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Managing labor cost is one of the most difficult things that company owners and managers do.  Most of the time, the workload never lines up perfectly with a 40 hour work week.  Either there is not enough time to get things done, or you end up with people that do not have enough to do.  Considering labor is typically one of the most significant inputs into overall cost, efficiency in managing it is key.

Sizing the Labor Force

Clients often ask me, “How many people should we have on staff?”  This is never easy to answer.  It’s next to impossible to be emotionless when working on these issues.  There are real people and families at the receiving end of every decision that gets made.  At the other end of the decision is the health and well-being of the company, which ultimately drives your ability to continue keeping people employed.

There is often a discussion in business about the concept of employee loyalty.  Conventional wisdom says that employees are supposed to be loyal to the company.  While that might be the case, I think it is also important to recognize that as an employer, you have a responsibility to your employees too.  Hiring a person is a two-way street.  The new employee is making a commitment to work for you, but you are also making a commitment to keep providing a job for that person, provided their work is acceptable.

This is why I think you must be very careful about bringing on additional labor in the first place.   The first question you should ask yourself is, “Can I keep this person busy enough to justify making the hire?”  If there is any doubt, it’s probably best to wait.  The reason for this is the concept of fixed costs.

Full Time Employees Have a Fixed Cost

total costIn my experience, when planning to make a hire, most employers think about the salary or hourly rate as the employee’s cost to the company. In reality, the cost is more, much more if you offer benefits.  Taxes,  Vacation/PTO, Holidays, paid lunch & breaks, and 401k Matches all count as part of the total cost of labor.

It is very important that business owners and decision makers understand what these costs are.  Obviously, not everyone takes out voluntary benefits, so making the calculation on a person to person basis can be challenging.  I recommend that you look at your financial statements and come up with an overall average carrying cost percentage.  Typically, for a company offering full benefits, this add-on percentage can be 25 to 30 percent.

The fixed cost of the full-time employee are those costs you pay no matter what.  It doesn’t matter how many hours a person works during the year, the cost of the time off, lunch & breaks, and health insurance is still the same.  In the example above, this equates to about $7.90 per hour.  Think of that as the embedded additional cost of making a hire.

If You Have No Overtime, You Probably Have People Standing Around

I have worked with companies who made it their mission in life to not pay any overtime hours.  Interestingly, these people have higher labor costs than they should.  This is based on the fact that they have people with downtime who are getting paid at a straight time rate, but there is not enough work to keep them busy.  The counter to this is to have them do non-value added tasks that are worth far less than the employees rate of pay.  This busy work is not paid for by the customer, and therefore causes profitability to erode.

Sticking with the previous example, the total hourly cost of overtime for the $15.00 per hour employee is $25.20, when accounting for the wage rate, taxes, and 401k match.  This means that the real cost difference between overtime and another full time employee is only $2.67 per hour, where overtime is cheaper.  Remember we are talking about actual hours spent on the factory floor at your workstation.

I have never shown anyone this who accepted it as fact the first time.  The first reaction is usually denial.  Once we get past the denial stage, then it is time for the real crusher.  If there is never any overtime, you can be sure that your labor force is not working for the full seven hours every day.  There have to be downtime periods, or times when your $15.00/hr employee is doing $10.00/hr work. By contrast, if you are working some overtime, as long as you are not allowing people to willingly slack off, that means every straight time hour is probably productive, and the overtime hours will be too.

How Much Overtime Is Too Much?

There is not really a perfect answer to this question.  Overtime is a balance between productivity and cost.  It is completely possible to work so many hours that employees are too tired or are demoralized, not to mention the safety risk posed by too much overtime.  I have always used a rough estimate of 10% of total hours when I am looking for red flags.  When overtime hours are between 1 and 10 percent of total hours, there is usually a decent balance.

The key to understanding this in your company is to have a good labor productivity metric.  In other words how do you measure units of work produced per hour?  Once you have this in place, you can test it by looking at total hours versus total units produced under different scenarios.  Balance this with employee morale and you will be on your way to finding the productivity sweet spot.