For service-based businesses like ours, profitability is directly tied to labor costs. While knowledge, technology, and operational efficiency all play a role, the biggest expense by far is labor.
If you run a product-based business, like a retail store or a contracting company, labor costs may not be your largest expense, but they’re still likely one of the top two. Regardless of your industry, understanding your true labor costs is essential for making informed decisions about pricing, hiring, and profitability.
We often see that many of our clients don’t know their true labor costs. They know the people they need to get all of the work done. They also know that many costs go into having employees. But knowing their actual labor costs? Not likely. This uncertainty can lead to business owners feeling like they are guessing in the dark to determine things like price, adjustments, and how to make improvements to their process.
So, how do you go about breaking down your labor cost? Here’s where you should start.
Get Educated on What's Tied to Your Total Labor Cost
In general, labor costs can fall into a couple of categories. The first is the actual salary and wages, the second is the cost of having employees (such as payroll taxes and employee benefit costs), and the third is the cost of managing all of the things. Technology, automobile expenses, training, computers, software licenses, overhead, and, and, and…you know, all the things.
Having employees is expensive.
When you misunderstand how to separate your labor costs into appropriate categories, it can be difficult to tell where your extra expenses are coming from. Unfortunately, this is not uncommon for business owners.
Many business owners lump all labor costs together, making it difficult to pinpoint which areas are driving expenses. Payroll taxes, insurance, and benefits often get misclassified, and labor expenses aren’t always recorded in the same period as the revenue they generate.
One of the most common mistakes? Failing to separate labor costs by category. This makes it impossible to see if each department is generating the revenue it should.
This is a problem because it prevents an owner from seeing the different costs associated with their production labor versus administrative labor versus the owner’s labor. Lumping all labor costs together doesn't provide any helpful data that a decision-maker can actually use when evaluating the overall labor costs.
This is why I suggest you begin here. Take the time to understand the roles of everyone on your team and assign them to the appropriate department/category.
Categorize Your Labor Costs for Better Insights
A good baseline for your categories includes these three buckets:
- Production Labor – Employees directly responsible for delivering your product or service (e.g., technicians, chefs, hairstylists, consultants).
- Administrative Labor – Team members who support operations but don’t directly generate revenue (e.g., HR, finance, office managers).
- Owner Labor – Your own compensation, whether salary, distributions, or reinvestment into the business.
Make sure the associated costs for each group (like payroll taxes for the people that are in that group and any direct employee expenses) are also appropriately tracked.
Once you have a baseline labor cost structure, you can break it down further for better insights. For example, a restaurant owner might separate production labor into front-of-house and back-of-house, while a service-based business might divide administrative labor into sales, marketing, and customer support.
By segmenting labor in a way that aligns with your business model, you’ll start to see which teams are driving revenue and which ones may be costing more than they should.
Determine the Direct Costs of Each Team/Category of Employees
Once you have your labor broken down by department, it’s time to dig into the direct costs a little deeper.
For example, sales and marketing teams often have additional expenses like travel, training, and expense reimbursements. Understanding these costs helps you determine how much revenue is needed to justify those expenses.
Let’s say your sales team is generating $5 in profit for every $1 spent on salaries and marketing costs—that’s a strong return. On the other hand, if it takes us 7 years to make a new customer profitable because our sales and marketing costs are so high, we may need to change how we are selling or, more specifically, we need to change who is selling. We can’t make these types of decisions without data.
For you to understand the levers you need to pull or push, you have to have the data to give you the insight.
Let’s say you realize, “Hmm… I’m spending $$$ on training for my sales team, but their close rates are so slow that it’s negatively impacting our ROI.” That is a key insight that should inform how you proceed. Are you going to hire more seasoned salesmen or revamp your training process to make it more efficient and cost-effective?
Knowing your detailed labor cost data helps you make better decisions for your business.
Industry Benchmarks for Labor Costs
Understanding your own labor costs is important, but it’s also helpful to compare them to industry standards.
For a service-based business, production labor should generally be 35-40% of revenue. For a product-based business, labor costs should be closer to 20-25%. If you’re in a high-growth phase, labor costs may temporarily reach 100% of revenue growth—but that’s not sustainable long-term.
If your labor costs are significantly higher than industry benchmarks, it’s worth evaluating:
- Are my employees being used efficiently?
- Is my pricing aligned with my labor costs?
- Are there unnecessary overhead expenses that can be reduced?
Having these insights allows you to adjust as needed and improve profitability over time.
Labor Cost Data Helps You Make Smarter Business Decisions
Understanding the true breakdown of labor costs gives you invaluable insight into your business.
Start by categorizing employees into the three primary labor groups: production, administrative, and owner’s labor. Then, track associated costs for each category—including payroll taxes, benefits, and direct expenses. The more granular your data, the better positioned you’ll be to evaluate productivity, optimize processes, and make smarter financial decisions.
There’s no perfect formula for every business, but knowing where your money is going allows you to adjust, strategize, and grow profitably.
Even if you have a clear view of your labor costs, inefficient payroll management—like overtime overruns, misclassified employees, or bloated administrative costs—can still hurt your bottom line. So, how do you keep payroll in check while ensuring your team gets paid fairly and on time?
To learn how to optimize payroll and protect your profits, check out How to Keep Your Payroll from Consuming All of Your Profit.
If you’re unsure where to start or need help getting clear on your labor costs, we’re here to help.
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