Do You Know What Your Direct Labor is Costing You?
One thing about COVID-19 it’s made small business rethink about their financials and what’s important. If you’re a small business owner it’s time for you to peek under your hood and check your direct labor costs.
Many think direct labor costs are really only for manufacturing or large companies who want to nickel and dime their employees with time cards to squeeze the most out of every employee. (and this is not wrong)
But it’s also a tool that small business owners can use to keep their costs for services in check.
I know you hate match but when we talk about 7 Simple Numbers one of the biggest factors is employees costs. Both direct and indirect. We’re on to Number 4. Direct Labor costs. Why is that important for you…
Direct labor is part of your cost of goods sold and if you’d like more information check out our article What the Heck is Cost of Goods Sold.
Free Direct Labor Calculator: Get our Direct Labor Calculator that lets you easily track and calculate your labor costs and keeps your profit margin in the green.
What Are Direct Labor Costs?
Direct labor is the salaries both in money and benefits that are paid to employees and contractors who are directly involved in supporting a project, a client, or who manufacture goods. Whew, what a mouthful.
Let’s give an example.
Mandy has opened up a Marketing Agency, Mad Agency. Mandy loves to write content but hates to come up with graphic designs so she outsources her designs to Henry. Henry charges $20.00 an hour and is not an employee. Mandy want to make sure that the labor charges are packed into the invoice she is going to give her client. She knows that it takes Henry 5 hours to complete the design. To complete the project Mandy has spent 20 hours of her own time plus another 5 hours for Henry’s
We know that Henry’s portion of the Direct Costs is $100.00. But what is Mandy’s?
Hmmm you didn’t think the direct portion only included Henry, did you?
Ok you probably did. You assumed that Mandy since she’s the owner of Mad Town doesn’t have direct costs as she is the owner. But Mandy is smart, and she pays herself a salary. And those 20 hours that she worked on this project is billable. She wants to make sure that the Project price will take into consideration both her indirect and her direct costs. (Smart Girl!)
The second reason that you want to include your time into direct labor costs is that you might one day want to outsource Mandy’s portion of the project too. If she doesn’t know what percentage of the costs is for direct labor, she won’t know how much to pay someone one and still be profitable.
If your still unclear as to why direct costs are important you should check out this white paper by Daniel S. Hameresh. “Do labor costs affect companies’ demand for labor”.
What Are Direct Labor Costs?
Direct labor costs are something you should track consistently. As your business grows so do your costs so keep in mind a few times that it’s imperative that your direct labor costs are in sync.
Starting a new project
Do you have a new client? Then it’s time to recalculate your direct labor costs to make sure your still in the black
Adding a new Contractor
Hiring a new contractor with different hourly rates. Then it’s time to update your direct labor costs to include the uptick in price.
Hiring a new employer
Did you hire a new employee who will be working on direct projects for clients or the manufacturing of goods and services?
What Are Direct Labor Costs?
Free Direct Labor Calculator: Get our Direct Labor Calculator that lets you easily track and calculate your labor costs and keeps your profit margin in the green.
Now that you know why direct labor costs are important it’s time to get onto how to calculate it. f you don’t feel like doing this by hand download the Direct Labor Cost Spreadsheet and Template Here
Step 1: Calculate Direct Labor Hourly Rate
The first step is to calculate the direct labor hourly rate which includes benefits, pay, and employee taxes.
Divide the value of benefits and payroll taxes by the number of hours of work for a specific payroll period.
For example:
Mad Agency employees work 40 hours per week, earning $13 per hour. They also get $100 in benefits and $50 in payroll taxes.
(100+50) divided by 40 and you get $3.75 add that to $13.00 an hour and your direct labor rate is
$16.75
Step 2: Calculate Direct Labor Hours
Direct labor hours is the number of hours needed to complete one unit or 1 project.
For Example:
On average Mad Agency completes a Client engagement in 80 hours per month
It takes the graphic designer 3 of those hours to complete their portion and it takes Mandy 30 hours to complete the cost then Multiply the graphic designer hourly cost times three
16.75 X 3 = 50.75
Andrea's Tip
If each of your projects is different use estimated time for Small, Medium, and Large projects for example if on average a small project is 10 hours, a medium project is 80 hours and a large project is 120 hours use the averages to determine direct labor costs.
Step 3 Calculate the labor cost Per Project, Client or Unit
This step is pretty easy just multiple the Direct Labor Hourly rate
It takes the graphic designer 3 of those hourse to complete their portion and it takes Mandy 15 hours to complete the cost then Multiply the graphic designer hourly cost times three
16.75 X 3 = 50.75
For the graphic designer.
Now let’s say we’ve calculated Mandy’s direct labor at $52.00 per hour
52 x 15 = 780.00
Now we know that
50.75 + 780 = 830.75
Will be in direct labor
Step 4 Calculate the Percentage of direct labor compared to Revenue
Let’s say the small project generated $1500.00
The total cost of employees versus labor is 55% of the revenue. Leaving a healthy profit margin
Free Direct Labor Calculator: Get our Direct Labor Calculator that lets you easily track and calculate your labor costs and keeps your profit margin in the green.
Putting it Altogether
Understanding your direct labor costs will help you figure out if your offering the right wage to not only pay people but keep your business profitable. If you’d like to know more about understanding labor market check out this article Major Factors Affecting Labor Costs.
So whether you’re a service based business like a lawyer, marketing company or accountant. Or a contractor bidding on projects, your business can maintain a great profit margin by keeping an eye on your costs.
Cheers
Andrea
