How To Determine Labor-Based Pricing? (+ Labor Cost Calculators)

All business revolves around turning labor into profit. Here's everything you need to consider to set the right price for your labor-based services, plus labor-cost calculators to get the estimation right.

Labor-Based Pricing cover (+ Labor Cost Calculators)

Labor cost 101

Since our topic is the pricing of labor, first, we ought to explain the term "labor" — it refers to the cost of services that involve human resources.

So, let's kick the article off by pointing out the three main indicators of labor cost, according to Eurostat.

  1. Average monthly labor cost — This should be the total labor cost for compensating all the full-time employees. Besides their net salary, other costs such as taxes and benefits need to be counted as well.
  2. Average hourly labor cost — Once you calculate the average monthly cost, you can divide it by the total number of hours for all the employees. That way, you'll get an estimate of how much you ought to pay for one hour of work.
  3. Structure of labor cost — The structure refers to the percentage of labor cost, compared to the total labor cost. Meaning — it's an estimate made to guide you when you're segmenting your budget.

Labor costs are related to and depend on the specific markets, as well as industries, even companies.

There's also an interesting relationship between labor costs and living costs, which heavily depends on the specific region, especially the urban-rural opposition.

Before you understand the labor-based pricing formula, you need to know several definitions, the main differences between direct and indirect labor costs, and relevant variables.

In this introduction to Labor cost 101, we'll provide the answers to frequently asked questions to help you grasp the big picture of labor-based pricing.

What is the cost of labor?

Several variables will determine what are direct and indirect costs, above all meaning — the cost of labor is more than the cost of the employees' wages. For starters, there are other employee-related costs, including payroll taxes, overtime, paid time off, vocational training or education, provided meals, etc.

Some industries or companies include covering the costs of materials, equipment, and transportation, while others offer health care, various benefits, and bonuses, which business owners must all include in their calculation.

The cost of labor is an integral aspect of the total production cost and is closely related to employees' productivity levels.

After all, human resources should be treated as the biggest capital of a company and an asset.

How tracking time can help you get the pricing right

In order to get the best results in terms of profit (and the most from their human resources), business owners need to track their team's productivity.

Once they analyze the data, they'll be able to compare how different employees spend their time on the same tasks, therefore spotting the weak links.

Timesheet entering screenshot in Clockify

Bear in mind that we're not suggesting that the weak links should be laid off — but rather just to understand why some people take more time than others.

By tracking time, employees themselves will have access to their personal data, which can motivate them to better understand their routines and improve the way they allocate time to different tasks.

Time tracking software like Clockify includes expense tracking. It lets you track expenses by project so you can have a clear picture of all of your expenditures separately.

Does labor cost more than materials?

In short — yes, it does.

Materials are among the most significant areas of expenditure for industries such as the construction or food industry. But, even in those, employees need to deal with the actual execution of tasks.

The nature of a specific task will further dictate the ratio between the total cost and materials-only cost. For example, the latest data on building a house in the US points out that the architect's fee only consumes between 8% and 12% of the total cost.

Additionally, the constructor management fees will consume up to 15% of the total budget. So, it's definitely not only the material cost.

We've mentioned that the term labor implies human resources, therefore — construction employees must be adequately compensated for spending that time working with said materials.

Once again, we're emphasizing the fact that it's vital to include all the relevant factors while setting the price for a product or service, in order to earn profit.

What are labor costs based on?

The demand for labor depends on both micro- and macro-level factors, and the only way to know how much a new employee will cost your company and whether or not it is profitable to start recruiting. Here are some relevant examples of both categories.

Micro-level factors:

Macro-level factors:

As we've mentioned, there are two broad categories of costs when it comes to the total price of labor — direct and indirect costs. It's essential to determine your hourly, monthly, and annual calculations based on your company's unique combination of direct and indirect labor costs.

Direct labor costs

Direct costs refer to the total compensation of all the employees, the cost of materials, as well as other company-provided elements for employees.

What matters is to understand that the term compensation not only includes net salaries for employees, but other things as well. For example, payroll taxes, coverage of a certain number of sick leave days, bonuses, and various company-provided benefits such as meals, phones, equipment, or vehicles would fit into the category of direct labor costs.

The most common direct labor costs are:

The latest statistics from the US Bureau of Labor indicate that wages and salaries account for the range between 61.7% and 70.6% of total employers' cost, depending on the sector. Now let's see how the compensation costs are distributed in the US, as of June 2021.

The total cost for the employer in terms of compensation only was:

You can find the percentages for the wages and salaries, as well as the most important categories of benefits in the table below.

Wages, salaries, and benefits costs by industry
Compensation component Civilian workers Private industry workers Government workers
Wages and salaries 69% 70.6% 61.6%
Paid leave 7.4% 7.4% 7.5%
Supplemental pay 3% 3.4% 1%
Insurance 8.4% 7.6% 11.7%
Retirement and savings 5.1% 3.4% 12.6%
Legally required benefits 7.2% 7.6% 5.5%

Indirect labor costs

As for the indirect costs, those are much more flexible and dependent on the specific industry of labor. However, there are some indirect costs we can mention that are quite common, such as company overhead costs, recruitment costs, and vocational training costs.

Here's another great example of an indirect cost — occasional maintenance of a vehicle or a piece of equipment.

The most common indirect costs are:

How to estimate direct and indirect labor costs

To estimate the total cost, one must thoroughly examine the specifics of both categories we've mentioned. Here, we'll provide an overview of our imaginary company's costs, helping you understand the importance of each segment.

According to Accounting Tools, direct costs can be oriented to job and process cost environments.

In a job costing environment, time tracking is extremely significant for employers, as such environments imply that workers spend their time on various tasks.

On the other hand, the process cost environment implies the production of the same item in large quantities but parts of the process can be streamlined in a better way.

An example of labor costs

Here's an example of a fictional company in the construction industry. We chose to focus on construction in our examples, because such work includes and requires all the elements we've mentioned.

Our imaginary company's name is "Builders INC." and it employs 10 full-time workers. There's an office space for administrative tasks and the workers spend most of their time on site.

Calculating net hours per employee per year

To calculate the total number of hours an employee works per year, we need to determine the number of hours they are expected to be absent.

Let's say our workers are entitled to ten vacation days per year and that they will be absent for an additional five, due to sick and personal leave.

The starting point is 2080 hours per year, from which we will reduce a total of 120 hours (15 days x 8 hours per day). So the actual number of net hours per employee per year is 1960.

🔽 GET Net hours worked per employee calculator

labor based pricing cost net hours worked per employee

Calculating gross pay per employee per year

Now that we know the exact number of hours per year, we can calculate the gross pay for an employee per year.

We just need to multiply the number of hours with their hourly rate, which is $10 in our example. These employees will therefore earn a total of $19,600 per year.

🔽GET Gross pay for an employee calculator

labor based pricing cost gross pay for an employee

To adequately compensate your employees for the work they've done AND gain profit, one must ensure the company's values promote efficiency and productivity.

Calculating the total additional cost per employee per year

However, the total cost for the employer will be a different number, as each employee comes with a set of other costs we've mentioned, such as taxes, benefits, and any other industry-specific costs.

To get the total cost, we must first determine the value of additional costs besides the base salary. In our example, additional costs equal $1,920 per employee per year.

🔽 GET Additional costs per employee calculator per year

labor based pricing cost additional costs per employee per year

Human capital is the greatest and the most valuable asset of a company, so one needs to nurture it to get the greatest results.

Calculating the total cost per employee per year

Now that we have both, we can add those up and the result is the total cost for the employer per employee per year. In our example, it's $19,600 + $1,920, or $21,520.

We can further multiply that total by the number of employees to get the total cost for all the employees per year, as shown in the table below.

🔽 GET Total annual cost per employee calculator

labor based pricing cost total-cost-per-employee-per-year

Shakespeare once said "The more, the merrier" — and in terms of business, it surely is true that great minds think alike. If you aspire to become great, you ought to master time management skills.

Calculating the total profit per year

So what's left? It's only natural to want to check out how much is the profit for the year, once you've dealt with total costs. Total annual profit can also point to your availability of hiring new employees, so let's crunch the numbers for our "Builders INC." company.

What we need to do is insert our total revenue and deduct the following annual costs:

🔽 GET Total profit per year calculator

labor based pricing cost total profit per year

And what's it all about? It's about growing, developing, and evolving at the same pace as technology does. As creators, we can use it to our advantage and Clockify is a great example of how a SaaS can help you improve. Remember, "Own time, or time will own you."

And that's all folks!

As you can see in our example, this fictional company did well. If your numbers reflect a similar situation, you might consider expanding your team to get more work done and, consequently, earn higher profit.

What are the steps to calculate labor-based pricing?

Okay, now that you understand what are the aspects to pay attention to, we can start with our step-by-step guide.

  1. Determine the total payroll cost
  2. Determine the total cost of materials, equipment, and permits
  3. Determine the overhead costs
  4. Determine some other possible expenses
  5. Consider the issue of time theft
  6. Think of the ways to reduce the total cost

Determine the total payroll cost

Employees' compensation should always be a starting point and don't forget about all the aspects we've mentioned besides their salary.

So, what are the components other than the base salary that comprise the total payroll cost? Well, for starters, no one is expected to work 40 hours per week, 52 weeks in a year and be productive.

People need to take regular breaks, on a daily basis, as well as on a yearly basis in order to avoid overworking and exhaustion. This applies especially to construction workers, who are often dealing with heavy machinery and working on heights.

Of course, even with regular breaks, properly training all of your employees is essential and will significantly reduce the margin of human error.

Total benefits for full-time employees include the following categories:

Determine the cost of materials and equipment

Once you've covered that integral section, you need to think about all the equipment, tools, vehicles, and any other company-provided elements that those employees will use.

This segment will include both categories of costs (direct and indirect) as you need to take into account aspects such as maintenance of equipment, fuel for the vehicles, and similar. Another thing to consider, especially relevant for estimating construction labor costs, is the category of licenses and permits.

So, the second most important aspect in estimating the labor costs are associated with supplies of any kind.

There are four major and broad categories of such costs and those are:

Determine the cost of materials

Some industries we've mentioned, such as construction, manufacturing, and food industry primarily depend on materials and the costs associated with materials are therefore higher. Take all the materials needed for a project into account and it's highly recommended that you calculate the 5%-10% of "extra", just in case.

If you're wondering why that is the case, the explanation is quite simple — accidents happen, things get spilled, etc.

Determine the cost of vehicles

Some companies have their own vehicles, while others rent them. For the latter case, the coverage of renting is all that it takes, but for the former, several other aspects need to be taken into account.

Two main categories are:

  1. Regular maintenance costs
  2. Coverage of fuel

Determine the cost of tools and other equipment

Make a list of all the necessary tools and equipment needed for the project and those costs will once again depend on whether you own the equipment or are just renting it.

Determine the cost of any other company-provided elements

These include phones, laptops, etc.

This is a pretty self-explanatory category and every company offers such perks. However, if yours does, you need to include the total cost of those and multiply by the number of employees.

Determine the overhead costs

Speaking about the topic of maintenance, here's a segment dedicated to it, but in terms of business in general.

The category is called company's overhead expenses and points out that most businesses (even when labor is mostly conducted on-site, such as with construction companies) require an office space for administrative tasks and important meetings with the staff and clients.

Following that logic, the next step includes the costs of rent, utilities, and office equipment.

Determine other possible expenses

The first three steps can be all but not necessarily, so you should think about other possible expenses.

Think of instances where the materials are delivered late, or a piece of equipment gets broken, for example. That can slow down or delay the whole process, resulting in lower profits, as you'll get behind the schedule.

One of the most important lessons from the global pandemic is that we need to take the omnipresent uncertainty into account. Many things can happen and the lockdown and social distancing measures resulted in much of the work being on halt.

For example, a report on job losses in California due to the COVID-19 impact revealed that close-contact industries suffered the hardest hit. The most affected industries were:

As for other industries, we'll mention several that are related to the topic:

Consider the issue of "time theft"

Time theft is an important issue when it comes to several aspects of businesses, such as total compensation of workers, productivity rates, and overall profitability. When we think of the term "theft", most people won't associate it with time.

However, a Forbes article mentions a stunning result of the American Payroll Association study — in the US, close to 75% of companies are affected by the issue of time theft.

Time theft happens primarily due to "buddy punching", which is a common problem for employers worldwide. Buddy punching refers to instances where one employee clocks in or signs on a timesheet for another one (who might be running late or even skipping the whole day of work.)

We can generalize and sum up various definitions of time theft into the following — an employee getting paid for the time they did not spend working.

The problem can be extremely expensive for employers and furthermore, consequences of time theft can damage the company's reputation. The estimation of a yearly loss due to time theft is a whopping $400 billion, again in the US only.

So how can a business owner deal with that?

The issue may seem trivial and, since there are no laws to restrict clocking in for other employees or taking super long lunch breaks.

Here's another example of time theft, presented in another Forbes article — employees overall spend around 21% of their working time on social media, entertainment, and news.

Dealing with the time theft issue

What's a possible solution?

It all starts with tracking your employees' time by the individual project or a task, depending on the nature of the industry. The importance and benefits of time tracking matter for several reasons besides time theft.

Employee productivity can skyrocket once they learn to effectively allocate time, which will further be reflected in the company's profits. Once you have the timesheets, it's easier to improve on a large scale.

How to calculate the labor cost in construction?

Based on every factor we've mentioned, let's put our knowledge into practice, specifically focusing on construction work.

The construction industry has been heavily automated in the previous couple of decades, but still relies on people to perform the tasks, or in some instances monitor how a job gets done.

Materials vs. labor: the ratio within the total cost

As for the ratio between the materials and workers in construction, there's an everlasting debate and we can confirm that there's no "one size fits all" rule available.

It will depend on how specialized the job is, the competitor's prices, and the overall consumer demand.

The range of material costs can be anywhere between 50% and 80% of the total cost, depending on the subcategory of work.

For example, for highly skilled requirements such as electrical, mechanical, plumbing, fitting, and roofing work, the cost for employees dealing with these delicate issues is 50%, while the other half goes to materials.

Other, not so delicate tasks, such as windows, doors, plaster, and walling usually get divided into 20% for workers' cost and 80% for the materials.

Construction project cost: relevant additional factors and the calculator

But here's another thing to think about. The latest news points to the soaring cost of materials in the US, which has been causing a decline in the construction projects demand, as well as in profit.

It's because once the materials are costly, the total price must be increased if you want to stay in a profitable business.

Consumers might not like that and the only possible solution is to try to reduce some of the other costs.

The formula for calculating construction costs per project goes as follows:

(Hourly Rate x Number of Hours Worked Per Employee x Number of Employees) + Cost of Materials

Here's an example of a total cost for a project involving 4 employees, each of them working for 52 hours on it. They have an hourly rate of $10 and the cost of materials, equipment, and other necessary tools were $1,080.

As you can see, the total cost is $3,160.

Bear in mind that the formula doesn't include overhead costs, as it can be hard to determine those if a project is shorter than a month.

🔽 GET Construction costs per project calculator

labor based pricing cost construction costs per project

Is there a way to reduce the total costs?

With that many factors in mind, what's left? Well, the only rational thing to do is to try to reduce the costs and increase the profit.

Once you've calculated the labor costs in the worst scenario (that everyone will use all of their sick days and that you'll have an unexpected one-time cost for a broken piece of equipment, for example), the total may seem too much.

Even though it's unlikely that will happen, it's always better to be safe than sorry, right?

However, business owners can (and should) be proactive and try to find ways to reduce the total costs. Here are several tips and tricks that will help you with that.

Step 1: Use a time tracking system for individual employees

Tracking your employees' time benefits everyone and is a proven method of boosting the efficiency and productivity levels.

Not only can it motivate employees to be more productive on a personal level, but it can also significantly reduce the opportunity for time theft we've mentioned before.

Step 2: Conduct regular time audits (preferably on a monthly basis)

The process of investigating how time is allocated to specific tasks is called the time audit and helps business owners understand the daily routine of their employees. By comparing the data from different months and for different projects or employees, it will be obvious where an improvement is needed.

Once you determine that, you can work on the necessary steps to increase productivity and stop the time wasting.

Step 3: Invest in training of employees

Companies that don't invest in adequate training of their employees are at a higher risk of their employees making mistakes.

This step is of utmost importance, in order to reduce the possibility of an error and motivate employees to increase their productivity levels.

Step 4: Actively engage in networking

Try to make a deal with the distributor of materials, supplies, and similar products with a discount on a yearly basis. Networking and commitment to a distributor can save you a large amount of money, if you have the right approach.

Step 5: Start the green initiative to reduce the overhead costs

Sometimes it's not about wasting time but rather resources. When it comes to a company's overhead costs, there's always something you can do to reduce those. For example, you can go green with the lightning and therefore reduce the electricity costs.

Many other eco-friendly solutions require an initial investment but you shouldn't be fooled by the fact — because you will end up saving money.

Labor based pricing conclusion

Adequately determining labor costs has multiple benefits for the company — as you can already conclude from the article.

Bear in mind, all the factors that include human capital are difficult to calculate, as they depend on a wide range of factors we've covered.

However, human resources can be tracked by the way they spend their time at work, so both the calculators we've provided and the software we offer will undoubtedly help you get the most of your resources.

With Clockify, you'll ensure:

Remember, it's all about setting the right price for a product or service — it can make or break a business.

Timesheet report screenshot in Clockify

Sources