What Small Businesses Need to Know About Labor Costs

What Small Businesses Need to Know About Labor Costs

Payroll is expensive, perhaps more so than the average small business owner realizes. Depending upon the industry, wages and associated compensation paid to employees range from 10 percent to 30 percent of revenue. That’s a chunk. It’s imperative that entrepreneurs understand exactly both the obvious and hidden costs of maintaining a staff of workers. The trick is to find that fine balance of exactly enough employees to maximize profit while not having people standing around looking for things to do. Every small business owner needs a baseline knowledge of labor costs. This understanding could be a contributing factor to success or failure.

Know Your Industry

Labor cost as a percentage of revenue vary wildly among business sectors. The manufacturing industry tends to have a lower percentage of labor costs than industries like restaurants, theme parks, or brick and mortar retailers. Trucking carries the highest costs of all at close to 60 percent of total cost.

The first thing to do is figure out what the standard is for your industry and see where your payroll falls on the spectrum. If you’re out of whack to either side make it a point to figure out why. High costs need to be reigned in. Even if  your labor costs come in low, you still need to figure out what you’re doing and make sure you keep doing it.

Know the Math

Any small business owner with a basic calculator can figure out what her labor costs are by percentage. If you had a gross revenue to $500,000 last year and spent $100,000 on payroll. Divide the revenue number by the payroll number and convert the result to a percentage. In this example you would come up with .2 which is equal to 20 percent. Keep in mind this calculation is only as valuable as the accuracy of the numbers in the equation. That means you need to total up all expenses associated with your employees and not just the obvious expense of wages. Keeping good records makes this easier.

Base Pay Plus…

Base pay is an easy number to figure out, but it’s the other expenditures that can drive the cost of an employee up to 40 percent higher. When you calculate labor costs, don’t forget to include health insurance premiums, uniforms, overtime, federal and state taxes, workman’s compensation, paid time off, and time spent training a new employee. Once you crunch all these sometimes forgotten costs, you’ll find that an employee you pay $14 an hour actually costs you close to $20. This can be a shock to the system of a small business owner who has never taken the time to add it all up.

Low Pay Equals High Turnover

One of the tricky issues you’ll run across when setting the pay scale for employees is how to balance the least you can pay against high turnover. Training new employees can represent a high cost that, if retention rates are high, can be a valuable asset. It does bring drawbacks though. Training takes valuable time away from you and your knowledgable employees. This isn’t a huge deal if the employees being trained will be around to use that training for a long time. This is where costs come into play. Pay too little and your employees may look for greener pastures. As a result you are liable to feel like you’re constantly hiring and training. Some businesses don’t seem to mind this – you may be one of them – but you should be aware that this practice might be more expensive than you realize.

Understanding Minimum Wage

In light of the discussion so far, it’s not surprising that some small business owners view political talk of raising the minimum wage with something that verges on terror. Chances are many are already paying minimum wage once other compensation is added in, but federal and state governments focus only on the base pay rate when setting policy. This one-size-fits-all way of thinking can force a small business to reduce staff, turn to creative automation techniques, or shut down completely. It’s important to develop a vast understanding of your business model, the number of employees you need to run it in a lean and efficiently manner, and any potential streamlining measures. This will allow you to determine which employees should be paid at the minimum wage, which should not, and how many of each is the right number for your bottom line.

The Bottom Line

Ultimately, you as an owner, must do what is best for the business. Presumably, you started the company with the intention of making money in order to improve the financial circumstances of yourself and family. That means you must run the business with an eye towards that bottom line. Know your expenses. With labor being at the top of costs, you have to maintain a constant state of vigilance that the staff doesn’t get too big, or too small. No boss likes to lay off employees, but be prepared to do so if the daily business doesn’t warrant a full staff. It doesn’t mean you are a bad person. The cliche is the truth; it’s nothing personal, just business.

About author

Michael Barry
Michael Barry 23 posts

Michael Barry is the Editor-In-Chief at SMBReviews.com. Currently living in Boston, Massachusetts, he received his B.A. in Financial Economics from St. Anselm College and his MFA in Creative Writing from the Stonecoast Program at the University of Southern Maine.

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