One of the most important decisions a small business will make is pricing. How a business sets up its pricing structure depends on a couple of variables, including the cost of materials and the cost of labor.
The cost of labor varies depending on the industry, the size of the company, and the type of position an employee holds. For service-oriented businesses, the cost of labor is incredibly important as the primary product of a service business is its employees.
Here are a few ways you can measure labor costs to make sure that your pricing is high enough to cover the costs of labor while providing a decent profit margin.
Analyze Gross Profit
When looking at your gross profit, you need to take into consideration not just the dollar amount, but the gross profit percentage as well. By looking at the percentage, you can see if your gross profit matches your expectations so you can adjust pricing if you find your margins are too low. On the other hand, if your profit margins are exceeding your expectations, consider creating an incentives program for your employees to keep profit margins high.
Factor in Realization Rate
In a service business, you need to factor the realization rate for each employee. This rate is how much revenue each employee earns per hour. To calculate the realization rate, you need to take the total revenue per client and divide that by the total hours the employee spends working for the client. This gives you the amount of revenue the employee makes per hour.
The realization rate is another indicator of employee performance. By reviewing the behaviors of your best employees, you can work to attract and retain more who fit their profile, and offer the right training and incentives to keep them performing.
Look at Market Rate for Salaries
An external factor you should consider when looking at your labor costs is the market rate for the salaries of your employees. If you are offering a competitive salary to your employees, you decrease the risk of employee turnover.
A lot of businesses don’t realize the real cost of employee turnover. Studies suggest that the average cost of turnover is 1.5 to 1.77 times the cost of a middle manager’s salary. Knowing this, you’ll want to ensure that your employees are being paid commensurately with the market rates.
For example, here at GrowthForce, we use market surveys to review each of our salaries. This allows us to set a salary grid for each position, which we then distribute to each employee. By doing so, our employees know what they can earn when they accept the position at GrowthForce, and (as long as the company continues to grow) they are aware of what it takes to grow their salaries.
Costs Dictates Pricing
There are Two Ways to Do Labor Cost Allocation. Once you have factored out all of your labor costs, you are better able to set the prices for your products and/or services. Your prices need to provide value to your customers, while covering the costs of labor, cost of materials, and providing a healthy profit margin for your company.