The national average for construction workers, according to the U.S. Joint Economic Committee, is $19.14 an hour but hourly wages are not the only thing you’re paying for labor.
Construction labor cost is a significant aspect in determining the overall expenses of a construction project. It is crucial for contractors and project managers to accurately calculate labor costs to ensure profitability and project success.
In this article, we will explore the indirect and direct labor cost formula in construction, including understanding what labor cost entails, differentiating between direct and indirect labor, and implementing strategies to lower labor costs.
What Exactly Is Labor Cost?
Labor cost refers to the overall expense associated with compensating your employees for the work they do. It includes wages, salaries, and benefits, making it a critical factor to consider when calculating and managing your business's finances.
These calculations help you determine how much you need to allocate in your budget for labor expenses. Understanding labor costs is essential for accurately forecasting and managing your business's financial health.
Direct Labor vs. Indirect Labor
Before delving deeper into labor cost calculation, it's vital to understand the difference between direct labor and indirect labor.
Direct Labor: It refers to the employees directly involved in producing goods or providing services.
Indirect Labor: This consists of employees who support the production process but do not directly contribute to the end product or service.
Direct labor costs are relatively straightforward to calculate. You consider the number of hours worked by employees and their corresponding wage rates. For example, if a construction company has five employees working on a specific project, the direct labor cost would be the sum of the hours worked by these employees multiplied by their respective hourly pay rates.
Indirect labor costs, however, are the costs that are not directly involved in a construction project. These costs include salaries of on-site contractors and project managers, for example. While these employees don't directly contribute to production, they play a crucial role in keeping the business running smoothly.
Why Is It Important To Calculate Construction Labor Costs?
As with all aspects of your cash flow, you need to have a clear picture of what you’re spending versus what you’re bringing in. If you don’t know what your actual labor costs are, you risk underbidding jobs and/or under or over-paying employees.
It’s also difficult to budget if you don’t have accurate data about your construction labor costs.
Understanding Construction Labor Costs
When using a labor cost formula in construction, you need to understand the different types of payments associated with it. Most labor costs are either direct or indirect costs. Some of these costs may be variable while others may be fixed.
For example, the cost of labor to run machinery is variable, based on how much you use it. You can increase or decrease variable labor costs by increasing or decreasing the use of that machine. Conversely, fixed labor costs might include set fees for long-term contracts, such as scheduled maintenance for the machine.
The base rate of labor costs is the amount each employee is paid per hour. If you have a small crew of a laborer, a framer, and a team lead, you would calculate their collective hourly pay rate as your base rate for having that team on a job.
For example, if the laborer makes $15 an hour, the framer makes $25, and the team lead makes $40, your total base rate for one day will be $80 for each hour worked per day.
Base Rate: $80/hour
Labor burden includes more than your hourly base rate. You have to consider the extra you pay for things like:
While each company is unique and perhaps you don’t offer benefits, there are still things to consider. For example, do your employees drive company vehicles home? Do they use your tools or their own? All of these things would contribute to the amount you’re actually paying to have that employee working for you.
Direct and Indirect Labor Costs
The best way to define the differences between direct cost and indirect labor cost in construction is that direct costs are the expenses specific to a particular project, and indirect costs are whatever expenses are left. Indirect costs are less defined and more variable like overhead, vehicles, and equipment.
Direct costs include things like material, labor, equipment, or subcontractor costs. These costs are usually less challenging to calculate because most often, they are allocated to a specific project or job and don’t vary much.
How to Calculate Labor Cost
Before you can calculate your labor costs, you’ll need to calculate your base rate and factor in your other direct and indirect costs. For that, you will need to use an indirect and direct labor cost formula.
We’ll use a hypothetical employee, Eddie, as an example. Eddie is an hourly, non-exempt employee, who works full-time in a construction company in California with more than 26 employees. He gets $22 an hour.
1. Calculate the Gross Pay
The first thing you want to do is figure out Eddie’s gross pay. Here is the formula:
Gross pay = gross hourly rate x number of hours worked for a pay period
Calculate Eddie’s gross pay per year. The total hours that Eddie is supposed to work for the period of one year are:
Total number of hours per year = 40 hours per week x 52 weeks = 2080 hours
This means his gross pay per year is:
$22 x 2080 hours = $45,760
2. Figure Out the Actual Worked Hours
The total work hours per year are 2080. However, every employee needs to take days off. Let’s say Eddie missed 12 days in the year. Here is how to calculate hours not worked:
Hours not worked = 12 days x 8 hours = 96 hours
Then you can easily get the net hours worked:
Actual worked hours = total number of hours per year - hours not worked
This would mean, in this case:
2080 hours - 96 hours = 1984 hours
The actual hours that Eddie has worked for a year are 1984 hours.
3. Determine All Annual Costs Per Employee
Next, you have to take into account all related expenses that you owe Eddie, such as taxes and healthcare. They come on top of her gross pay. Only after you calculate them can you get the actual labor cost per hour for a particular employee or the true cost per hour.
Some typical labor costs besides actual pay are:
- FICA taxes (7.65%), of which Social Security is 6.2% and Medicare is 1.45%
- FUTA taxes (standard rate of 6%, but exceptions apply)
- State unemployment taxes
- Local unemployment taxes
- Health insurance
- Additional insurance such as dental, life, or disability
- Retirement plans
- Paid time off (sick and vacation days)
- Meals at work
- Education and training
Other Possible Expenses:
- Overtime pay
- Workers’ compensation insurance
- Work supplies
In Eddie’s case, here is the breakdown of additional labor costs:
- $3,339.07 annual taxes (6.2% Social Security is $2706.18, 1.45% Medicare is $632.90, 0.6% FUTA on the first $7,000 is $42, and California state unemployment insurance is 3.4% on the first $7,000, which equals $238
- $3,100 health insurance
- $2,000 benefits
- $900 overtime
- $500 meals
Thus, the extra annual cost you must pay for having Eddie as an employee is $10,119.07.
4. Calculate the Total Annual Payroll Cost
You are now ready to determine the actual annual payroll cost for Eddie, or the total labor cost for her. Here is how to do that:
Annual payroll cost = gross pay + other annual costs
In this example, the amount is:
$45,760 + $10,119.07 = $55,879.07
This is the total annual cost of Eddie’s work.
5. Calculate the Hourly Labor Cost
Now you can figure out Eddie’s cost of labor per hour.
His hourly labor rate (wage) is $22. However, you want to get the total cost per hour. Here is how you can do that:
Annual payroll cost / actual hours worked = hourly labor cost
For Eddie, calculations come up to:
$55,879.07 / 1984 hours = $28.16 per hour
Now you know the actual hourly labor cost for Eddie.
4 Strategies for Lowering Direct Labor Cost
Direct labor cost is a significant expense for many businesses, particularly those that rely heavily on employee manpower in their operations, like construction. As such, finding ways to reduce direct labor costs can greatly impact a company's overall profitability.
1. Implement Time Clock Regulations
One effective strategy to lower direct labor costs is to implement time clock regulations. By accurately tracking employee work hours, businesses can avoid overpaying for idle time or unauthorized breaks. Time clock systems can provide valuable data on employee attendance and productivity, enabling construction businesses to make informed decisions to optimize workforce efficiency.
2. Reduce Absenteeism
A high rate of absenteeism can have a significant impact on direct labor costs. When employees are absent, businesses may need to hire temporary workers or pay overtime to cover the workload. To lower direct labor costs, it's essential to implement strategies that reduce absenteeism.
Encouraging a positive work environment, offering incentives for good attendance, and implementing supportive policies such as flexible work arrangements can help reduce absenteeism. By addressing the root causes of absenteeism, construction businesses can minimize the impact on direct labor costs.
3. Cross-Train Employees
Cross-training employees is a valuable strategy to lower direct labor costs. By training employees to perform multiple tasks or roles, construction companies can optimize workforce utilization and reduce the need for additional labor.
Identifying the potential within your current team is an investment that will likely yield significant returns in the long run.
4. Invest in Automation and Technology
Another effective strategy to lower direct labor costs is to invest in automation and technology. By automating repetitive tasks or utilizing technology to streamline processes, businesses can reduce the need for manual labor and increase overall efficiency.
How to Choose the Right Labor Cost Estimating Software
The right software will help you calculate your base rates and other costs much more efficiently.
Track Labor Hours
With time-tracking software, you can get accurate, real-time hourly data about how much your employees’ rates are costing on the job. You can ideally filter by employee or job to get a fast report on how much you’re paying in base rates.
Track Job Progress
With the right software, you can stay on top of each job or project to have a clear idea about how long it’s taking, who is working on it, what types of equipment or materials are being used, etc. Each of these things will help you get a more accurate picture of your labor burden
With a software solution, you can have a centralized place to store records of expenses, making it easier to keep track of what is spent on each individual job or project.
Improve Job Costing
With accurate time reporting and material data, your future job costing is made much easier and more accurate. When you have the cost of your actual labor burden - a part of your job costs - you are more likely to increase your profit margin.
Calculate Labor Costs in Construction
Whether you choose to calculate labor costs with a labor burden calculator or with software, it’s essential to get it right so you don’t lose money by underbidding jobs. If you find you’re frequently falling short on your labor costs, it might be worth it to invest the time it takes to truly calculate your labor costs in construction.