How to calculate a labor rate

In general terms, a labor rate is either the cost or price of labor. To expand on these two concepts:

  • Cost based. A labor rate is the cost of labor that is used to deriving the costs of various activities or products within a business.
  • Price based. A labor rate is the rate charged to customers for services performed by company employees.

When a labor rate is used for defining the cost of labor, it can be further refined into the incremental cost of labor or the fully-loaded cost of labor. Consider the following differences and usages:

  • Incremental labor rate. This rate is the cost of labor that will be incurred if a specific action is taken. For example, if an employee is asked to work one additional hour, the incremental labor rate will likely include the person's base wage, any associated shift differential, and payroll taxes. The concept can yield widely differing results, since asking someone to work overtime yields a 50% higher incremental labor rate. This information is most commonly used when a customer asks for a special production run at a reduced price, and the incremental profit must be calculated.
  • Fully loaded labor rate. This rate contains every possible cost associated with an employee, divided by the total number of hours worked by the employee. For example, the cost may include the company's contribution to the employee's pension plan, all benefit costs, payroll taxes, overtime, shift differential, and the base level of compensation. This rate is typically aggregated for entire classifications of employees, so that (for example) the fully loaded labor rate for an average machine operator may be commonly available.

When a labor rate is to be used as the billing rate for an employee to a customer, a number of considerations must go into its calculation. At a minimum, the labor rate cannot be lower than the incremental cost of the employee, since the employer would otherwise lose money for every hour worked by the employee. Instead, it is customary to build into the labor rate an apportionment of company overhead and a standard profit percentage, so that a long-term, fully-loaded cost is set as the minimum possible labor rate to charge. A further option is to simply set the labor rate at what the market will bear, which may be substantially greater than the cost of an employee. In this latter case, the amount of profit earned by the employer may be outsized, if the demand for an employee is substantial.

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