If you run a small business, you already know that tracking cash flow is critical to making sound business financial decisions. But keeping track of cash flow isn’t always straightforward, especially when you’ve got so many costs on your plate - like product costs, marketing, and payroll. The result? You may feel like you’re biting off more than you can chew. Fortunately, there’s a way to break the large chunk of your costs down into bite-sized pieces: one expense category at a time. Take payroll. It’s probably the toughest expense to deal with between rising living costs and employee turnover. So, let’s start there. With the owners we talk to who are behind on debt payments, it is where we start, too.
So what percentage of revenue should payroll be? The usual answer to this question is that the acceptable range is between 15% and 30% of revenue and that it depends on your industry. For example, in the construction industry, it is generally 20% of gross revenue because there is a reliance on skilled employees and there may be training and safety investments that are required, and you might also be covering per diem travel.
How do you measure payroll to revenue? Simply put, divide your total payroll expenses by your total gross revenue and multiply it by 100. Written out, payroll to revenue ratio = (payroll costs / gross revenue) x 100. This allows you to measure the health of your company against your industry average and determine if money is being lost on your payroll system. If your company’s payroll to revenue ratio is higher than the industry average, then you may need to review your payroll expenses and controls.
Payroll Costs
Before you can run the formula, you need to know what actually counts as payroll. Payroll costs are the expenses that come with paying your employees. This generally includes the employee’s base salary or wage, employment taxes that you have to pay to the IRS, and any benefits the employee receives (such as workers’ compensation insurance). Employees typically have a regular pay rate mentioned in their employment contract. This rate depends on the industry and where you live. If you want to attract the best talent, you at least have to pay a competitive wage. You can check out wage estimates put together by the Bureau of Labor Statistics for a sense of how much you should be paying for a certain position. Next, make sure to keep an eye on minimum wage laws. The federal minimum wage is $7.25 per hour, for the most part. But, there are states and cities that have a higher minimum wage. Look up the minimum wage for your state.
According to the federal Fair Labor Standards Act (FLSA), you have to pay non-exempt employees 1.5 times their regular pay rate for hours worked over 40 in a single workweek. Your state may have its own overtime laws. In California, for example, non-exempt employees are entitled to overtime for hours worked over eight in a day. You have to pay twice your employees’ regular rate of pay for hours worked over 12 in a day. If your state has holiday pay laws or you have a holiday pay policy in place, keep it in mind. In Rhode Island, for instance, you must pay non-exempt employees 1.5 times their regular rate for hours worked on Sundays or a state holiday.
Then there are the taxes, and this is where a lot of owners get caught short. As an employer, you are on the hook for payroll taxes owed to the federal government as well as the state governments. For the federal government, you are required to pay FICA taxes, consisting of a Social Security tax and a Medicare tax. The former is 6.2% of an employee’s base pay while the latter is 1.45% of an employee’s base pay. You are also on the hook for Federal Unemployment Tax Act (FUTA) taxes which are 6% tax on the first $7,000 you pay any employee who earns more than $1,500 in a quarter or has worked for you for more than 20 weeks in a year. Then you have the state taxes that vary from state to state. Most states require you to pay state unemployment taxes and you can visit your state’s Labor Department website to learn more about those.
We’ll use California as an example of how these state taxes work: in California, as an employer, you are also on the hook for Unemployment Insurance (UI) tax and Employment Training Tax (ETT) which you are required to pay on the first $7,000 you pay any employee. The ETT rate is 0.1% and the UI rate ranges from 1.5% to 6.2% (this rate is determined by the California Employment Development Department). For a $40,000-a-year employee in California, the payroll taxes total $3,921, which means that personnel costs are actually $43,921. To calculate the proportion of payroll taxes in personnel costs, you divide payroll taxes by personnel costs. In our example, it works out to $3,921 / $43,921 which equals 8.9% which means that almost 9% of payroll costs are taken up by payroll taxes. As a rule of thumb, you can budget around 10% of your small business payroll costs to account for payroll taxes. This figure can vary depending on the number of employees you have, their gross pay, and your benefits.
You may provide benefits to be competitive in the labor market, or you may simply be required by your state to do so. If your state requires workers compensation insurance, disability insurance, sick pay, health insurance or time off, be sure to include those expenses in your payroll budget. Beyond that, if you offer a 401(k) or life insurance, dental care, or any number of things, that will factor into payroll. There are also hidden fees involved with the mechanics of transferring money and tracking payments. These might seem negligible, but they can add up. For example, electronic payments might cost you 15 cents per transfer, while printing the checks could add another $2-4 a check. If you use payroll software, the cost of the subscription needs to be factored in as well.
Keeping Your Payroll Under Control
Once you have your number, the work is keeping it under control. And keeping your payroll under control starts by tracking it. You need to know how much you are paying each employee, how much base pay, how much overtime pay. Also consider how your payroll compares to others in your industry. How do you measure up? Head over to the website of the United States Census Bureau and explore the Economic Census. There you will find average annual payroll and revenue figures for your industry. Plug them into the payroll to revenue ratio formula and compare the industry standard to your own.
When you think payroll expense, you often don’t consider employee turnover. But turnover can cost your company, by reducing productivity, as well as revenue. Advertising, interviewing, and training can add up pretty quickly, and experienced employees are kept away from their regular jobs, having to be the tour guide for new people. The costs of retaining employees by creating a good work culture and offering competitive pay can often more than offset the costs of replacing employees, and that can help you save the $4,683 you could otherwise incur to replace one.
Knowing your payroll percentage won’t fix a cash crunch on its own, but it should be one of the numbers you keep on your radar to make sure you are funded enough to cover your team’s pay. Spend time this week figuring out how much you spend on labor. Compare it to what other businesses are spending. Figure out where you can make adjustments. However, if your payroll percentage is where it needs to be and what’s squeezing your cash flow is your debt (including merchant cash advance, stacked advances, SBA loans, equipment finance, lines of credit) then we can help. At Delancey Street, our senior debt settlement advisors negotiate with funders and lenders for less than the full balance owed. We do not sell another loan. Delancey offers free first consultations that are confidential. If we can’t win your case, or if there’s an alternative cheaper solution, we’ll tell you on the first phone call. We are not a law firm. When bankruptcy or litigation makes the most sense, we’ll refer you to a vetted independent attorney.
