Knowing the dollar figure that your company spends on labor only tells you part of the story. Granted, it's a useful part of the story, especially if you're trying to make sure there's enough money in the bank to cover your paychecks and payroll taxes. However, your labor cost percentage is a better indicator of the overall health of your business model because it shows the relationship between your labor costs and your overall sales revenue.
How to Calculate Labor Cost Percentage
To calculate labor cost percentage, divide your labor cost for a period by your gross sales for the same period. Labor cost percentage doesn't just include payroll, but also any employee benefits and taxes associated with your payroll. If your labor costs for the first quarter come to $33,000 and your gross sales for that quarter were $100,000, your labor cost percentage is 33 percent. If you spent $50,000 on the payroll during the second quarter and sold $200,000 worth of goods during that quarter, your labor cost is 25 percent.
Why Labor Cost Percentage Matters
Labor cost percentage tells you whether your payroll cost is sustainable. It is especially important to pay attention to this number when your company is poised for growth because this information will tell you whether an increase in sales revenue will actually earn you enough extra money to be worth the investment. If your sales revenue for the previous year was $10,000 and you spent $3,000 on labor costs, your company may not have netted much at the end of the year, assuming your other expenses were manageable, but your prospects for profitability are promising if you can grow your company to $100,000 in revenue. If your sales revenue for the previous year was $10,000 and you spend $7,000 on labor, you'll earn considerably less even if you're able to grow your company to $100,000 in revenue.
Fixed vs Variable Costs
Labor is a variable cost, meaning that it varies more or less directly relative to how much business you transact. In contrast, fixed costs such as rent and utilities stay reasonably consistent even when your business grows. Knowing your labor cost percentage helps you to make useful projections. If you've had a consistent labor cost percentage of 40 percent over the past two years, it's reasonable to assume that unless there are mitigating circumstances, your labor cost will stay in that ballpark for the foreseeable future.
Economies of Scale
Labor cost percentages often improve as a business grows due to economies of scale. If you own a restaurant, it takes a minimum number of payroll hours to keep your kitchen and the front of the house fully staffed even if you've just opened and you haven't yet attracted much business. As you start to bring in more customers, you'll be able to make money using the excess capacity, or time when your staff had previously been standing around. This extra business will earn you extra money without increasing your payroll, improving your labor cost percentage. It is sometimes difficult to predict precisely when economies of scale will kick in and start benefiting your business, but it's important to recognize and leverage them when they do occur.