group multiracial factory workers sewing in clothing factory to illustrate "labor costs"
Jordan Schneir
By: jordan_shneir
Read in 14 minutes

How to Reduce Your Labor Costs

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Small businesses can be extraordinarily difficult to run efficiently. As a small business owner, you’re sure to have spent hours determining how you can cut costs without sacrificing the quality of your products or services. Labor costs, along with production costs, are one of the largest costs that every small business incurs.

 

What are labor costs?

Labor costs consist of salaries and wages paid to employees: it’s a necessary expense and an investment when efficiently managed. However, if you don’t monitor and control your labor costs, they can eat up a significant portion of your budget. As many of these expenses are crucial to the success of your business, it can be difficult to figure out how to trim them. But actually, calculating your cost of labor and reducing it without hurting your business can be much easier than you’ve probably imagined. Here we’ll show you how to do it. 

 

How to Calculate Your Labor Costs

First, we need to understand all the costs associated with labor. Many first-time entrepreneurs make the mistake of assuming it’s only the hourly wage or salary for each employee. Unfortunately for you, the cost of an employee doesn’t stop there. Based on the labor laws and tax code of your state, the following costs are included in your labor costs:

  • Salaried employee wages
  • Hourly employee wages
  • Bonuses
  • Overtime
  • Payroll Taxes
  • Healthcare and other benefits
  • Sick and vacation days

Basically, anything that can be categorized as “labor-related” is part of the labor cost and should be considered in your calculation.  

Quick Tip: Involuntary termination of employees will result in higher employer deductions towards your unemployment reserve. To put it bluntly, the more people you fire the higher the cost per employee.

When evaluating labor costs, it’s important to break out your direct labor costs. These costs are directly associated with producing or distributing a product or service. For instance, the direct labor costs of a fast food restaurant chain include the cashiers, cooks, store manager and other staff working at the restaurant. The indirect labor costs would be administrative staff and management responsible for the entire chain of restaurants.

So why are direct labor costs so important? This metric will tell you how much labor you can use to produce a product or service. Remember, the goal is to earn a profit for every unit you sell so always make sure your labor costs NEVER exceed how much you earn by selling the unit. In the case of the fast-food restaurant chain, the business owner will only staff the necessary people required to demand AND earn a profit.

So should direct labor costs equal sales? Absolutely not!! Your business likely has other costs associated with delivering a product or service, such as the cost of materials (e.g. ingredients to make food at a restaurant). Every industry has a benchmark for what % of your sales should be used to cover your direct labor costs. In the case of restaurants, your direct labor costs should not exceed over 30% of your store revenue. See below a simple formula to measure your direct labor cost margin.

Direct Labor Cost Margin (%) = Direct Labor Costs / Sales

The direct labor cost margin is equal to the total cost of direct labor (hourly wages, commissions, salaries, and fees for all personnel directly involved with production or distribution + payroll taxes and employer deductions) divided by total sales.

 

How do Labor Costs Affect Sales Prices?

When any business determines its sales prices, it is vital that it takes into account all of its business expenses – including labor costs. Sales prices must reflect the business’ total expenses in order to ensure that they experience the profits that it expect. Therefore, as your labor costs increase, you would need to increase your sales prices in order to maintain your profit levels.

You should also be aware of how the cost of sales affects your sales prices.

10 Ways to Reduce Your Labor Costs

Now that you understand what all is included when evaluating your labors costs, you might be wondering:

“How can I reduce my cost of labor?”

The following 10 methods should help you effectively reduce your cost of labor, no matter what industry your business operates in.

Outsource Anything That You Can

Here’s the deal: there are many jobs within any business that can be completed without hiring a full-time employee. For these positions, a freelancer or company which offers related services can be extremely low-cost options to complete tasks without requiring a salary or benefits. However, you should be sure that doing this would not negatively affect your product or service in any way.

Reduce Turnover Rates

High employee turnover rates can unnecessarily and dramatically increase your expenses due to the expenses required during the recruitment process for new employees. Not only that, but high turnover rates can negatively impact production time and product quality. Reducing turnover rates is crucial in order to maintain the fluidity of production and trim your cost of labor. The best way to reduce the turnover rate is to keep your employees happy. That will reduce the chances of them leaving your company for a better opportunity. Learn here some easy techniques to keep your employees motivated.

Cross-Train Your Employees

As a small business owner, you are used to wearing many hats. Same goes for your employees. The bottom line is that hiring an employee to perform only one function is often a waste of money. While certain positions often require specialization, most do not. If employees are only trained to complete one job, then production can grind to a halt if one decides to quit. Putting together a workforce that is trained to complete multiple tasks throughout the production process can help reduce your labor costs, increase production efficiency, and make changes without disrupting workflow. In other words, you should definitely invest in human resources, but you must know how to do it. You will realize you don’t need a big team to bring your business to the next level, as long as they are properly trained (in multiple tasks) and motivated.  

Avoid Paying Overtime

As a small business owner, you are almost certainly aware of how much overtime can add up and impact your labor costs. While it may be necessary for certain scenarios, overtime can add up to several thousand dollars throughout the year if you are not careful. Additionally, you should pay close attention to ‘time theft.’ What does this mean? Time theft is when businesses pay employees for the time that they haven’t worked. This may be inadvertent on the employee’s part, but you should be sure to accurately track the time worked for each of your employees. You can find online a variety of time tracking apps (most of them free) that you can start implementing.

Utilize Technology

Implement technology to automate select procedures in order to reduce labor expenses. Technology for production and automation is quickly and constantly evolving – making it easier than ever for small businesses to utilize these tools to reduce production costs. While this equipment does require maintenance and supervision, it can be much cheaper than a full-time employee.

Want to know the best part? Technology can help you keep your production domestic and improve quality control. As a result, automation may not only allow you to reduce labor costs but can also increase quality and efficiency.

Standardize All Procedures

Optimizing efficiency and workflow often comes down to one thing:

standardization. Standardizing all procedures help increase output, reduce production time, and improve consistency. Furthermore, standardization can work hand-in-hand with automation to help your small business realize these benefits. However, even if you choose not to utilize automation, standardizing your operating procedures is a fantastic way to reduce your cost of labor.

Use Part-Time Labor

Hiring part-time employees is a great way to reduce costs without having to lower the number of hours needed to complete the task at hand. If you find that a certain job does not require a full work week to complete, hiring a part-time employee, or splitting a full-time job between two employees, will allow you to avoid issuing benefits when unnecessary.

Review Wages

You should constantly review what you are paying your employees in order to ensure that their wages are up-to-date with the current market. Often, you will find that certain employees are being paid more than what the market demands. In this case, you should delay raises, or only give the standard raises until everything evens out. This can also be an opportunity for you to train your employees to complete other tasks in order to increase their value.

Eliminate Redundancy

It is likely that your small business will begin to split into different branches and departments as it grows and expands. When this happens, it is often the case that many branches have one or more employees who are doing the same job. So, as you grow, you should take special care to review your operating procedures in order to reduce your redundancy as much as possible.

Optimize Scheduling

Last, but certainly not least, poor scheduling practices often contribute to unreasonably high labor costs – particularly your indirect costs. How does this happen? Businesses often try to make scheduling as simple as possible by organizing their employees to work certain hours every week. However, If the business is the type of establishment that interacts with customers, this often leads to too many hours being allocated to times during which sales are generally low, and to allocate too few hours to times during which customer traffic peaks. Thankfully, scheduling software makes it easy to optimize this process. Forecasting which times you expect your sales to be at their highest and lowest can help you reduce costs and optimize effectiveness.

Final Thoughts

Running a small business is all about figuring out how you can maximize your profits, and reducing your labor costs is one of the most effective methods of doing just that.

Lowering your cost of labor can help you reap a number of benefits, such as improving production efficiency, maximizing sales, and increasing profit margins. Following the 10 techniques laid out above can help you experience these benefits without sacrificing the quality of your products or services.

As you surely know, running a successful small business goes beyond reducing your labor costs, so it is important that you stay on top of current business trends, and remain aware of the various tools and strategies you can utilize to grow your business. Subscribe to the Camino Financial Newsletter to be a part of a community of over 40,000 people that receive weekly tips on growing your business.

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