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The impact of labour costs on your business’ profitability can have a devastating impact. Labour costs are frequently one of the most significant expenditures for a business owner

This has become even more critical during these epidemic days where businesses are having to find that extra dollar to keep afloat.  

We need to understand payroll in the context of it being a recurring expense. Over and above that, direct labour costs (salaries/wages) have additional related costs such as insurance, taxes, vacation leave days liabilities, sick days, pension etc. For purposes of this article, labour expenses refer technically to the human costs of running the business. Labour costs are often cited as one of the items that can make or break your business if not responsibly managed. Let me however hasten to say, cutting payroll unreasonably has got its own undesirable consequences on your business. 

To put the labour costs in a context, let us start by addressing the issue of profitability. Profitability is the ability for a business to earn a profit. It is revenue generated from business activities, less your expenses. Basically, the primary factors for profitability of a business is revenue from sales of products or services less all the costs and expenses related to your business activities. ... If the number is positive, you're profitable; if is negative then the business is not profitable. 

Among the common profitability ratios businesses use are net profit margin, gross profit margin, operating margin, return on assets and return on equity.

Increasing profitability in any business is the desire for most entrepreneurs and legal firms.

One of the most challenging areas that business owners therefore face as already mentioned is that of managing the business’ payroll. A business must manage that fine line of having too few staff and hiring too many of them that can balloon the labour costs which is detrimental to the business. What the Owner/CEO needs is to find the right manning levels to optimise business performance. Related to this arises the question of whether the business is paying too much or too little. Extremes on both sides, may lead to the demise of your business. 

As for the optimal payroll expenses to revenue ratio, it all depends on the type of industry. For instance. for a highly automated production plant, labor could be a relatively small percentage of the costs of producing the product. In another industry such as a restaurant, which is labor- intensive, the labor costs are a much higher or constitute a greater percentage of costs. These could range from 20 to 40 percent. In some cases, such as the trucking industry, percentages as high as 60 percent of total costs have been cited. 

Ball park average percentages for the manufacturing could be 10- 15% and for a restaurant an average of 30 percent would be acceptable. 

Some of the key ratios I recommend include: 

• Revenue Per Employee

• Gross Revenue to Payroll Percentage

• Sales to Payroll

• The Net-Profit-Per-Employee Ratio- calculated as NPE = Net Profit / Total Employee Workforce

• The net-profit-per-dollar-of-payroll ratio (NPDP = Net Profit / Total Payroll Expenses)

• Average-profits-to-payroll ratios

• etc 

In calculating these ratios remember payroll does not only cover employees but also encompasses management and owners of the business. While it may sound obvious its worth emphasizing that the more money spent on payroll, the less net profit the business makes.

Use the Net-Profit-Per-Employee Ratio to determine if a business can function with fewer employees. The net-profit-per-dollar-of-payroll ratio calculates the amount of each payroll dollar spent as it relates to the company’s total net-profit earnings. If in your calculations, you get a high net-profit-per-employee number that equates to a lower overhead per employee cost. That may mean your business is highly profitable but may also mean you are underpaying your employees. You can use this ratio to compare each business department’s performance to its departmental profit generation or to determine where employee cuts may least impact business profits.

You can use the Average-profits-to-payroll ratios in the pricing of goods and services. As you determine mark-up, include all payroll expenses within the markup percent formula-

It must be obvious by now that to increase the net profit in your business, one of the ways to accomplish this is to reduce the amount of money you spend on payroll. For instance, reducing the number of employees will result in you spending less money each month on payroll. However, there is a trade-off to take into account. Such a reduction may result in an increased workload on the employees, higher worker dissatisfaction, loss of key personnel due to lower morale etc. Furthermore, the overburden on the remaining employees not only impacts morale bur may also the quality of work or service delivered.

Achieving the optimal labor productivity levels is not simply reducing staff numbers so as to lower costs. Maximizing labor productivity calls for such initiatives as training employees to improve efficiency, improving processes. It may also mean assessing and improving your business’ management style, having the right culture, engaging your employees more etc.

In conclusion, as a business owner aim to have reasonable payroll expenses, along with reasonable overhead costs. If your payroll expenses start rising, the business needs to find a way to increase revenue otherwise it begins to lose profits. There are ways to combat higher payroll expenses such as increasing the price of goods or services you provide. Alternatively, you could use cheaper raw materials as long as you realise that there is a down side to any of these initiatives. These could negatively affect the overall quality of your products or services leading to loss of customers and if unabated the collapse of your business. Properly managed, you need not have sleepless nights due to the impact of labour costs on your business.