True Cost of an Employee & How to Cut It Without Cutting Headcount

Understanding the true cost of an employee is the first step towards realistic and effective budgeting, profitable pricing, and revenue generation.

Don’t believe me?

The math is pretty simple.

First and foremost, knowing an employee's actual cost allows you to make informed decisions about each worker's expenses (like benefits packages, raises, bonuses, promotions, etc.) that are aligned with the company's budget.

Second, fair compensation packages can help retain top talent. When you offer (generous) raises and benefits, it can keep employees satisfied and reduce turnover.

Third, when your company has a low turnover rate, it's quicker to determine the total cost of an employee, allowing you to incorporate labor costs into your product or service pricing.

So, basically, when you know the total cost of an employee, you know how to maintain healthy profit margins and avoid underpricing.

However, calculating the true cost of an employee isn’t that quick or easy.

As a manager or team lead, you must consider much more than an employee's base salary.

Benefits, taxes, and the resources they need to perform their job all contribute to the total cost per employee. Plus, the specific demands of each position (e.g., the position's flexibility or lack thereof) also have a deep impact. Not to mention, there are tons of hidden costs of employees you can overlook or forget about.

So, to help you understand how to calculate the true cost of an employee, we created an in-depth guide on labor costs.

In this article, we covered:

At the very end, we also included three practical ways to reduce labor costs without cutting headcount. We at Memtime believe there is a smarter way to reduce labor costs without downsizing the company. And the trick lies in streamlining your operations.

But I am getting ahead of myself.

Let’s start from the beginning, shall we?

What variables affect the actual cost of an employee?

The five top components affect the total cost of an employee.

Let’s break them down.

#1 Location

Location is one of the top factors that must be included in the true cost of an employee, as it determines labor legislation and cost of living.

Differences in labor laws between regions and countries, plus the specific location of employees (e.g., urban vs. rural areas), can lead to shocking variations in labor costs.

Here’s how location impacts the total employee cost:

• Minimum wage laws. Higher minimum wages increase the base salary that must be paid to employees, ultimately raising total costs. For instance, the federal minimum wage in the US is $7.25 per hour, but it varies from state to state. California has set its minimum wage at $16 per hour in 2024.
• Overtime regulations. Overtime laws require employers to pay a premium for hours worked beyond standard work hours per week (40 hours). For example, in the US, the overtime rate is 1.5 times the regular hourly wage.
• Social security contributions and payroll taxes. Social security, health insurance, and unemployment insurance contributions also vary by location. For instance, in France, employers contribute approximately 45% of an employee's gross salary to social security, which makes employing workers in France quite expensive.
• Employee benefits and mandatory leave. Different countries require different levels of employee benefits like paid leave. For example, in the UK, employees are entitled to at least 28 days of paid annual leave, which the employer must provide, while the US does not mandate paid vacation, leading to lower labor costs for US-based workers.
• Actual geographical location. The cost of living and each country’s economic conditions affect salary expectations and statutory requirements. For instance, salaries in San Francisco are typically higher than in rural areas due to the higher cost of living and a competitive job market (which increases total employee costs in urban locations).
• Cost of living. This variable affects the employee’s salary expectations and the overall cost of employment; when the cost of living is high, employees expect higher salaries and vice versa.

#2 Industry

The industry in which you operate determines the true cost of an employee.

The logic behind this is simple: different industries require different skills from their employees. They also offer varying working conditions, contributing to the cost of hiring and retaining staff.

Here are a few ways in which industry affects employee costs:

• The difference in education and skill level. Some industries require highly specialized skills or advanced education from their employees, so they tend to have higher employee costs; they must offer competitive salaries and training to keep their workers. For example, in the tech industry, software engineers or data scientists usually have high salaries due to their specific skill set, so it's not surprising that the median annual wage for software developers in the US was $132,270 in May 2023.
• How strict compliance and regulatory requirements are. Industries with strict regulations have higher costs as they need to comply with safety measures and regulatory requirements. If you need an example, think of the pharmaceutical industry, which is heavily regulated and demands compliance with FDA standards and other international regulations.
• How strong labor unions are and if there's a collective bargaining policy. In industries with strong labor unions, collective bargaining agreements are designed to help workers achieve higher wages and better benefits (which increases the cost of employees). The automotive manufacturing industry is a great example: the United Auto Workers (UAW) union has negotiated contracts that include higher wages, health benefits, and pension plans, which made labor costs much higher than they initially were.
• The presence of health and safety standards. Industries with higher risks of injury and hazards have to invest more in safety training, equipment, and insurance, increasing employee costs. To give you an example, according to the Occupational Safety and Health Administration (OSHA) regulations in the US, companies must spend on safety training, equipment, and workers' compensation insurance.
• How high the turnover rate and recruitment costs are. Industries with high employee turnover have increased recruitment expenses, as they need to constantly invest in job posting, recruitment (and using recruiting software), background checks, onboarding, and training costs. A prime example of this is the hospitality industry, which is always on the hunt for new waitstaff and housekeepers.
• The need to offer benefits and compensation packages. Some industries offer broad benefits packages, such as bonuses, stock options, and extensive health insurance, which increases the cost of employment. The best example is the tech industry, which is known for offering generous benefits to attract top engineers.

#3 Company size

Company size affects the true cost of an employee; no doubt there. Large, medium and small companies all face different financial challenges.

Here’s how company size affects employee costs:

• The difference between large and small companies. Larger companies tend to offer better employee benefits and insurance, ultimately reducing the turnover rate and per-employee cost. Smaller companies often don’t have that luxury.
• The difference in administrative costs. Smaller companies have higher administrative costs, while larger firms have minimal; they often rely on HR and legal teams to handle admin tasks efficiently.
• Salary and wage difference in large and small companies. Larger companies often have more resources so they tend to offer competitive salaries. In contrast, due to their budget limitations, smaller companies might offer lower salaries but can compensate with other perks like flexible working hours.
• Rent and work equipment costs. Larger companies face higher overhead and hidden costs due to rent and work equipment expenses, while smaller companies operate with lower overhead, affecting the overall cost per employee.

#4 Market conditions

Market conditions affect the true cost of an employee in the sense that they shape the demand for labor, wage levels, benefits, and other employment-related costs.

Here’s how market conditions affect employee costs:

• Situation with the labor market. When there are more job openings than qualified candidates, companies need to offer higher wages, better benefits, and additional perks to attract workers. And vice versa, where there are more workers than jobs, employers find it easier to hire at lower wages. Just think of the 2008 financial crisis, when the companies could cut salaries without losing employees.
• Recession or economic growth. During a recession, companies don’t have a budget for hiring, leading to reduced salaries and layoffs. In contrast, economic growth increases demand for goods and services, leading to higher employment and wage increases. Think of the COVID-19 pandemic: many industries, especially hospitality and retail, faced layoffs, reduced wages, and cut benefits.
• Inflation and cost of living. Increased inflation increases the cost of living, which leads to higher wage demands from employees. In such cases, employers must increase wages or offer cost-of-living adjustments to retain employees. Low-inflation economies have less pressure to raise wages, keeping labor costs more stable.
• Technological innovations. Technological innovations can enhance demands for particular skills, leading to wage increases in specific sectors. The greatest example of this case is the rapid growth of AI adoption, which has increased demand for AI engineers and specialists, data scientists, who all have substantial wage requirements.
• Competitive dynamics. When the market is highly competitive, companies offer higher compensation to attract top talent. This competition can drive up employee costs significantly.

#5 Roles and responsibilities

The role or position of an employee is a significant factor in determining their true cost because the role affects the benefits, training, and other associated expenses.

Here’s how roles affect the true cost of an employee:

• Compensation variability across roles. Specialized roles involving serious responsibilities, technical skills, or leadership require higher salaries. For example, the average salary for a skilled software engineer at Google is around $166,000 annually.
• Role-based benefits. Roles essential for the company’s success often require additional benefits and perks like stock options, bonuses, benefits, and flexible work arrangements.
• Role-specific tools. Particular roles require specialized tools or software, which increases the overall employment cost. For example, a graphic designer at a branding agency might require expensive software licenses for the Adobe Creative Suite, iMac Pro, Wacom Pro Pen, Herman Miller Aeron chair and other specialized equipment.
• Role-specific legal or physical risk. Roles that involve higher risks, such as crane operators or electricians, often result in increased insurance costs for employers. These positions require premium insurance coverage due to the risks associated with the job.

What about performance? Does it affect the true cost of an employee?

Oh, absolutely.

The more productive your employees are, the more resources (time and energy) they save the company.

In fact, low employee productivity drains more resources and increases the employee turnover rate.

Luckily, there are many ways to boost employee productivity, including performance bonuses, professional development activities, and additional paid time off. However, it’s important to note that many of these productivity-boosting strategies can also lead to higher labor costs.

But, let’s pause for now with productivity and its impact on labor costs. We’ll go back to it at the end of the article with a special tip on how to improve productivity (and lower turnover rate) without losing more money.

How to calculate the true cost of an employee

An exact calculation of the actual cost of an employee is pretty hard to achieve, as the number relies on all the previously mentioned variables.

But it’s not impossible to complete.

Here are the three most effective ways to calculate labor costs from most to least time-consuming.

#1 Manual calculation

Follow these steps as a guide to manually calculating employee costs beyond their base pay:

1. Determine the employee's gross annual pay, meaning the pay before withholding the taxes.
2. Calculate the yearly payroll taxes that must be paid on your employee's behalf.
3. Add additional expenses like benefits, onboarding costs, and work equipment.

Two things to note when you are calculating the expenses.

The first thing is that “additional expenses” should cover a variety of costs. Here are the expenses you could potentially overlook but shouldn’t:

• Recruitment costs. HR teams spend their time, energy, and resources (e.g., for job posting and applicant tracking) to find talent for the company.
• Onboarding costs. These costs usually involve filing paperwork for a new employee, setting up a workspace, traveling and relocating (if needed), and training and supporting the new employee.
• Statutory benefits. As mentioned before, these benefits vary from country to country and affect the true cost of an employee by dictating annual bonuses, medical insurance, and pension funds.
• Additional (supplemental) benefits. These benefits go beyond the statutory minimums.
• Taxes. As mentioned earlier, taxes vary between regions, countries, and states, and employers must contribute several federal or state funds for each employee.
• Hidden costs. The "invisible" expenses like ongoing training, seminars, and retreat visits should also be calculated for the actual employee costs.

The second thing to know is that additional expenses aren’t always directly tied to a specific employee but are associated with your company overall. These costs are commonly known as overhead expenses, and every business faces them.

Overhead costs vary between businesses, but here are the most common ones:

• Office space rental and utilities.
• Office supplies (like laptops, monitors, software, etc.)
• Company uniforms.

To determine the per-employee cost of overhead, divide the total overhead by the number of employees. Doing this step will give you a clearer picture of the actual cost per employee.

#2 Using a formula

If the previous method sounds like too much work, perhaps you could use a well-known formula to give you a range for the minimum and maximum cost of an employee.

But before you dive into calculating, keep in mind that no formula fits all types of business.

That being said, the general rule of thumb is that an employee usually costs between 1.25 and 1.4 times the base salary.

To calculate, simply multiply the base salary by 1.25 and 1.4. The 1.25 multiplier represents the minimum cost, while 1.4 represents the maximum.

Since this is a quick formula varying from industry to industry, use it wisely and just as an initial estimate for the true cost of employees. View it as a ballpark number that can be included in the business profitability calculation with a more thorough approach and analysis.

#3 Using a calculator

If you can't be bothered to deal with manual calculations or formulas, check out available calculators online. Take a look at QuickBooks and Artema calculators to help you estimate employee costs with minimal effort.

Three ways to reduce labor costs without cutting headcount (downsizing the company)

When companies need to reduce labor costs, the go-to strategy is often cutting headcount. It’s the primary solution because:

• A company can immediately save on salaries and wages.
• Such a move decreases the costs associated with benefits.
• Fixed costs per employee are lowered (like equipment-related expenses).
• Reducing headcount is often seen as a method of streamlining business processes.
• Headcount cuts in publicly traded companies often impact reports and stock prices, making everything appear more “shareholder-friendly”.

But what if I told you there are effective ways you can reduce labor costs without cutting headcount or damaging company morale?

Yep, that’s possible.

Here are the three ways to control labor costs while keeping your team intact:

#1 Incorporate remote work

I’m sure you saw this tip coming.

Offering employees the possibility of remote work can save you thousands of dollars. No joke.

Businesses can save around $10,000 to $11,000 per employee annually by transitioning to remote work. For example, companies like IBM saved around $50 million by reducing their real estate needs due to remote work.

And the benefits of remote work don’t stop there.

Remote work also leads to increased productivity, with studies showing a 35-40% boost in output from remote workers. It also allows companies to hire from a broader talent pool (hiring employees worldwide), which leads to reduced hiring and training costs​.

#2 Use the right time tracking tool

I know it seems a bit off-putting to suggest you use oNe MoRe ToOl when you are trying to reduce labor costs.

But, although it seems counterintuitive, investing in the right time tracking tool can actually help you reduce employee costs. Here’s how:

Get the idea?

Now that you know the benefits of using a time tracking app to reduce labor costs, allow me to introduce Memtime.

Memtime is our fully automated time tracking software (that doesn’t have a start/stop timer) that gives you and your team insight into your working habits. It is ideal for companies and teams of all sizes and just the right fit for remote teams.

Here are some of Memtime’s features:

I suggest trying our free team trial to see how powerful and cost-saving Memtime really is.

Schedule a call, and we’ll run a custom live onboarding for your staff.

At the end of the trial, we’ll arrange another live session to answer any questions you might have and hear your team’s feedback and results. From that point on, you can choose a Memtime package that best suits your team and company:

#3 Focus on employee retention

As we’ve mentioned earlier, the costs associated with recruiting and onboarding new employees can be significant, especially when dealing with high turnover. That’s why it’s crucial to invest in improving retention rates.

One practical approach is introducing generous employee benefits packages for employees worldwide.

Need an example?

Unilever, a consumer goods company, has implemented these benefits to the global workforce. The company offers additional healthcare coverage, wellness programs, employee assistance programs, and discounts on goods and services.

The three mentioned strategies can drastically reduce labor costs. I encourage you to try them out:

• First, calculate the true cost of an employee.
• Implement these strategies.
• Calculate labor costs again.
• Watch how the financial burden lifts off the company’s shoulders (after using these three methods)

We’ve come to the end, but you are just getting started

And there you have it!

We've added everything you need to calculate an employee's true cost. Many factors contribute to the actual labor expenses, from the impact of location and industry to the role and performance.

And remember: understanding your labor costs is like finding the missing piece to your financial puzzle. It's the key to building a profitable business without "slimming the squad". Remote work, time tracking with Memtime, and focusing your attention on employee retention can work wonders, leading to increased productivity and cost savings.

So, while this is where we say goodbye, your journey to optimizing labor costs is just beginning.

Roll up your sleeves, write down the numbers, and see what you’ve been missing revenue-wise. Happy calculating!