- Nov 13, 2023
- 13 min read
Ways to Reduce Labor Costs Without Cutting Headcount: Efficient Labor Practices
Controlling labor costs is vital. It is key to maintaining healthy profit levels. After all, your profit is revenue minus operational cost. And labor is the biggest chunk of operational costs for businesses. According to Deloitte, it is typically 50 to 60%. For Fortune 500 this adds up to billions of dollars per year.
If your labor costs are high, how do you cut them? Layoffs jump to mind. But if you lose production capacities, your revenue can decrease. A high workload for remaining employees will increase turnover. This often means losing your best talent.
So, reducing headcount isn’t the right answer. In this article, we will discuss how to lower labor costs without hurting your business.
Understanding Labor Costs
The first step to reducing labor costs is understanding their meaning, components and types.
Components of Labor Costs
Labor cost goes beyond worker salary and wages. Here are the most common components of labor costs:
– Salaries and wages,
All payments to workers fall into this category. You can pay employees per month, shift, day or hour.
– Payments to contractors,
Often, companies hire contractors to do certain tasks. For example, a dry cleaning business can pay software development experts to create a website for them. Such tasks can be project-based. So, there is no need to hire someone full-time. This helps to save labor costs.
– Employee benefits (healthcare insurance, gym, etc),
With benefits, employers promote desirable behavior. For example, if you offer a “free” gym, more employees will do sports.
– Overtime pay,
If you ask employees to work beyond their regular hours, you should pay them overtime. In many countries law requires it.
– Payroll taxes,
Payroll taxes are mandatory costs when employing workers.
– Overhead costs (office rent, equipment, software, etc.)
These are other costs you pay for having workers. For example, if you have an office, you need to pay rent and utilities. Software costs also fall into this category.
Labor costs differ, depending on your location, company structure and policies. For example, you need to offer healthcare insurance to attract top talent in the US. This is not necessary in Sweden. But there, you should expect to pay higher taxes.
What are direct labor costs?
Direct labor costs are money you spend on workers who produce your goods or provide your services. They are directly responsible for company output. Let us imagine, we have a tech startup. Then, direct labor costs examples are the salary, benefits and taxes of your developers. At the same time, a startup needs good sales and marketing. So, the cost of this labor falls under the same category.
If a company has an office, it likely has an office manager, a janitor and a guard. These people do not directly contribute to business success. So, the costs of employing them are indirect.
Other direct labor cost examples are money spent on
– lawyers for law firms,
– assembly line workers for manufacturers,
– drivers for courier companies, etc.
In some cases, it can be difficult to figure out whether employee-related costs are direct. Recruiters, HRs, accountants and corporate lawyers are often questionable. Ask yourself, is the person essential for your business success? Thus, pharma companies operate in a heavily regulated market. They need a full-time lawyer. But, a marketing agency doesn’t.
Fixed vs variable labor costs
Personnel costs can be fixed or variable. Fixed costs do not vary depending on your output. And variable labor costs do. For example, let us imagine that you own a tech startup that sells robotic pets. The costs of employing engineers and software developers who design your product are fixed. But to build robotic pets you also need metal, microchips and other components. These costs are variable. The more robots you build, the more materials you need.
Variable costs offer flexibility and cost-efficiency. And fixed pay can attract top talent and ensure stability.
5 ways to calculate personnel costs
To understand and control the labor cost better, use the following calculation methods:
1. As a percentage of operational costs or revenue
At the beginning of the article, we said that labor takes around 50 to 60% of operational costs. These are average numbers. Calculate yours. Similarly, you can calculate what part of your revenue goes to labor payments.
2. By department
Calculate personnel costs by department. Determine the amount of direct and indirect costs. Direct costs should be the majority.
3. By project
Calculate labor costs required for your projects. Are there projects or clients that demand lots of effort? Are they worth it? Sometimes, by rejecting a certain client you can free resources for more profitable projects.
4. Per product/service
Similarly, you can measure how much labor your products and services need. Labor-intensive goods and services must be priced higher to offset extra labor costs.
5. Per hour/day/month/year
You should know personnel costs per
Top 3 employee cost-reduction strategies
Here are the top 3 ways to reduce labor costs without
1. Optimizing Workforce Efficiency
Lower labor costs by helping employees to be more productive.
Use efficient collaboration software
Whether your business is online or offline, efficient software can make your team shine. There are many excellent free options. Try Trello, Monday, Asana or Slack. Check our guide to effective collaboration to learn more.
Manage schedules and working hours
Save labor by reducing unnecessary overtime
Why do your employees work overtime? Do deadlines often move forward? Or, additional work is frequently added to the scope? It can be a management issue.
Avoiding overtime leads to significant labor cost reduction. First, it cuts overtime payments. Second, it improves employee morale and productivity.
Leverage technology and automation
Technology is your friend. It can help you improve productivity and service quality. You can find useful tech for any industry. For example, law firms use document and contract management software. Real estate agencies use Big Data to estimate property prices. Healthcare workers use telemedicine, e-prescribing software and remote patient monitoring tools.
Offer remote work options
Why is labor so expensive? The number one reason is living costs. Everyone wants a comfortable lifestyle. Usually, this means earning at least an average salary. But, average salaries differ, depending on employee location. You can use this to your advantage.
Thus, you can hire employees from small towns. Living costs there are lower than in cities like New York or London. Plus, your employees would not need to waste time or money on commuting. So, they would expect a lower salary.
Also, you will decrease your overhead costs. A smaller office or no office, means less rent and utility payments. And you can decrease your indirect labor costs. No office – no need for an office manager.
2. Performance improvement and incentives
Efficient labor is key to decreasing personnel costs. You can save labor costs and increase output by improving retention and using performance incentives.
1) Improve team retention
Guess how much employee turnover costs US businesses per year. It is 1 trillion USD. Here are some tips to create a workplace with low turnover:
– Be honest during the hiring process
Sometimes, recruiters don’t talk about job downsides. For example, it can involve lots of unexpected overtime. Be honest and straightforward about such shortcomings.
– Set a clear career path
Explain to your employees what career paths they can have in your company. Ask them about their aspirations. But remember, it is okay for employees to change their goals.
– Promote good work-life balance
A good work-life balance is necessary to avoid burnout. Make sure that your employees take their vacation days. Also, offer flexibility whenever possible. For example, you can offer flexible work hours. Or a choice between office, hybrid and remote.
– Encourage a healthy lifestyle
Healthy employees take fewer sick days. Also, they are happier and concentrate better on their tasks. Good practices include free psychological counseling, gym reimbursements, healthcare insurance, and wellness retreats.
– Offer learning opportunities
To keep workers motivated, teach them new skills regularly. They should understand that the longer they stay, the more they will know.
– Keep up with the market rate
Keep an eye on the labor market rates. When the price for an expert’s services rises, they have more reasons to move forward. Replacing such experts can be expensive.
– Analyze your current situation and address issues
What is your current team turnover rate? You can calculate it for a certain year or any other period. To control labor costs efficiently, aim for a 10% turnover rate or lower. This means that the retention rate should be above 90%.
💡 How to calculate employee turnover rate?
Figuring out the turnover rate is a two-step process. The first step is calculating the average number of workers for a certain period. This means that you need to add the number of workers at the beginning and at the end of the year and divide it by two.
Then, divide the number of people who left your company by the average number of workers. Then, multiply it by 100.
The result is your turnover rate.
2) Promoting performance with incentives
Reduce labor costs by motivating employees to work harder. Here are the popular ways to do it:
Commissions are very common for certain experts, like salespeople. The more they sell, the more money they bring home. Similarly, you can offer commissions to recruiters, retail store managers and insurance agents. But make sure that quality of work doesn’t suffer. For example, don’t pay recruiters just for the fact of hiring. Instead, make sure that the new person passes their probation period first.
Bonuses are rewards you give employees for certain achievements. For example, you can set a desirable level of sales or revenue. Then, you tell employees that if they reach these goals, they will receive a bonus. Be specific about the terms.
– New opportunities and promotions
You can offer better opportunities or promotions to the best performers. For example, your best employees can get access to top clients or interesting business trips.
Gamify working experience. You can set up a challenge for employees. For example, the seller who attracts the most new clients gets an all-expense-paid vacation.
– Praise and recognition
Word is a powerful tool. Tell your employees that you value them.
3. Using the global talent pool
Sometimes to reduce labor costs, you need to get creative. Hiring from abroad is one of the finest perks of globalization. The best part is that nowadays it is very easy to do.
Hiring from a global talent pool
Any job that can be done remotely, can be done by experts abroad. And this strategy is amazing for reducing labor costs. Popular professions for international hiring include
– software developers and tech support,
– web designers,
– customer support experts,
– supply chain managers,
– accountants, etc.
Also, by hiring abroad, you don’t need to reduce headcount. So, your productivity and revenue will not suffer.
The pros and cons of hiring employees abroad
So, why should you hire from aboard? Here are the benefits of international hiring:
1. Low labor cost
International hiring is the most straightforward and certain way to reduce the labor cost.
Earlier, we discussed why labor is so expensive. Workers want to have a comfortable lifestyle. But, living costs in Eastern Europe, Africa and most of Asia are a lot lower than in the US or Western Europe. So, experts there can have good lifestyles with much lower salaries.
And your savings go beyond that. There is no need to spend money on bonuses. And your taxes will be much lower.
2. Excellent quality and the best talent
Foreign experts are just as qualified as domestic specialists. Often, they are even better. And, you will have more candidates to choose from. So, you can select the best experts.
Also, some countries are hubs for certain professionals. For example, Ukraine is a mecca for Java software engineers. Poland specializes in game development. And India is full of excellent accountants.
If you have never hired international contractors, no need to worry. This is a very widespread practice. Opt for those who have experience working with foreign businesses. But we still recommend you consult with an international law attorney and a tax accountant.
4. Hiring speed and flexibility
Your talent pool is much larger. So, finding a perfect fit is much faster. It can take just several weeks. Also, working with contractors brings flexibility. You can negotiate and set contract terms that work for you.
International hiring has several disadvantages too. Keep reading so that you know what to avoid:
1. Imperfect language skills
There is a chance that the language skills of your new worker will be imperfect. Talk to the person before signing a contract. If you don't understand each other well, avoid them.
2. Cultural differences
Cultural differences can lead to misunderstandings. For example, in Latin America, it is okay to be up to 30 minutes late. In Africa, to do business, people might want to know more about you as a person. Asian countries are the most challenging. For example, subordinates often avoid asking clarifying questions.
Eastern Europe is the most similar to the US and Western Europe in terms of culture.
💡Check out our list of the top Eastern European countries for software development outsourcing.
3. Difficult to meet in person
Meeting in person can be difficult. Sure, you can hop on a plane and visit each other. But, a journey out of the country can be long and expensive.
Best practices for effective outsourcing
Here are our top tips on how to reduce labor costs efficiently with outsourcing:
1. Define your goals first
Make a list of your goals and requirements. Consult your colleagues. Brainstorming helps to capture all necessary detail.
2. Choose your strategy
When it comes to international hiring, there are two main strategies. These are staff augmentation and managed services. If you want experts to join an existing team, you need staff augmentation. But, if you just need a project to be done, choose managed services. In this case, a dedicated team will work on your project. They will take care of project management. You can learn more in our previous article.
3. Select a compatible contractor
Your contractor should be a good fit. This means that they should know your industry and its standards. For example, if you need a healthcare app, your contractors should be familiar with HIPAA and GDPR.
4. Communication is key
When you have found the right contractor, establish clear communication channels. Use collaboration software, like messengers and task management tools. Provide opportunities for them to interact with your other employees.
How to hire software developers abroad? Top solutions
Are you looking for software developers? There are several ways to find the perfect fit:
1. Independent web resources
2. Personal recommendations
Personal recommendations are often the most reliable. Talk to your business partners, colleagues and clients. Ask whether they can recommend someone.
3. Opening an office abroad
This is an excellent long-term solution. And, this strategy is very popular. For example, in Ukraine alone, there are more than 110 international Research and Development (R&D) centers. They belong to various tech giants, including Microsoft, Samsung, Siemens, Google and Oracle.
💡Pro tip: reduce other types of operational costs
Reducing labor spending will bring down your operational costs. But you can optimize other processes too. A prime example is cloud infrastructure. Around 94% of businesses overspend on the cloud. The main reason is that setting up cloud services efficiently is difficult. It requires a specific expertise.
Many businesses don’t even realize that their cloud costs can be reduced. Several of our clients hired us for other tasks. And they were pleasantly surprised when we offered to optimize their cloud spending. Thus, we decreased AWS costs for SOLD.com by 23.4%. One simple feature now saves them around USD 2k per month. Another client was using Google Cloud for their microservices. We decreased their cloud spending by 40%.
Labor costs include several components. Usually, these are salaries & wages, payroll taxes, employee benefits, contractor payments, overtime pay and overhead costs (e.g. office rent). Controlling labor costs is key to maintaining a healthy profit margin.
There are 3 efficient employee cost-reduction strategies:
1. Optimizing efficiency
This means managing your staff more effectively. You can save labor costs by
– cutting unnecessary overtime,
– managing schedules better and
– using good collaboration software.
2. Improving productivity
Higher profit makes labor costs proportionally lower. Businesses use different incentives to increase worker productivity. Examples are commissions, bonuses, competitive challenges and praise.
3. Hiring internationally
This is the most straightforward way to decrease personnel costs. International hiring brings many benefits, including faster hiring, excellent quality and reduced labor costs. To find international talent, you can use dedicated web resources, open an office abroad or ask business partners for recommendations.
1. What are labor costs, and why are they important to businesses?
Labor costs are money that businesses pay people for their work. Controlling labor costs is important since it affects company profit.
2. What are the four factors that affect labor costs?
The main four factors are
– salaries & wages,
– benefits and
– overhead costs.
3. What industries can benefit the most from outsourcing labor to reduce costs?
Nearly any industry can benefit from outsourcing. Top examples are tech, finance, manufacturing and healthcare.
4. What are the long-term benefits of reducing labor costs for businesses?
The main benefit is increased competitiveness. When your operational costs are lower, your profit is higher. You can pass it on to your customers by offering better prices. Or you can reinvest money to expand your market reach.
5. How to cut costs without cutting staff?
The first step is efficient labor management. Optimize employee schedules and cut unnecessary overtime. Second, improve performance. You can offer bonuses to top-performing workers. Third, you can start hiring internationally.
6. Is labor a fixed cost?
No, you can lower labor costs if you are flexible. Yet, some labor costs can be considered “fixed” while others are “variable”. Fixed costs are constant. You pay them regardless of your output. Variable costs depend on how many goods or services you produce or provide.
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