and convert the result to a percentage. In this example you would come up with .2 which is equal to 20 percent. Keep in mind this calculation is only as valuable as the accuracy of the numbers in the equation. That means you need to total up ALL expenses associated with your employees and not just the obvious expense of wages.

Base Pay Plus…

Base pay is an easy number to figure out, but it’s the other stuff that can drive the cost of an employee up to 40 percent higher. When you calculate labor costs, don’t forget to include health insurance premiums, uniforms, overtime, federal and state taxes, workman’s compensation, paid time off, and time spent training a new employee. Once you crunch all these sometimes “forgotten” costs, you’ll find that an employee you pay $14 an hour actually costs you close to $20. This can be a shock to the system of a small business owner who has never taken the time to add it all up.

Low Pay Equals High Turnover

One of the tricky issues you’ll run across when setting the pay scale for employees is how to balance the least you can pay against high turnover. We’ve talked about the high cost of training new employees. It takes valuable time away from you or other employees. Pay too little and you are liable to feel like you’re constantly hiring and training. Some businesses don’t seem to mind this – you may be one of them – but you should realize this practice might be more expensive than you realize.

Understanding Minimum Wage

In light of the discussion so far, it’s not surprising that some small business owners view political talk of raising the minimum wage with something that verges on terror. Chances are many are already paying minimum wage once other compensation is added in, but federal and state governments focus only on the base pay rate when setting policy. This one-size-fits-all way of thinking can force a small business to reduce staff, turn to creative automation techniques, or shut down completely.

The Bottom Line

Ultimately, you as an owner, must do what is best for the business. Presumably, you started the company with the intention of making money in order to improve the financial circumstances of yourself and family. That means you must run the business with an eye towards the bottom line. Know your expenses. With labor being at the top of costs, you have to maintain a constant state of vigilance that the staff doesn’t get too big, or too small, for that matter. No boss likes to lay off employees but be prepared to do so if the daily business doesn’t warrant a full staff. It doesn’t mean you are a bad person. The cliche is the truth; it’s nothing personal, just business.

About author

Michael Barry
Michael Barry 25 posts

Michael Barry is the Editor-In-Chief at AgeOfTheSmallBusiness.com. Currently living in Boston, Massachusetts, he received his B.A. in Financial Economics from St. Anselm College and his MFA in Creative Writing from the Stonecoast Program at the University of Southern Maine.

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