What is the cost of labor?
– Definition: The cost of labor is the total expense an employer incurs to hire and retain workers. It includes gross wages and salary plus employer-paid items such as payroll taxes, benefits, and other labor-related overhead. Employers often separate labor costs into components that can be traced directly to production and those that support operations more generally.
Core concepts and definitions
– Direct labor: Wages and related costs for workers whose time can be traced to producing a specific product or service (for example, assembly-line operators).
– Indirect labor: Labor costs for employees who support production but cannot be tied to a single product (for example, maintenance staff, security, or supervisors).
– Burden rate (labor burden): A way to express the additional employer costs associated with labor. Commonly calculated as the ratio of non-wage labor costs to direct wages (e.g., benefits + employer payroll taxes + insurance divided by direct wages).
– Fixed labor cost: Labor-related expenses that do not vary with short-term production levels (for example, contracted maintenance fees).
– Variable labor cost: Labor expenses that vary in line with production activity (for example, hourly wages for machine operators).
– Undercosting / Overcosting: Errors that occur when an organization allocates too little or too much of shared labor costs to a particular product or service, causing distorted product cost and potentially incorrect pricing.
– Cost of living (different concept): The household expenses needed to maintain a given standard of living in a location (housing, food, transport, etc.). It is not the same as the employer’s cost of labor.
Why it matters for pricing and profitability
When setting product prices, firms should include total labor costs (direct + allocated indirect) along with material and other overhead. If any labor-related costs are omitted, product margins will be overstated and actual profit will be lower than expected. Competitive pressure or falling demand may force firms to reduce labor-related expenses through fewer staff, higher productivity, or shifting costs to customers (for example, encouraging tipping).
Step-by-step checklist to calculate and allocate cost of labor
1. List direct wages: hours × hourly wage (or allocated salaries) for production employees.
2. Add employer payroll taxes: Social Security, Medicare, unemployment taxes, and other statutory employer contributions.
3. Add benefits and insurance: employer share of health insurance, retirement contributions, paid leave, workers’ compensation.
4. Add indirect labor costs: salaries for supervisors, maintenance, security, quality control that support production but aren’t tied to a single product.
5. Include contracted/other fixed labor charges: service contracts, training, recruiting costs amortized over a period.
6. Compute burden rate (optional): (payroll taxes + benefits + indirect labor + insurance) ÷ direct wages.
7. Allocate shared/indirect costs to products: choose a fair driver (machine hours, direct labor hours, or units produced).
8. Compute per-unit labor cost: (direct labor per unit + allocated indirect cost per unit) × (1 + burden rate if using that method).
9. Review and adjust periodically for overtime, seasonal staffing, or changes in benefit costs.
Worked numeric example
Scenario: XYZ Furniture makes dining chairs and bed frames. Machine-related direct labor totals $20,000 per month. XYZ produces 1,000 chairs and 400 bed frames in the month. Maintenance and security salaries (indirect labor) are $4,000 per month. Employer payroll taxes and benefits for production staff total $3,000 per month.
Step A — Total labor pool:
– Direct machine labor: $20,000
– Indirect labor (maintenance/security): $4,000
– Employer payroll taxes & benefits: $3,000
– Total labor cost to allocate = $27,000
Step B — Choose allocation driver (units produced). Total units = 1,000 chairs + 400 bed frames = 1,400 units.
Step C — Allocate per unit:
– Labor cost per unit = $27,000 ÷ 1,400 = $19.29 per unit
If XYZ mistakenly allocates $15,000 of the $20,000 direct machine labor to bed frames and only $5,000 to chairs, then:
– Allocated labor to bed frames becomes too large and chairs receive too little. Prices based on those allocations would misstate profit margins for each product (overcosting bed frames, undercosting chairs), potentially leading to poor pricing decisions.
Alternative: compute a burden rate
– Burden rate = (indirect labor + payroll taxes & benefits) ÷ direct wages
– Using the example: burden rate = ($4,000 + $3,000) ÷ $20,000 = 7,000 ÷ 20,000 = 0.35 or 35%
– Per-unit direct labor (chairs): if direct labor for chairs was $12,000 of the $20,000, direct labor per chair = $12,000 ÷ 1,000 = $12. Burdened labor per chair = $12 × (1 + 0.35) = $16.20.
Practical notes and common responses to rising labor cost
– Reduce workforce, increase productivity per worker, or cut other production costs.
– Shift some labor cost to consumers where possible (e.g., tipping models in hospitality).
– Use clearer allocation bases (machine hours, labor hours) to reduce under/overcosting.
Assumptions and limitations
– Allocation results depend on the chosen cost driver (units, hours, machine time). Different choices produce different per-unit costs.
– Some items (training, recruiting) are best amortized across multiple periods rather than charged entirely in the month incurred.
– Payroll tax rates, mandated benefits, and workers’ comp vary by country and jurisdiction.
Reputable sources for further reading
– Investopedia — Cost of Labor: https://www.investopedia.com/terms/c/cost-of-labor.asp
– U.S. Bureau of Labor Statistics — Employer Costs for Employee Compensation: https://www.bls.gov/news.release/ecec.htm
– U.S. Internal Revenue Service — Employer’s Tax Guide (Circular E): https://www.irs.gov/publications/p15
– Organisation for Economic Co-operation and Development (OECD) — Unit Labour Costs: https://data.oecd.org
Practical checklist for calculating and reporting cost of labor
– Identify the scope: which workers (employees, temporary staff, contractors) and which time period (monthly, quarterly, annual).
– Collect gross wages and salaries for the period (regular pay, overtime, bonuses).
– Add employer payroll taxes and statutory contributions (social security, unemployment tax, workers’ compensation).
– Add paid non‑working time: vacation, sick leave, parental leave — either included in payroll or separately tracked.
– Add employer-paid benefits (health insurance premiums, retirement plan contributions, group life/AD&D).
– Capitalize and amortize training, recruiting, signing bonuses, and relocation costs if they provide multi-period benefit; otherwise expense them in period incurred.
– Include other labor-related costs: uniforms, safety equipment, payroll processing fees.
– Decide allocation base for per-unit or per-hour measures (direct labor hours, machine hours, units produced).
– Compute totals and divide by chosen denominator (total paid hours or units) to get per-hour or per-unit labor cost.
– Document assumptions (payroll tax rates, amortization periods, allocation drivers) and update when policy or rates change.
Worked numeric example (step‑by‑step)
Assumptions for one month in a small manufacturing shop:
– 10 employees, each gross pay $3,000/month → Gross wages = $30,000.
– Employer payroll taxes = 10% of gross wages → Payroll taxes = $3,000.
– Employer benefits (health + retirement contributions) = $4,000.
– Paid leave cost (estimated extra cost) = $1,000.
– Training cost incurred this month $2,000, amortize over 12 months → Monthly amortization = $167.
– Recruiting cost this month $1,200, amortize over 12 months → Monthly amortization = $100.
– Workers’ compensation insurance = 1.5% of gross wages → $450.
– Total paid hours in month = 10 employees × 160 hours = 1,600 hours.
– Units produced in month = 20,000 units.
Step calculations:
1) Total labor cost = 30,000 + 3,000 + 4,000 + 1,000 + 167 + 100 + 450 = $38,717.
2) Labor cost per hour = Total labor cost / Total paid hours = 38,717 / 1,600 = $24.20 per hour.
3) Labor cost per unit (direct allocation) = Total labor cost / Units produced = 38,717 / 20,000 = $1.936 per unit.
4) Alternatively, compute labor hours per unit = 1,600 / 20,000 = 0.08 hours/unit. Then cost per unit = 0.08 × $24.20 = $1.936.
Notes on the example
– Amortization smooths one‑time costs across periods; choose amortization periods that reflect expected benefit lives.
– If direct labor is a manufacturing overhead, you might allocate only direct labor wages to COGS and classify benefits/indirect payroll as overhead.