If your business is falling behind on its bills, payroll is probably the biggest number you look at every month. For some companies labor runs as high as 70% of total operating expenses, and yet plenty of owners have no idea whether they are spending too much or too little. One quick way to get a handle on how severe the problem is is to calculate the labor cost as a percentage of the business’ revenue. So how much should labor cost? That depends on the industry and on what the competition is doing.
There is no golden number that works for every company. Benchmarks exist for a reason, but you can’t compare yourself to everyone else. A benchmark is supposed to give you a frame of reference. It can help you determine whether your labor costs are high, reasonable, or low. Two ratios give you that frame: payroll against revenue, and payroll against operating expenses.
Payroll Percentage
The payroll-to-revenue ratio, or payroll percentage, measures the percent of gross revenues that is consumed by the payroll. That means wages and salaries plus payroll taxes, benefits, incentives, insurance, pensions and the cost of processing payroll. If you only consider wages or salaries as a labor cost, your payroll-to-revenue ratio is not an accurate reflection of the actual cost of labor. Let’s say you spent $500,000 on payroll last year, and grossed $5,000,000. That’s a payroll percentage of 10%, which can also be translated into an average of $10 in revenue per $1 spent in payroll, a 10-to-1 return. Your competitor who spent $1,000,000 on payroll paid out 20% of its gross income, or only $5 in gross revenue per $1 of payroll, a 5-to-1 return. An efficiency-minded competitor who spent only $200,000 on payroll paid out 4% of its gross revenue, or $25 in gross revenue per $1 of payroll, a 25-to-1 return.
In general, the lower the ratio, the better, but you do not always want to be at the bottom. At the high end, costs are excessive and the company probably isn’t very efficient. At the low end, costs are too low and the staff may be underpaid, leaving the business at risk of losing talent.
As a broad rule, a payroll-to-revenue ratio between 15% and 30% is usually considered okay in almost any line of business. Benchmarks for each industry are helpful. Klipfolio, a business performance measurement company, puts insurance at about 9%. In manufacturing people spend 18% of revenues for the payroll. In construction 20%, in retail 20%, in restaurants 30%, in hospitality 30%, in scientific and tech services 39%, in beauty parlors 44%, and in healthcare 45%. The data tells us that insurance businesses have the best return on the money they spend on payroll, while healthcare companies have the worst. Service businesses like law firms and financial advisers routinely land above 30%, because they have to pay a lot of salaries to the professionals who do the work.
That benchmark can help a company see how it stacks up against other companies in its industry. If you have 3 different companies with payroll-to-revenue ratios of 10%, 20% and 4% respectively, and all of them are in the insurance industry, it means that your first 2 businesses have a worse return on payroll than the standard, and your 4% one performs better than the standard.
Payroll Divided by Total Operating Expenses
The second number is the staff cost ratio. Payroll-to-operating-expenses ratio is payroll divided by total operating expenses. (Working out a firm’s operating expenses is the same as taking all the normal expenses spent to keep the business going, such as SG&A.) This is useful to see whether labor costs are making up too big a chunk of total expenses. If the company in the earlier example had operating expenses of $2,000,000, its payroll-to-operating-expense ratio would be 25%. For every $100 of operating expenses, $25 is payroll. At the same $2,000,000, the two competitors would come in at 50% and 10%.
Wiki Accounting says that for most companies, payroll ranges from 10% to 20% of their operating expenses. In labor-intensive industries it can get as high as 30% to 40%. It can be as low as 5% to 10% if outsourced, but you will still have to count the outsourced support function in your operating expenses. Services and labor-intensive businesses have a higher staff cost ratio than goods-producing businesses.
The two ratios of payroll to expenses and payroll to revenue should always be used in conjunction. For example, if payroll is 50% of operating expenses for Firm X but only 30% for Firm Y, X might seem to be in trouble, but if payroll is only 10% of revenue for X, while 40% for Y, then X is likely ok: the increased payroll is more than offset by increased revenues. A low payroll-to-operating-expense ratio may signal that a company is treating its people poorly, maybe paying them far less than they should be paid and putting them at risk of leaving.
Your Labor Cost Is Higher than the Industry Average
If the ratio of payroll to revenues is significantly higher than your peers, you should consider either reducing the number of people on staff and seeing if they can maintain the same revenues through the use of automation, or leaving the staff alone and trying to increase productivity through performance-based compensation, better technology, or happier staff. There are several factors that may explain why your labor cost is higher than the industry average. The first one is obvious: you may be paying too much to your employees. The other is carrying more people than is typical for your industry.
The opposite case deserves attention too, because if your labor percentage is lower than your competition then you need to investigate to make sure you aren’t cutting corners, or paying too little. Workers who learn that a competitor spends more on staff for the same revenue may be tempted to leave. Payroll is a cost. Reduce the ratio by cutting back and you risk losing good people and hurting efficiency and sales. On the other hand, if labor costs run too high in relation to the company’s income they can starve out other necessary expenses. The balance usually lies close to the industry standard.
It also pays to think about the cost of doing payroll itself - the wages aren’t what we’re talking about here. Let’s think about things like the administrative time and cost to manage payroll. A more efficient payroll management system will reduce both ratios. It will also help you develop the data to calculate the ratio and benchmark to the industry standard. And a flexible system will help you set up a performance-based pay structure so extra payroll spending is matched by revenue.
For owners who are behind on debt payments, remember, the labor line item on the income statement is often your biggest single expense item. Be sure that you know if you are paying too much (or too little). When creditors start calling, knowing your payroll percentage is critical to getting a handle on your business finances and getting your business back on track. Benchmarks can’t take all the mystery out of labor costs. They are useful tools but you shouldn’t use them as your sole decision-making tool. Work out both ratios and set them against your industry before you cut anyone.
