What is a labour cost and how to calculate it: a small business guide Here’s everything you need to know about labour costs, and exactly how to calculate them in your small business. Written by Stephanie Lennox Updated on 30 January 2023 Our experts We are a team of writers, experimenters and researchers providing you with the best advice with zero bias or partiality. Written and reviewed by: Stephanie Lennox Writer Calculating labour costs are a crucial part of formulating your business strategy.These costs are necessary expenses that all businesses must take into account, as no business can survive without them.It’s important to know these costs so that when you are setting the sales price of your products, you can take them into account and your prices can mitigate the expense. If any costs are left out or overlooked in the sales price calculation, your profit margins will potentially be inaccurate or lower than expected, leading to unhappy shareholders or simply an unprofitable business. No one wants that. Who doesn’t want to know what their actual figures are at the end of the year? Your ‘Net Profit’ is your profit minus labour costs (and taxes).Your net profit figure is easy to discover and manage using HMRC-recognised accounting software come tax season. All VAT-registered businesses – including those that are voluntarily registered – are now required to do so due to the new Making Tax Digital (MTD) legislation which came into effect on April 1 2022. In this article, we will cover: What are labour costs? What are the factors involved? How to calculate labour costs Average annual labour costs by industry Top tips to help reduce increasing labour costs Conclusion What are labour costs?Labour costs are the total expenses of hiring, training, wages, benefits, taxes and other additional costs afforded by the employer over a given period of time.There are two types of labour costs (direct and indirect), and within those there are also two further types (fixed and variable).Direct labour costsDirect labour costs are the wages of anyone directly involved with the production of your products.This is arguably the most important type of cost because you can’t run a business without having a product or service to sell, so the people who manufacture or provide this product or service are as essential as you can get. It’s also an important one to watch because finding ways to reduce it could mean more profit and ensuring you have enough left to spend on indirect costs.Indirect labour costsIndirect labour costs relate to all the other employees excluding the direct labour employees who also work to keep a company running.These might include a legal team, an IT department, and a human resources team.They don’t directly manufacture the products, and don’t have anything to do with the output or production line – but they are all still necessary for a fully functioning business.Fixed costsFixed costs are the ones such as wages and taxes, which are inevitable and predictable aspects within any company.Variable costsThere are also variable costs. As much as we’d all like to be able to track and determine every single cent in our businesses, life doesn’t quite work that way. There will of course be emergencies, unforeseen events and bumps in the road from as close as week to week – depending on employees taking time off, compensating employees for sickness, and so on. What are the factors involved?These are just a few examples of the various different costs (fixed and variable) that may occur over the course of a year:WagesPayroll taxesPayroll softwareOvertimeBonusesHealth careSick daysHolidaysInsuranceBenefitsSuppliesTraining How to calculate labour costs Annual labour cost = Yearly salary + other annual costs Knowing this number can greatly contribute to the future efficiency of the company. With this knowledge, you can analyse trends, adjust your standard operating procedures, and find ways to optimise or streamline your processes.This formula can then further go into calculating the hourly costs:The hourly labour cost = yearly salary + other annual costs/ the number of hours the employee will work in a year. Average annual labour costs by industryGraph showing the percentage change in unit labour costscompared with the 2019 levels. (Source)According to the International Labour Organisation, the average UK labour cost for an employee in 2023 is £25.92.Post-Covid, labour costs in the UK increased across all industries except for the human health and social work industry, where they fell by 5.4%. Employment costs rose in general but also within that, and most notably, it was the compensation of employees that was responsible for the biggest increases. Top tips to help reduce increasing labour costsSo now we have established what labour costs are and how to calculate yours, you should now know: how much is your labour costing you?Not just in terms of money – but also in terms of efficiency, time management and energy.Thinking like this can be a great way of figuring out what costs are essential to a business and which you can cut down on throughout the year.Decrease employee turnoverIf you have employees in place but the workforce is unhappy for some reason, for example, you may encounter the invisible cost of having employees taking more days off than usual, or producing at lesser rates than they potentially could and leading to a decrease in profits. We talk about this in our article about how to improve employee engagement.Employee turnover is a labour cost: the average staff turnover costs between £14,800 and £22,200 per employee. (Source)Hiring new staff is a labour cost: The Society for Human Resource Management estimates the cost to replace a salaried employee is 6-9 months of their salary. (Source)Upskill high-performing employeesYou might be able to recognise that one of your employees has more skills and knowledge of maintaining production equipment, or happens to be much faster than other employees – and therefore could be considered as someone who has a higher value to your business – so you could use that knowledge to ensure the happiness of that employee in order to avoid having to spend the increased labour cost of training someone new.Incentivise productivityHiring more employees and training old ones are both costs, but one thing that can cost nothing (or significantly less) is incentivising the productivity of your employees. This can be done in a number of ways, with anything from a shout-out from their team or a gift card – but the purpose is as a thoughtful gesture which keeps morale high and productivity flowing. Lowering your direct labour costs doesn’t mean you have to pay your employees less. Strategies could be as simple as preparing your employee’s work rota a little more in advance, to give employees time to find substitutes for days they can’t work so you’re not left short-staffed. ConclusionNow that you know what labour costs are, how to calculate yours, and know to take heed of the unforeseeable and indirect labour costs most businesses would overlook. You may want to include them in your business plan or business continuity plan.This way, you can ensure the costs will be accounted for in your overarching strategies and plans, and so you can stay ahead of the game. Share this post facebook twitter linkedin Tags Essential Guides News and Features Written by: Stephanie Lennox Writer Stephanie Lennox is the resident funding & finance expert at Startups: A successful startup founder in her own right, 2x bestselling author and business strategist, she covers everything from business grants and loans to venture capital and angel investing. With over 11 years of hands-on experience in the startup industry, Stephanie is passionate about how business owners can not only survive but thrive in the face of turbulent financial times and economic crises. With a background in media, publishing, finance and sales psychology, and an education at Oxford University, Stephanie has been featured on all things 'entrepreneur' in such prominent media outlets as The Bookseller, The Guardian, TimeOut, The Southbank Centre and ITV News, as well as several other national publications.