A practical guide on what employee cost is and how to calculate it.
Whether hourly or salary, every employee at a business costs a certain amount to employ. The largest of those costs is, of course, employee wages. In addition to wages, however, businesses incur other employee costs such as taxes, insurance, benefits, and more.
How do you know which costs to include and how to calculate employee cost? It's not straightforward, but don't worry, we'll work through it together. At the bottom of this post, see the section “Let’s Calculate Employee Cost Together” for a downloadable excel template that you can use to calculate your employee cost.
In addition to wages, typical employer costs include:
- FICA taxes (social security and Medicare) on behalf of any W2 employee (employer pays half of FICA while the employee pays the other half)
- Insurance - health, dental, and / or vision
- Benefits – retirement, gym, transportation, food, and other benefits
- Equipment / supplies – computers, books, and other supplies
- Overhead – office rent, utilities, and more (Further discussion on why we don’t think overhead should belong in the employee cost calculation later in this post, but we include it here because some believe it should be included.)
As you already know or are beginning to see, these costs can vary from company to company. Thus, it’s important to understand yours in order to get a true understanding of how much your employees’ time is actually costing you.
We refer to the annual sum of these costs that an employer incurs per employee, divided by the number of hours worked by that employee per year, as “employee cost”. Because the denominator is hours worked per year, this cost is expressed as a cost per hour worked. The formula for calculating employee cost below:
Employee cost = Total cost of employing an employee during a year / total hours worked by that employee per year
Other names for the same concept are “true employee cost”, “real employee cost”, “fully burdened employee cost”, or “fully loaded employee cost”. We’ll stick to “employee cost”.
At this point you might be asking yourself, “Why should I care what the cost of my employees’ time is?” Though we won’t go too deep into this question here, I’ll give a quick answer. If you are a service-based business, understanding the total cost of your employees is important for having a valid understanding of your profitability. Imagine you’re a manufacturer, but instead of selling widgets, you sell completion of a project for your client. The manufacturer of widgets has to make sure her unit economics make sense (that her cost of materials going into the widget are less than what she sells it for). Just like her, as a “manufacturer of projects”, you should know the cost associated with the completion of your project. Employee cost is how we get there. Let’s continue.
In order to help you understand what an employee costs your company, we’re going to describe two methods of calculating your employee cost:
- The first method we call the “multiplier method”, because it uses a standard multiplier on an employee’s wage to help you estimate their total cost.
- The second method we call the “detailed method”, because it involves a more detailed analysis of company costs. As a consequence of taking a detailed approach, this method will ultimately get you to a more accurate idea of what an employee’s true cost is to your company.
The Multiplier Method
The multiplier method is the simplest, but also least accurate, method used to determine employee cost. Though less accurate than the detailed method, if the choice of multiplier is directionally correct, it will yield a good result.
The purpose of the multiplier method is to multiply someone’s base wage / salary by an amount that corresponds to the additional costs the employer has to pay for that employee. As a starter, an employer’s FICA responsibility is 7.65%, so we can safely assume that the multiplier will be no lower than 1.0765x for any W2 employee (1099 employees pay all FICA taxes themselves, so this cost doesn’t fall on an employer). In addition to FICA, there are Federal and State unemployment taxes, insurance, and benefits that must be accounted for by the multiplier.
Depending on your unique situation, this will typically make the multiplier fall in the 1.2x – 1.4x range. We cannot reliably say where your multiplier should fall within that range, however. Best to read on to learn how you can use the detailed method to back solve for an appropriate multiplier.
The Detailed Method
The detailed method, if followed diligently, will help you understand the true cost of your employees. This is because the detailed method walks you through all costs that are associated with employing someone, and from that information derives an accurate cost per hour for an employee.
As we’ve described before, additional costs on top of salary are FICA taxes, State and Federal Unemployment taxes, insurance, benefits, and other variable expenses related to the employment of an individual. Examples of other variable expenses could include cost of equipment and supplies, travel, off-sites, and more.
Though this method will get you to a more accurate employee cost, it also requires a bit more effort. You will need to understand or estimate some of the costs mentioned above.
Let's Calculate Employee Cost Together
If at this point you’re feeling a bit overwhelmed, don’t run! We’re just now getting to the fun stuff.
We at Allocate have put together an Employee Cost Calculator that you can use to calculate your employee cost. Please download it here.
Once you’ve opened the Allocate Employee Cost Calculator, please explore the two different methods in the calculator and, given the discussion above, determine which you want to use to determine your employees’ cost.
If you’re pressed for time but want to be as accurate as possible, we recommend using the detailed method to determine someone’s employee cost. Then, use the “effective multiplier” that that employee cost represents, and apply that to other peoples’ wages at your business to get to an understanding of their employee cost.
There is no sense doing the same work twice, and once you’ve completed the detailed cost calculator, as long as those costs included are similar amongst all employees, using that multiplier derived from the detailed method should prove to be an accurate and efficient approach to understanding the cost of other employees.
Hopefully you’ve found this discussion on employee cost to be useful. It’s a tricky matter, and that’s why we’ve provided you with the Allocate Employee Cost Calculator to help manage the process of figuring out your employee costs. Be confident that, even if you didn’t follow everything in this how to guide, if you are able to get accurate figures into the employee cost calculator, you will arrive at an accurate employee cost figure for your employees. We’ve handled all of the complexity in that calculator. Just fill it in and you’ll be well on your way to being able to believe the numbers you are seeing in your project management software. Shameless plug – Allocate’s software of course handles this for you, so if you’re on the lookout for a better way to manage your time and projects, check us out. If you want to chat about employee cost or anything else, feel free to reach out at firstname.lastname@example.org
Thanks for reading!
(Bonus) A Brief Discussion on Fixed vs. Variable Costs
Though the calculator should be fairly straightforward, we would like to briefly discuss why we think all costs included in the employee cost calculation should be variable costs. In particular, some people believe that overhead such as office rent, property taxes, annual utilities, and other fixed costs should be baked into the employee cost calculation.
We think that this is incorrect because these costs don’t directly scale with the hiring of a new employee. To make the point with a clear example, imagine you are working out of a co-working space and pay $500 / month per employee that you have working there. If you hire a new employee, that extra hire will cost you an additional $500 / month and thus that cost should be included in the employee cost calculation. I.e. – this cost is variable with the addition of a new employee.
On the contrary, if you are paying $3,000 / month for office rent, and hiring an additional employee doesn’t change your rent, then this employee hasn’t increased your fixed rent cost. That’s why it’s a fixed cost. If hiring an employee doesn’t change your rent cost, then it doesn’t make much sense to include this in the employee cost calculation, because the cost isn’t related to their employment. The same would go for other fixed costs such as property taxes, and to an extent, utilities. You could argue that utilities will increase as you have more people in the office, but the amount of increase per employee is likely negligible.
That being said, fixed costs are real costs that your business incurs and thus, they should be accounted for. What we recommend at Allocate is making sure that you understand what sort of project margin you need to maintain in order to cover your fixed costs. This way, you can be confident that your project margins are valid (costs pertain to the cost of delivering a project – like COGS for a manufacturer of widgets –, and revenues pertain to the fees paid by your client), and can work on improving margin as a way to cover fixed costs and ultimately boosting your firm’s profitability.