Wondering how to do labor cost allocation? We’ll walk you through it. When you own a business, you have a lot of costs to consider. How much will you pay for your space, materials, and marketing, for example? One of the largest costs for most businesses labor. And as any accountant will tell you, your […]
Wondering how to do labor cost allocation? We’ll walk you through it.
When you own a business, you have a lot of costs to consider. How much will you pay for your space, materials, and marketing, for example? One of the largest costs for most businesses labor. And as any accountant will tell you, your business can’t make money until you learn how to do labor cost allocation.
What Is Labor Cost Allocation?
Businesses need to know a lot more about their labor costs than just how much they’re paying people in salary and benefits. They need to know how much it costs them, in labor, to produce whatever products or services they sell. This is especially true for businesses who sell more than one product or service.
Let’s say you own a housecleaning business– we’ll call the example ABC Cleaning. You offer a variety of services. For most customers, ABC Cleaning does a standard maid service once a week. You send in a cleaning crew of three people, and they mop the floors, scrub the kitchens and bathrooms, vacuum the carpets, and dust the furniture. Some of your clients also purchase “extras,” like window washing, laundry folding, and carpet shampooing.
In order to know how much to charge for all of these services, you need to know how much each one costs your company. Perhaps it takes three employees a total of two hours to clean a two-story house top to bottom. It takes another 40 minutes for one of those workers to wash all the windows while the other two work elsewhere in the house. You also paid a scheduler for a few minutes of time to book the appointment, and a billing specialist to process the payment.
So how much did it cost you to clean that client’s windows? To arrive at that answer, you must go through a process called “labor cost allocation.”
Calculating your labor cost allocation is a little more complicated than simply adding up everyone’s salary. Let’s take a look at how to do labor cost allocation the right way. We’ll have you up to speed by the end of this article.
How to Do Labor Cost Allocation: Two Distinct Methods
There are two distinct methods for how to do labor cost allocation. They are the standard cost and actual cost. We’ll walk through the benefits and limitations of each so that you can choose which method is best for your business.
Standard costing is an accounting term. Most businesses track the standard costs of direct material, direct labor, and overhead. Here’s how it works for labor cost allocation:
Rather than assigning the actual costs of direct labor to a particular product or service, the company assigns the expected (or standard) cost. In other words, the company determines how much it should cost them to produce the product or service, and uses that information to determine the price of that product or service.
Let’s go back to our cleaning company example for a moment, “ABC Cleaning.” Again, this cleaning company does a standard, weekly maid service for most clients, but a few of their customers add on a window cleaning every now and then. Let’s figure out the standard cost of the window cleaning.
For simplicity’s sake, we’re going to say that every employee of ABC Cleaning is paid $20 per hour, plus $5 per hour in benefits. ($25 per hour total.)
ABC Cleaning sends a three-person cleaning crew to each house for a standard maid service. It takes them two hours to clean the house. They also pay a scheduler for about 10 minutes of time to schedule the cleaning appointment, and a billing person for another 10 minutes to send and process the invoice. They estimate that each job will include 20 minutes of travel time for each of the 3 workers. Adding on a window cleaning means that one cleaner will work an additional 40 minutes.
So far, we have:
- 3 workers working a total of 6 hours.
- 3 workers traveling a total of 1 hour.
- 1 worker working an additional 40 minutes.
- 1 scheduler working 10 minutes.
- 1 billing person working 10 minutes.
All together, that’s 8 hours multiplied by $25, or $200.
The window cleaning by itself is only 40 minutes, though. That’s ⅔ of an hour, or $16.65. And since the workers are already traveling to the house, and the scheduler and billing person are already doing their respective jobs for the standard house cleaning, you don’t need to add on those labor expenses to the cost of the window cleaning.
Therefore, the standard cost for window cleaning is $16.65. ABC Cleaning can charge $50 per window cleaning and make a $33.35 profit. That’s 66.7 percent.
On the other hand, the market will bear only so much for a standard house cleaning. Remember, $16.65 of that $200 was for the window cleaning, so that means that ABC Cleaning has a standard cost of $183.35 for a standard house cleaning. The most they can charge, without driving away customers, is $250. That means that the company makes a profit of $66.65, or 26.7 percent, for a standard house cleaning.
Now which of those services do you think ABC Cleaning should consider more profitable? The window cleaning appears to be the winner.
What’s more, the company can do standard costing calculations for all of their other “add on” services as well. Maybe laundry costs them one hour times $25. They charge $50. Boom, 50 percent profit. Carpet shampooing costs two hours times $25, or $50. They charge $100. Again, they make a 50 percent profit.
Using this standard costing method, ABC Cleaning knows that their add on services are much more cost effective than their standard service. That means that they do everything they can to sell add on services to every customer.
Other Benefits of Standard Costing
As we’ll lean in the next section, standard costs are often compared with actual costs. We’ll explain further in a moment, but a company’s actual costs reflect the amount of money that the company actually paid, dependent on a few variables. (For example, odds are, the windows won’t always take exactly 40 minutes to wash. And travel time won’t always be exactly 20 minutes. Those times will probably vary a little with each job.)
But when a company knows their standard labor cost, that allows them to compare it to their actual labor cost. Of course, the company still has to pay the actual cost, and there are almost always differences between the standard costs and the actual costs. In the accounting world, we call those differences “variances.”
As wishy-washy as it may sound, those variances are part of a valuable management tool. When you have a variance, that lets you know that your performance has differed from your expected (standard) costs. If the actual costs are more than the standard costs, that’s bad. You want to figure out why and try to improve it next time. If actual costs are less than standard costs, then great! Look at what you did and see if you can replicate it in the future.
Just like it sounds, actual cost means the amount of money that your company actually paid to produce a particular product or service. It’s different from your standard cost because it considers all of the variables that might change over time.
Let’s go back to our cleaning company example. ABC Cleaning had a good month. They sold at least one add on service to every customer they served. How did they do it? They offered a $100 bonus to each employee who successfully sold five or more add ons.
All together, they provided their standard cleaning service to 100 customers. They averaged:
- 6 cleaning hours,
- .95 travel hours,
- .15 scheduling hours, and
- .15 billing hours per standard cleaning.
When they add up all of the labor costs for those 100 standard cleanings, ABC cleaning paid 7.25 hours X 100 customers X $25 = $18,125. They charged those customers 100 X $250 = $25,000. They made a profit of $6,875 for their standard cleaning service or 27.5 percent of revenue.
For their add-on services, they averaged:
- .65 hours for window washing for 15 clients (9.75 hours = $243.75)
- 1 hour for laundry for 70 clients (70 hours = $1,750)
- 2.2 hours for carpet cleaning for 15 clients (33 hours = $825)
So their total labor costs for add-ons was:
$243.75 + $1,750 + $825 = $2,818.75
But they charged:
- $50 X 15 customers for window washing ($750)
- $50 X 70 clients for laundry ($3,500)
- $100 X 15 clients for carpet cleaning ($1,500)
So they brought in:
$750 + $3,500 + $1,500 = $6,750
That makes a total profit of:
$6,750 (total revenue) – $2,818.75 (actual labor) = $3,921.85, or 58.1 percent (total profit on add-ons)
Clearly, the add-ons are most profitable for ABC Cleaning. But there are other variables that might affect their actual labor cost:
- How many employees received bonuses for booking 5 or more add-ons?
- Did the company reward any other employees with bonuses?
- Did any employees receive a raise this month?
- Did any customers request an “add-on” service without booking a standard house cleaning?
As you can see, the actual labor cost calculation is a bit more complicated than the standard labor costs.
Your company probably has a more nuanced set of labor costs than our example. You might have other overhead costs for management and administration and employees whom you pay varying salaries.
But we hope that this break down of how to do labor cost allocation helps you determine your own company’s needs. You may want to do only one method of labor cost allocation, or you may find that you need to do both. You may even have to re-evaluate on a monthly or quarterly basis.
Regardless, how to do labor cost allocation the right way will vary based on your business’s circumstances.