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Cost of labour – how to avoid hidden costs

3-minute read

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Zach Hayward-Jones

Zach Hayward-Jones

5 July 2023

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Managing labour costs is a fundamental process for small business owners with employees. It’s usually one of the biggest expenses a business has while also being essential to your long-term growth.

But with a few tweaks to your approach, you can balance the cost of labour more efficiently, and maximise your profits. But how do you define labour costs? And what strategies can you introduce to make them as predictable as possible? Read on to find out.

What are labour costs?

Labour costs are the total sum you pay to your employees. This includes their wages, employee benefits, training, and tax contributions.

The cost of labour is broken down into two categories, direct and indirect. A direct labour cost is the wage of an employee who’s directly involved in the production of your product.

For example, the wage of a chef who makes food in your restaurant would be considered a direct labour cost because they produce what you sell.

An indirect labour cost is for an employee who works away from production. Legal, financial, or marketing employees are indirect labour costs because they work away from your production.

Labour costs are then separated further into fixed and variable costs. Fixed costs are predictable outgoings, like wages and tax.

Variable costs are the unexpected extras that come with employing staff. Sick pay and compassionate leave are common examples.

How to calculate labour cost

It’s relatively straightforward to work out your labour costs. The calculation is the total amount you pay in yearly salary plus your other annual costs.

Here are some of the annual outgoings you should consider when calculating your labour costs:

  • overtime
  • bonuses
  • health and dental care
  • payroll taxes
  • payroll software
  • insurance
  • benefits
  • staff supplies
  • training
  • holidays

Once you’ve worked the additional costs, it’s worth using a cost of labour calculator to check your figures are correct.

Having a clear idea of how much you’re likely to spend a year on labour costs makes your budgeting and cash flow forecasting easier and more accurate.

How to manage your business's labour cost

Managing your labour cost efficiently can save your business money. This doesn’t mean reducing wages or your number of employees but cutting unnecessary spending.

There are various strategies you can introduce to lower your labour costs but it’s primarily about maximising the potential of your workforce.

Employee retention

Retaining talented employees is a constant challenge for business owners. But beyond wanting to keep valued workers, there’s a cost that comes with hiring new employees and it’s something you'll want to avoid committing to regularly.

According to BrightHR, replacing an employee with a salary of £25,000 a year costs a business over £30,000 in annual turnover.

Here are some of the reasons why replacing an employee is so expensive:

  • recruitment – the price of posting a job ad is between £80 and £130 depending on which site you use. And if you successfully hire someone through a recruitment agency, their fees sit between 10 and 20 per cent of the annual salary of your new employee
  • loss of productivity – If you're replacing an employee, you're usually short one staff member, which reduces your productivity. But the time that’s dedicated to the search, like conducting interviews, will also reduce productivity
  • training – when your new employee joins, you’ll spend time and money training them. And without a guarantee they’ll pass probation, it’s potentially wasted money

It makes your labour costs and production more predictable if you retain employees where possible. Our guide to employee retention shares some tips on how to keep a hold of good employees.

Why is managing your labour costs important?

Labour costs can be one of a business's biggest regular outgoings – managing them carefully can help bring stability to your finances. Reducing unnecessary spending on labour costs helps you save money.

In the short term, finding inefficiencies in the way you run your business can make a difference to your labour costs right away.

An example of this is to arrange your staff rota so there are no gaps in production and everyone has enough time off. You’re making sure there isn’t a drop in sales from a pause in production while also being considerate of your employees.

And by managing them effectively, you make your labour costs more predictable. This improves your forecasting because you have a clearer idea of what your outgoings are. Which means your financial planning will be more accurate in the long-term.

How do you manage your business’s cost of labour? Let us know in the comments below.

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Zach Hayward-Jones

Written by

Zach Hayward-Jones

Zach Hayward-Jones is a Copywriter at Simply Business, with six years of writing experience across entertainment, insurance, and financial services. Zach specialises in covering small business and landlord insurance. He has a particular interest in issues impacting the hospitality industry after spending a number of years working as a pastry chef.

We create this content for general information purposes and it should not be taken as advice. Always take professional advice. Read our full disclaimer

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