Most small and medium-sized businesses don’t know their exact employee labor cost – or how much they should charge for their employees’ time.
Cost of Labor: Why Do You Need Accurate Employee Labor Cost Calculations?
I’m going to be bold and state that if you don’t have accurate labor cost calculations for every employee in your company, you’re probably underbidding jobs and losing potential profits.
It may appear that the easiest way is to “wing it”, or to adopt cost averages for your industry, but if you use either of these approaches to determine what your employees’ time is worth, you may very well lose out when it comes time to factor that number into construction or production costs and quotes.
Calculating Your Cost of Labor
First, you’ll need to know each employee’s true cost of labor which – of course – encompasses far more than their gross pay rate per hour. In addition to what they earn per hour working directly on a job, you’ll need to include the costs of:
- Paid time off
- Health, workers comp, and other insurances
- Retirement and/or union benefits
- Training (e.g., initial or basic training, training to stay up-to-speed or to enhance skills in a current position, certifications training, ‘transition’ training, and safety training)
- Company equipment and general supplies utilized by individuals (or by groups of employees)
- If an employee utilizes office or shop space, the cost of their workspace (facilities cost per employee)
- Errors, rework, and warranty costs
- Supervision and support
- Transportation time and costs
- Client communication time and costs (time spent communicating with clients while not on site)
- Time and cost not assigned to jobs for administration, company meetings, and “no work available”.
When all these factors are thrown into the mix, it’s clear that business owners cannot leave their estimates of labor costs to chance or quote jobs based on industry averages. Why? If you want to achieve a certain gross profit margin for your company, you need to be able to start with your estimated costs and then add your desired markup.
Let’s look at 2 scenarios in which the company owner (or estimator) prepares a quote and relies on industry averages (or old, inaccurate data). Let’s lay it out like this:
Example 1: Understated Labor Rate
- Desired gross profit margin at 30%
- Hours required for this job – 120
- Industry average of $35/per hour.
- Industry average cost for this job = $4200 (120 x $35)
- To achieve a 30% gross margin, this labor cost needs to be marked up approximately 43%
- Industry average price = $6006 ($4200 x 1.43) – so this is the labor rate (price) included in the quote to the customer.
- That would leave you with the following:
Income of $6,006 – $4,200 = $1,806 Gross Profit ($1806 ÷ 6006 = 30% GP)
- So far, the labor portion of the job is looking good… right?
BUT, what if the true cost of labor in this company is actually $38.50/hour?
- The real cost of the job will come in at = $4620
The difference means that, if you price based on industry average, your true gross profit will be – not 30% but instead, 23%: a large difference in gross profit results! (See below)
Income of $6,006 – $4,620 = $1,386 Gross Profit ($1386 ÷ 6006 = 23% Gross Profit)
In this case, if you use the true cost of labor, the job should properly be priced at $6606 (120 x $38.50) That’s $600 higher.
Example 2: Overstated Labor Rate
IN CONTRAST, what if your company runs ‘lean and mean’, and your cost of labor is actually $30/hour average? If you quote the job at the higher industry-average-based labor rate of $35, you may very well lose the job (and the related profits) to someone who really knows their costs and beats you by bringing in a winning bid that’s lower than yours.
The numbers that I outlined above are quite small – so you can easily see the calculations and the concepts. But in real life, the hours and amounts involved are normally MUCH larger. Try running these same calculations for one of your company’s average-sized jobs… What do the results look like?
Accurate Employee Cost Calculations Are Vital
So, which employee labor rate should YOU use to charge for your employees’ time?
A rate that’s too high – and risk losing the job? A rate that’s too low – that risks your company’s profitability?
As illustrated above, where does that markup calculation start? The answer: with an accurate assessment of your underlying employee labor rate cost. And, as you can see, without the right ‘cost-foundation numbers’, you’re working in the dark.
Could it be that it’s far better to take a few extra front-end steps to ensure that you’re using an employee labor rate amount that’s ‘just right’ – so you can win the right jobs at the right price + achieve your gross profit requirements?
Speaking as an accountant, to me it just makes sense to use ‘quality ingredients’ when you’re pricing individual jobs. When company-wide success (or failure) hangs in the balance, it seems logical to take steps to ensure that the current, underlying labor cost computations used for your estimates and quotes are comprehensive, logical, and accurate for YOUR company!
So is the ‘easy way’, really the easy way? Or is what initially appears to be the harder way (to start with current, accurate numbers), actually easier in the long run? It’s worth thinking about…
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