Before I start, please be sure to understand the definition of direct and indirect compensation paid to employees by reading: The Different Forms of Compensation.
Additional Employee Costs
Those costs an employer is legally obligated to pay and has committed to pay are additional expenses used to determine the labor burden. In general, they exist in three groups. Below are the three groups of costs and examples of the individual costs:
1) Compliance (Legally Mandated Costs)
- FICA Matching Taxes
- Worker’s Compensation Insurance
- Health Insurance Premiums/Contributions under the Affordable Care Act
2) Company Provided Benefits
- Paid Sick/Vacation Time
- Retirement Plan Contributions
- Health Insurance Premium Contributions in Excess of ACA Requirements
- Holiday Pay
- Christmas Bonuses, Other Bonuses
- Life Insurance Premiums
- Cafeteria Plans
- Safety Equipment
- Personal Tooling
- Human Resources Department
- Education Material
It is not uncommon for these costs to accumulate to over 50% of total wages paid. Just as a simple formula, look at the most core costs as a percentage of base wages:
Matching Taxes + FUTA/SUTA 9%
Worker’s Compensation Insurance 6%
ACA Compliance 8%
Vacation/Sick Time 7%
Retirement Matching 3%
The above equals 36% alone and there are no operational costs included. This is why rates of 50% or more are not uncommon.
How to Calculate Labor Burden Rate
Labor burden is often discussed as a percentage of the wage base. It is commonly stated as: the labor burden rate is 38%. This means that the company must earn from the service or value the employee renders 1.38 times the wage paid to that employee to cover all the additional costs for that employee.
So how is this labor burden rate derived? Are there any nuances that should be considered when developing this rate? Is the rate static? Let’s find out.
The key to a good result is ensuring all costs related to the employee are included in the formula. Look at the list above. Those respective costs are just the more common ones. Some industries have significantly more costs associated with their employees. In general, the more risk associated with loss of life or limb for the employee the more likely the costs associated with the core wage increases.
For example, imagine a diver working for a salvage company. The company charges a rate per hour for the diver’s work. However, there is more to this than one realizes or can imagine. Preparation time for a dive often exceeds the actual dive time by a factor of three. So right away, the minimum multiplier is 300%. Safety costs increase dramatically (think of hyperbaric chambers), worker’s compensation insurance will exceed 25% of the wage base and then there is down time as divers require rest between dives. Most divers must maintain a license to do this work. In this case, the formula can get pretty convoluted.
Other more traditional jobs are easier to calculate the labor burden rate. With more common forms of work, the accountant simply takes all the costs incurred in the prior year and tallies them up and calculates the percentage against the total W-2 wages paid. The accountant will customarily use all Medicare wages and not the Social Security wages as Medicare wages have a broader definition under the tax code.
When summing all the costs, the accountant will include all the costs of the human resources department including their share of costs for rents paid, technology, office supplies and so on. In addition, the employee salaries and wages associated with the human resources department are included too.
The formula is a three step process as follows. First, identify the operational rate as a percentage of all wages paid. As stated above, add up all costs for human resources, training, safety equipment, small tooling (customarily expensed as consumable when purchased), uniforms, education and recruitment of employees. This value is then divided by all Medicare wages paid in the prior year and you have a percentage.
Expect this percentage value to run between 3 and 6% depending on the nature of the business. Those operations that are more professional in nature and have higher standards for employees will have rates that are in the 6% or more range. For example, hospitals hire a wide array of staff, most of them are licensed and therefore there is more involved in recruitment, education and training of these employees. Whereas those companies that have a high turnover rate with employees due to physical demands and limitations will have lower overall operational rates. For example, a car wash business will hire more youth and the employer/employee relationship is tentative at best. Training is limited, recruitment is basic and focused, safety gear is limited and uniforms are often just golf shirts. There is no human resources officer or even a human resources department.
The second step is a lot more complicated.
If the company offers personal time off with pay or vacation/sick time with pay, then the formula gets convoluted. Throughout the year, paid sick/vacation and personal time is included in the gross wages of the employees but not as a function of their direct wage. Therefore the accountant must create a spreadsheet listing all employees and their respected earned time off and the corresponding value.
The value is summed but it still needs to be converted into a percentage of direct compensation. The solution is to assume all paid personal/sick/vacation time is paid each year and the balance of total wages paid are considered the wage base. The following is an illustration:
An interesting side note for the above formula. I kept it simple, in reality the accountant has to adjust the Medicare wages paid for other payroll items too, such as overtime pay, bonuses, pay in excess of the Social Security limits, benefit values included in gross wages and non performance pay. There is another article on this site that goes into detail about how to calculate separately the amounts as a percentage for both compliance and benefits.
The third part of the formula relates to compliance taxes, actual benefits paid by the company for employees and ACA requirements.
All of the above are summed and divided against the actual wages paid for physical services rendered and a percentage is formulated.
The most common mistake with the above formula is to include all corporate personnel. In reality you should only include the costs related to field workers and not the front office administration with the exception of the operational costs related to human resources, training etc. If all personnel are included in the formula the formula can easily be distorted higher or lower depending on the ratio of administrative and management payroll against field workers (those that actually render the service).
Another nuance relates to its purpose. Often the burden rate is calculated as a function of a long-term contract, usually with a governmental project, and the underlying elements of labor burden are defined in the contract. Therefore, it is possible the formula is more inclusive than the items I identified above or it can be more restrictive. Thus it is important to understand the definition as defined in any contracted negotiation. As an owner, you will want the term to be as broad as possible in order to offset as many costs as possible.
For example, I believe the labor burden rate should include the costs of the back office administration and any associated software costs to monitor time and track time for employees involved.
One last nuance related to the labor burden rate is its functional purpose. In general, it has one of two primary purposes. One is for management to have an overall understanding of the real cost of an employee based on an hourly rate; it basically gives the management team an idea of the cost of an employee. The other purpose is often a contractual agreement value. The customer is agreeing to pay a base rate for an employee’s time and the corresponding employee overhead. The final amount then has an agreed upon percentage to add for administration and profit.
One of the interesting aspects of the total amount relates to the downtime the employee encounters. In almost every situation, employees have down time or pauses due to logistics. Examples include travel time, set-up, clean up and so on. The key is the language used in the agreement between the customer and the company. Is the customer only paying for actual direct time on the job or is the customer also paying for down time? If the customer is paying for the down time, then there is no need to adjust the labor burden rate; but if not, then the burden rate should be adjusted to take into consideration the costs of the employee’s compensation for the down time periods. Again, the wording with the contract is important related to the definition of employee time and how the labor burden rate is calculated.
Is Labor Burden Rate Static?
Novice business owners and/or managers firmly believe the rate never changes.
The labor burden rate is constantly changing, usually increasing due to governmental compliance. When the Affordable Healthcare Act when into effect a few years back, the rate changed significantly for many employers. This happens frequently and it is a good policy to revisit the formula no less frequently than annually. This also requires the ability to modify a contract that defines this rate when the rate changes or the company will have to absorb the additional costs from its profit. Therefore, long-term contracts should have adjustment clauses built in related to the labor burden rate formula.
How to Use the Labor Burden Rate
As stated before, the number one reason to use this formula is to have an understanding of what it really costs to have an employee working for the company. Often owners, managers and estimators woefully miscalculate two important parts of every proposal or business formula. One, they misunderstand how much it really costs to have an employee. As stated above, often the additional costs for an employee exceed 40% of their base wage. The more professional the organization, the more likely the labor burden will exceed 50% of the employee’s wage.
Secondly, and the most costly is the common understatement of how long it will take an employee to get something done. Unlike an owner or manager, the employee’s heart and soul isn’t in getting the work done in a timely fashion. There are multitude of factors that contribute to this thinking and their actions. They include:
- How professional the workers are that are involved?
- Age of workers, often younger workers don’t appreciate the importance of what they do.
- Experience, the more complicated the task, the more likely the employee lacks the experience to successfully complete the task in a timely manner.
- Leadership, owners, managers and estimators often believe the leadership in the field is adequate when in reality, most supervisord are under trained or don’t have the demeanor to lead.
To compound the under estimated time cost related to the wages, are the additional labor burden related to the wasted time in the field. So this aspect of the formula is often misapplied.
When negotiating a long-term contract that is cost plus, explain the benefits that employees receive to the customer so they understand why the labor burden rate is higher than the competition. When the customer wants to know why he should pay a higher rate, spin the answer back to the customer. You are in business for the long haul. Finding, training, and maintaining good employees is expensive; the savings to the customer comes in the form of having a professional, mature, experienced and well led group of field staff. This is what will keep the overall costs of the contract down in comparison to the competition. Simply put, the competition will take longer to get the job done and therefore the customer pays a lot more because the hourly wage is more costly than the benefits and if the competition takes 20% longer to get things done, the cost to the customer will far exceed the agreed upon amounts in a contract with your company.
Summary – Labor Burden Rate
The labor burden rate is a formula used to determine the average additional costs per unit of wage to have an employee. It is comprised of many underlying elements including 1) taxes and compliance, 2) employee benefits, and 3) operational costs of having an employee. It is necessary for owners and managers to fully understand how much an employee costs other than just the core wage paid to an employee.
When applying the formula, be sure to restrict it to the field staff for one part and create a separate formula for the administration and management team. Be sure to define the term carefully if utilizing this formula in a contract especially long-term contracts. The rate will change frequently and therefore it is a good practice to reevaluate at least annually the cost to have employees. ACT ON KNOWLEDGE.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.