The cost of labor

The cost of labor is the salaries and wages paid to employees, plus related payroll taxes and benefits. The term may also relate to a specific time period or a job (if the employer is using a job costing system to track costs).

The cost of labor may be subdivided into the cost of labor related to the production of goods (known as the cost of direct labor) and the cost of labor related to all other activities (known as the cost of indirect labor).

It may be necessary to include a large number of benefits in the calculation of the cost of labor. For example, if an employee is paid $1,000 in an accounting period, here is a sample of what the total cost might be:

Expense Type Amount Explanation
Wages $1,000.00  Gross wages paid to employee
Social security tax 62.00  6.2% of wages
Medicare tax 14.50  1.45% of wages
Workers’compensation 10.00  Allocated from total w/c cost
Medical insurance 100.00  From the insurer's invoice
Pension plan (employer match) 80.00  From contribution spreadsheet
Disability insurance cost 5.00  From the insurer's invoice
Life insurance 3.50  From the insurer's invoice
Total $1,275.00  

The additional costs noted in the table are representative of the costs that an employer can expect to pay as part of a benefits package. Thus, the typical cost of labor includes a premium of usually 20% to 35% for additional tax and benefit payments, of which medical insurance is usually the largest component.

It is useful to understand the cost of labor for a number of reasons, including:

  • Cost management. If it is necessary to conduct a layoff, it is useful to know which costs of labor will be eliminated as the result of an employee termination.
  • Outsourcing. Management should understand its labor costs before outsourcing any activities to a supplier, in order to estimate the revised cost structure of the business.
  • Union negotiations. If employees are represented by a union, management must understand the labor cost associated with each bargaining position, to determine the overall cost to the business.

In a few situations, the cost of labor can be reduced by shifting the cost directly to customers. For example, tipping is encouraged in the hospitality industry, which allows employers to keep their labor costs low.