Labour costs: what the cost of labour means, the wage and non-wage halves, how to work out the cost per hour worked, and the ratios people use

A manager asks what a new hire will cost and gets the salary. The salary is what the person will be paid; it is not what the employer will spend. Somewhere between the two sit National Insurance, pension contributions, statutory sick pay, the laptop, the training and the eight weeks a year when the person is not at work. What is cost of labor, properly understood, is that whole figure, and knowing it changes decisions about hiring, pricing, overtime and outsourcing.

This article defines labour costs using the Office for National Statistics's own definition, sets out the wage and non-wage halves, works an example that turns a salary into a cost per hour actually worked, explains direct and indirect labour, compares the ratios people use and what each one hides, and lists the costs the calculation usually forgets. It describes the UK position and is general information, not tax or legal advice; rates and thresholds change, so check the current ones.

Labour is usually the largest controllable cost in an organisation, and the decisions that move it are made by managers, not by a spreadsheet. See how New Dynamics Goals & OKRs keep the objectives behind those decisions visible beside the numbers they affect.

What are labour costs?

The ONS publishes an index of labour costs per hour and defines the measure plainly: it “represents the total cost of employing an individual, which is primarily the earnings of the employee, but also includes non-wage costs”. It splits that total in two:

• Wage costs include “wages and salaries (including bonuses and arrears) and benefits in kind”.
• Non-wage costs include “sickness, maternity and paternity pay, National Insurance contributions and pension contributions”.

That is the definition worth using, because it draws the line in the right place: everything the employer pays because this person is employed, whether or not it reaches the person's bank account.

The non-wage half is not optional

In the UK an employer cannot choose to skip most of the second half. GOV.UK's guide to employing staff for the first time walks through the employer's responsibilities, and two of them shape the cost:

• Employer National Insurance contributions, paid by the employer on top of the employee's pay, above a threshold.
• A workplace pension. GOV.UK's guidance on workplace pensions for employers says employers must provide a scheme “for eligible staff as soon as their first member of staff starts working for them”, and must “enrol and make an employer's contribution for all staff” who are aged between 22 and State Pension age, earn at least the earnings threshold and normally work in the UK. Staff who become eligible through a change in age or earnings must be enrolled and written to within six weeks.

Statutory sick pay and statutory maternity, paternity, adoption and shared parental pay sit alongside them, as do holiday pay and, for many employers, the apprenticeship levy. Rates, thresholds and the earnings trigger change; look them up on GOV.UK each year rather than trusting a figure in an article, including this one.

From salary to cost per hour worked

The figure that makes decisions is not the annual salary but the cost of an hour of work. The arithmetic is simple and the numbers below are invented and round, to show the method.

A full-time employee is paid £30,000 a year. Add the employer's on-costs: National Insurance, the pension contribution, and a provision for statutory pay and other employment costs. Suppose those add 20 per cent, so the annual cost is £36,000.

Now the hours. A 37.5-hour week over 52 weeks is 1,950 contracted hours. Subtract the time the person is paid for but not producing: say five weeks of holiday and bank holidays, one week of sickness and three days of training, which is about 245 hours. That leaves roughly 1,705 hours actually worked.

• Cost per contracted hour: £36,000 ÷ 1,950 = about £18.46.
• Cost per hour actually worked: £36,000 ÷ 1,705 = about £21.11.
• The headline salary per contracted hour: £30,000 ÷ 1,950 = about £15.38.

The gap between the first and last figures is the one that surprises people: on these invented numbers, an hour of work costs roughly a third more than the salary rate suggests. Use your own on-cost percentage and your own absence and holiday pattern; the method matters more than the numbers.

Direct and indirect labour

Accountants split labour cost by how it attaches to the output:

• Direct labour is the cost of people working on the product or service that is sold: the machinist, the carer on shift, the consultant on a client project. It can be traced to a unit, a job or a case.
• Indirect labour is everyone whose cost supports the work without attaching to a unit: supervision, maintenance, administration, HR, finance.

The split matters for pricing, quoting and understanding margin, and it is a common source of argument: whether a supervisor is direct or indirect changes the cost of every unit. Decide the rule once, write it down, and keep it stable so that this year's figures can be compared with last year's.

The ratios people use, and what each hides

Two rules follow. Never manage on one ratio: a labour cost percentage falling because revenue rose on low-margin work is not an improvement. And always pair the cost ratio with a quality or service measure, so that a saving made by understaffing shows up somewhere.

The costs the calculation usually forgets

• Recruitment: advertising, agency fees, the time of everyone who interviewed.
• Induction: the new starter's first weeks at partial productivity, and the colleague who trains them.
• Equipment and space: laptop, phone, software licences, desk, tools, uniform, vehicle.
• Overtime and premium hours, which cost more per hour than the base rate.
• Agency and bank cover for absence, which usually costs more than the person it replaces.
• Turnover: the vacancy gap, the lost knowledge and the recruitment cost again. This is the cost most often ignored and most often the largest.

How to reduce labour cost without cutting people first

1. Fix the scheduling. Most organisations pay for hours that do not match demand. Match rotas to the pattern before touching headcount.
2. Reduce absence and turnover, which buy back hours already paid for.
3. Remove work that nobody needs, including reports, approvals and rework, before removing the people who do it.
4. Automate the repetitive, and move the time saved to work that earns.
5. Look at overtime and agency use as a symptom: sustained overtime usually means a vacancy or a scheduling problem, and paying a premium for it is the expensive way to stay short-staffed.
6. Then, if necessary, look at headcount, with the full cost of change, including redundancy and rehiring, in the calculation.

Frequently asked questions

What is the cost of labour?

The total cost to an employer of employing someone. The ONS defines labour costs as representing “the total cost of employing an individual, which is primarily the earnings of the employee, but also includes non-wage costs”: wage costs such as wages, salaries, bonuses and benefits in kind, and non-wage costs such as sickness, maternity and paternity pay, National Insurance contributions and pension contributions.

What is included in labour costs?

Wages and salaries, bonuses, overtime and benefits in kind, plus the employer's National Insurance, pension contributions, statutory sick and family pay, holiday pay, and in many organisations training, recruitment and the cost of covering absence. The line to draw is everything the employer pays because this person is employed.

How do you calculate labour cost per hour?

Take the annual salary, add the employer's on-costs to get the annual cost, then divide by the hours actually worked rather than the hours in the contract. Deduct holiday, sickness and training time from contracted hours first. The difference between cost per contracted hour and cost per hour worked is usually large enough to change a decision.

What is the difference between direct and indirect labour costs?

Direct labour is the cost of people working on the product or service being sold and can be traced to a unit, job or case. Indirect labour is the cost of people who support that work without attaching to a unit, such as supervisors, maintenance and administration. Where the line falls changes unit costs, so define it once and keep it stable.

What is a good labour cost percentage?

There is no general figure: it depends entirely on the industry and business model, because a consultancy, a restaurant and a distributor turn labour into revenue in different proportions. The useful comparison is with your own trend on a stable definition, paired with a quality or service measure so that a fall driven by understaffing is visible.

How can you reduce labour costs?

Start with the hours you already pay for rather than with headcount: match rotas to demand, reduce absence and turnover, remove work nobody needs, and treat sustained overtime and agency use as a symptom of a vacancy or a scheduling problem. Look at headcount last, and put the full cost of the change, including redundancy and rehiring, into the calculation.

Your next step: work out your own cost per hour

1. Write down your on-cost percentage: employer National Insurance, pension, statutory pay and any levy, from current GOV.UK rates.
2. Calculate hours actually worked after holiday, absence and training for one typical role.
3. Produce a cost per hour worked and compare it with the salary rate you have been quoting.
4. Choose one ratio to manage by, pair it with a quality measure, and review both each quarter.

For a policy that sets out how pay decisions are made and reviewed, read and download our compensation policy guide. The guide is free to read, and the PDF uses our short download form.

Want the objectives behind a cost decision, and the reviews that follow it, recorded in one place? Book a New Dynamics demo and bring your current staffing plan. You can also email contact@new-dynamics.com.