How to Calculate Labor Costs in Manufacturing

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From handling employee grievances to recruiting the right team members, as an HR manager, there’s no shortage of challenges in your role.

Not to mention the pressure to keep labor costs low to maximize your bottom line. 

Keeping costs low is one of the easiest ways to keep a business profitable. Unfortunately, many companies choose not to keep track of this useful metric when analyzing their profit and loss, leading to poor efficiency and overspending.

With labor costs rising rapidly, every cent of your budget that’s overspent on labor can negatively impact your bottom line.

So, what’s the solution?

Calculating the cost of your labor is the first step. Once you’ve established your total labor costs, you can work out how to reduce them without damaging your company’s productivity. 

Let’s dive in and find out how to calculate labor costs in manufacturing. 

What is labor cost in manufacturing?

In short, labor cost in manufacturing industry is the total amount spent on employees by your company. 

The total amount includes the salaries for hourly and salaried workers, plus employee taxes, bonuses, and company-specific extras such as employee compensation schemes.

Overtime, sick pay, maternity pay, and training costs all contribute, so your total labor cost will be much more than just employees’ basic salaries. 

In small-medium businesses especially, labor costs can make up a large percentage of your overall costs. 

What’s the difference between direct and indirect costs?

There’s a significant difference between direct and indirect labor costs, and you should consider both when measuring labor costs’ impact on your business. 

Direct costs

Direct expenses are the costs associated with a specific object, such as raw material, software, or tool used the create your company’s product or service.

If an employee uses raw materials or tools to develop your business’s product or service, their salary is a direct labor cost example. 

In manufacturing, the salaries of your engineers, production supervisors, truck drivers, and assembly line workers are considered direct labor costs. 

Indirect costs

Indirect labor costs include costs that are not linkable to a specific product or service that your business offers consumers. Administrative expenses are a common example. 

The salaries of payroll staff, sales team members, administrative assistants, and office managers are labor costs that are considered indirect. 

Indirect labor contributes to your company’s overhead, but these costs aren’t attributed to a particular product or service because the roles relate to the entire business. Indirect costs also include rent, insurance, depreciation, and quality control. 

While these indirect costs don’t directly contribute to the development of your product or service, they’re necessary expenses for the successful running of your business. 

Indirect costs also include opportunity costs, which indicate the money lost because a particular aspect of your business isn’t running as it should be.

In the manufacturing industry, for example, a staff shortage means fewer machines will be able to run and, therefore, you’ll create fewer products. This staffing issue is a cost to your company because of the money you miss out on generating, as opposed to the money you spend. 

Indirect costs related to lost opportunity can make your company’s total costs and profitability harder to calculate. 

How to calculate manufacturing labor costs

Now you understand the importance of calculating labor costs, you’re probably wondering how do you calculate labor cost in manufacturing? Let’s take a look. 

Calculate the direct hourly labor rate

To calculate the direct labor hourly rate, add up all wages, taxes, and other benefit costs for a given period. Then, divide that total by the number of hours worked in the pay period. 

To calculate your company’s direct labor hourly rate, use the following formula:

Wages + taxes + other benefits divided by number of hours worked during the pay period

Calculate the direct labor hours

This calculation measures the number of direct labor hours it takes to produce one unit of the product you manufacture. 

To work out your direct labor hours, divide the number of units produced by the hours it takes to create them using the following formula: 

Units produced divided by labor hours needed 

Calculate the direct labor cost per unit

Once you’ve calculated the direct hourly labor rate and the labor hours per unit, you can calculate the labor cost per unit by multiplying the hourly labor rate by the labor hours per unit. 

Calculate the direct labor cost per unit using the following formula:

Direct labor hourly rate x direct labor hours

Once you’ve calculated your labor costs, you may establish that your labor costs comprise a large proportion of your overall running costs. You can then decide to reduce labor costs or increase the price of your product to factor in the costs (or both!). 

How to reduce your manufacturing labor costs

When your labor costs are lower, your profit margin is higher. With that in mind, reducing labor costs should always be at the forefront of your long-term business plan. 

The good news is, there are easy ways to reduce your labor costs without negatively impacting your company’s productivity or selling your employees short. 

Here are some ways:

1. Accurately track your employees’ hours

Tracking errors can have costly ramifications and lead to overpayment of staff for hours worked. 

Rather than relying on traditional techniques such as paper sign-in sheets or punching clocks, try using a schedule that monitors employee time and attendance and ensures timesheet accuracy. 

The best part? Using a digital system to record hours will make payroll easier than ever. 

Image of how labor costs are displayed on Voilà!

 2. Keep overtime to a minimum

Avoid relying on a small pool of workers to fill the majority of the hours.

Allocating the majority of hours to a few workers can lead to a small group of workers being paid overtime salaries while other workers are underused. 

Plus, favoring a smaller group of employees can cause resentment in the rest of the team.

Instead, use smart scheduling software to split shifts evenly across employees, leading to fewer overtime costs and fairer shift allocation. 

3. Train your staff properly

Better-trained employees work more efficiently. If your employees are efficient, they’ll create more products during their working hours, so you’ll be getting more bang for your buck with your labor costs. This will reduce the ratio of labor cost to the revenue generated by the products. 

4. Use helpful software where possible

Indirect labor costs can significantly impact a company’s profitability, and administrative tasks make up a large chunk of these costs. 

To reduce the time your staff spend scheduling hours, invest in workplace management software for manufacturing that allows you to easily create schedules, manage time and attendance, and find last-minute replacements for staff sickness. 

That way, you and the rest of your HR team can focus your time on other essential tasks. 

FAQs

Does manufacturing costs include labor?

Manufacturing costs are the costs involved in producing a product, including the costs of materials, direct labor, and overheads. 

 What is the average hourly labor cost for manufacturing?

As of February 2022, in Canada, the average hourly labour cost is 28.94 CAD/hour

As of April 2022, in the United States, the average hourly labor cost is 24.82 USD/hour.

How do you calculate the variance between the standard and actual labor cost?

The formula used for calculating the variance is as follows:

Total direct labor variance = (actual hours × actual rate) – (standard hours × standard rate).

Another way is by combining the direct labor rate variance and the direct labor time variance.

How much should you pay employees?

Paying employees a fair wage is important, and there are ways to reduce labor costs that don’t involve lowering salaries. 

To work out a reasonable salary for an employee, research what similar companies in your area are paying employees with the same roles. Remember to always pay at least your country/state’s minimum wage. 

What is job costing?

Job costing calculates and records the expenses and revenue for a particular project. This practice is also known as project-based accounting. 

Job costing takes into account the project’s labor, material, and overhead expenses. 

Job costing is a widespread practice in sectors such as construction, marketing agencies, law firms, and consultancies, where the amount of work and associated costs can vary significantly depending on the project. 

The bottom line

We understand that labor costs impact your bottom line. We also understand that keeping track of costs, creating optimized schedules, and maximizing efficiency are easier said than done.

By setting predefined rules for each production line and creating recurring schedules, rotas, and shift rotations, a workforce management tool like Voilà can help keep your production lines running like clockwork

Not only will you increase worker efficiency to keep your direct labor cost down, but the money you can save on administrative tasks will also help you save on indirect costs. 

You could continue to overspend on staffing costs and compromise your bottom line with out-of-date workplace management techniques. Or, you could save valuable time and money with a management platform that actually works. 

If you want to see how Voilà can revolutionize your approach to labor management and save your company labor costs, book a demo with one of our product experts.