Understanding the Exact Cost of an Employee

• Lorea Lastiri
• January 5, 2024

An employee costs much more than the salary or wage an employer pays. Aside from the base salary or wage, there are payroll taxes, non-mandatory payments, and other costs the employer pays when hiring or employing a person. If you don’t keep track of all your costs, you’re in for some financial problems.

Determining and understanding the actual cost of an employee will help you budget and make sound financial decisions for your business, regardless of its size.

We will tell you all you need to know about the cost of an employee, the formulas to calculate it, variables and elements of employee costs, and their computation.

Formula to calculate the cost of an employee

The total cost of an employee includes the base salary or wage and other expenses that the business incurred to hire a person. No one formula fits all types of businesses when it comes to employee costs. However, an employee typically costs 1.25 to 1.4 times the base salary.

To calculate the total cost per employee, you multiply the base salary by 1.25 or 1.4. This formula determines the minimum and maximum costs of each employee.

If you hire a new employee with an annual salary of \$52,000, the true cost is between \$65,000 and \$72,800. An employee with an hourly rate of \$20 costs \$25 to \$28 per hour based on this formula.

The formula gives employers an initial estimate of the real costs of employees. With this estimation, an employer can also predict project costs and business profitability.

Variables that affect employee cost

The formula previously mentioned only gives an estimation of how much an employee costs. The true cost of an employee depends on a series of variables and other factors.

Here are the variables that affect employee cost:

1. Location

Where you set up your business is a big variable in your employee compensation. Each place has different state and local employment taxes, cost of living, market demands, which all affect the total cost of employees.

2. Industry

The industry also matters in determining cost per employee because each industry has its employment norms. For instance, industries like insurance and software development often require additional benefits such as paid health insurance, which can significantly impact employee costs. Others only give partial coverage as the standard health benefit plan.

Currently, online computer software sales are the leading industry with the highest labor costs in the U.S. Similarly, contractors can find it simpler to handle industry-specific costs like workers’ compensation with advice from ContractorNerd.

3. Company size

Larger companies may sometimes have lower employee costs than small businesses. They can also afford to give higher compensation to employees.

A small business may have difficulty offering competitive rates, which can sometimes cause high turnover rates (adding up hiring costs).

4. Market Conditions

The law of supply and demand in the employment market can affect the employment cost. Companies may adjust their compensation packages based on supply and demand forecasting, offering competitive benefits to attract top talent with rare skill sets.

On the other hand, a high supply of human resources in a position will not have a compensation lower than the set minimum wage by the state.

5. Turnover rate

A company with a high turnover rate causes a lot more employee costs than others due to hiring and onboarding costs.

There are costs to consider when recruiting an employee, depending on the company’s recruitment practices. The recruitment costs include the fees for job postings, recruitment software, background checks, and human resources. Onboarding of new hires also incurs other costs, such as training.

High turnover necessitates frequent onboarding sessions, diverting valuable time and resources from productive tasks. The process of training new hires not only demands financial investment but also strains existing staff, who must allocate time to mentor and integrate newcomers into the company culture. Companies may opt for cost-effective solutions such as free recruitment agency software, which streamlines the hiring process and minimizes expenditure on recruitment fees and administrative tasks

6. Education and Role

People with rare skill sets, education, and experience that prove their job expertise can demand a high salary. Most companies also offer high compensation with competitive benefits to recruit and keep them, which can ramp up the labor cost.

Employee costs also vary by role. Senior and higher positions require higher compensation and benefits than junior hires.

Generally, workers who handle more challenging tasks receive higher compensation. For example, conducting research and data analysis is more difficult than encoding data.

8. Performance

Employee performance also plays a role in the total employee costs. High-performing and productive workers can lower employee costs by being efficient in the assigned tasks. Being efficient helps lower the time and resources required for the job, thus lowering the total cost.

Most employers conduct performance appraisals to distinguish high-performing workers from low-performing ones and to use as a basis in determining the pay level for the workers.

You can easily track your employee’s performance using time tracking tools, such as TimeCamp. A time tracking app provides productivity data on how much time an employee spends working on a task. This data can give you valuable insights into your employees’ productivity and your business costs.

How to calculate an employee cost?

Joe Hadzima is a senior lecturer at MIT who came up with how one can calculate employee costs. Here are the factors to consider in calculating the total employee cost:

1. Recruitment Costs

The first cost that a company incurs when hiring a new employee is the recruitment cost. These costs depend on the hiring practices of a company.

Recruitment costs include:

• Labor costs for internal recruitment
• External recruitment costs, wherein companies usually pay them 15 to 30 percent of the new employee’s base salary as a retainer’s fee
• Background checking, which usually ranges from \$10-\$20
• Recruiting software to manage the hiring process.

Additionally, companies also have to pay for onboarding costs, training, mentoring fees, and onboarding kits, to assist a new employee and help lengthen employee tenure. Fractional CHRO services can be crucial in optimizing these investments, ensuring that each dollar spent contributes effectively to employee development and retention.

If you are recruiting a new hire every month, knowing how much an employee costs per hire will help you budget and adjust your business’ growth plan. When it comes to hiring new employees, managing costs – from recruitment to onboarding and training – is crucial. An effective way to do this is by using a tool like Vena, which provides a template for managing labor costs.

2. Salary or Wage

Base compensation is the largest part of the total employee cost. Companies have to consider the industry and the minimum salary or wage set by the government when deciding and setting an employee’s base compensation.

Note that salary is a fixed payment for employees given per pay period. On the other hand, wage fluctuates depending on the total work hours of an employee. For hourly employees, it is necessary to use time tracking software to efficiently and accurately track the employee’s total hours worked. Utilizing services like OGS Capital business plan consultants can significantly streamline financial forecasting, aiding in precise budget allocation for employee costs and overall fiscal management.

Even though salary or wage is the largest expense of an employee cost, it is not the only determining factor of the total cost of an employee.

Pure middle market based salary structures are getting out of functionality nowadays, so many companies consider the minimum salary wage and the industry in which the employee works to determine the cost of the employee. The use of compensation benchmarking tools is widespread and pretty helpful in the process, since these tools offer compensation solutions developed by compensation professionals.

3. Mandatory Payments

Mandatory payments are required payroll taxes that companies need to take into account when preparing employee budgets and calculating the cost of an employee.

Here are the mandatory payments:

• Federal Insurance Contributions Act (FICA) tax

Federal Insurance Contributions Act (FICA) constitutes Social Security taxes (old-age, survivors, and disability insurance) and Medicare taxes (hospital insurance tax). Different rates may apply for these taxes.

The social security tax rate is 12.4%, with 6.2% from employers and 6.2% from employees.

A wage base limit is set for social security to know the maximum taxable wages. For 2022, the wage base limit is \$147,000. Thus, the maximum social security tax an employer can pay is \$9,114 per employee.

Meanwhile, Medicare tax has no wage base limit. Its required total tax rate is 2.9%, 1.45% for employers, and 1.45% for employees.

You can refer to the tax guide for employers and agricultural employers for more information.

• Federal Unemployment Tax Act (FUTA)

Federal Unemployment Tax Act (FUTA) is one of the payroll taxes that a company pays for. It provides payment for unemployment insurance for unemployed workers. The tax rate is not deducted from the employee’s salary or wage because only the employers pay FUTA tax.

The FUTA tax rate is 6% on the first \$7,000 wages paid per employee during the year. This is usually referred to as the FUTA wage base.

A company can file Employer’s Annual Federal Unemployment (FUTA) Tax Return (Form 940) if they have paid wages of more than \$1500 to their employees. This may qualify them to get 5.4% tax credit and have a 0.6% net FUTA tax rate.

• State Unemployment Tax (SUTA)

Each state also has an unemployment tax rate, called State Unemployment Tax (SUTA), as the state’s unemployment benefits fund. It serves as unemployment insurance to workers who are terminated. There are states where only the employer pays the SUTA tax while other states also get a partial payment from employees’ salaries or wages.

The tax rates also differ in each state. Always check updated state tax rates to accurately pay taxes and calculate total employee costs.

• Workers’ compensation insurance

Another mandatory payment for companies is the workers’ compensation insurance or workers comp. This serves as protection and insurance for both employer and employee in case an employee gets injured while working.

Employees receive the benefits regardless of who caused the accident. If an employee loses their life while working, workers’ compensation insurance also provides death benefits for the employee’s dependents.

Each state regulates the workers’ comp rate. Each job has its assigned rate per \$100 of salary or wage. The rate is higher for riskier jobs.

Let’s have a sample computation for the true cost of a salaried worker.

Anne has an annual base salary of \$50,000. We will have based the SUTA tax on Indiana’s new employer rate, which is 2.50%. We will also use the lowest worker’s compensation insurance rate in Indiana, which is \$0.70 per \$100.

Below is the calculation of the total payroll taxes.

 Type of Mandatory Payment Rate by Percentage Amount  (Base Salary: \$50,000) FICA Social Security 6.2% \$3,100.00 FICA Medicare 1.45% \$725.00 FUTA 6% \$42.00 SUTA 2.50% \$237.50 Workers Comp \$0.70 per \$100 \$350.00 Total \$4,454.50

The total payroll taxes that Anne’s employer will pay is \$4,454.50. If we add this to the basic salary, the total cost is \$4,454.50.

4. Non-mandatory Payments

Managing payroll effectively requires accurate documentation, including the generation of secure pay stubs that employees can rely on for loan applications, tax purposes, and personal record-keeping. Ensuring compliance and avoiding errors are crucial in maintaining trust and transparency within your workforce. In the ever-evolving payment industry, companies are increasingly turning to specialized software and services to streamline this critical process.

There are also non-mandatory payments that a company pays voluntarily for their workers. These are benefits packages that companies give on top of the mandatory benefits, which contribute to the employee’s total cost.

• Health Insurance

Health Insurance is one of the most common voluntary benefits an employer can give to workers. However, it is not cheap. The cost depends on the health insurance plan you want to offer.

KFF 2021 Employer Health Benefits Survey revealed that the average annual premium that companies pay for health insurance is \$7,739 for single employees and \$22,221 for family coverage.

A small business can lessen the health insurance cost per employee by filing federal taxes when they meet the requirements for the Small Business Health Care Tax Credit.

• Dental Insurance

Dental insurance is another common benefit for employees. According to the labor statistics of the Department of Labor, 40% of private workers and 60% of government workers had dental insurance in 2021.

The cost depends on the type of insurance the company gets for its employees, the number of employees, and the company’s location. The annual dental insurance cost typically ranges from \$300 to \$600 per employee. The employer can choose whether to fully sponsor the cost, have an 80/20 employer-employee ratio, or offer it as a voluntary benefit for workers to pay at a discounted price

• Life Insurance

Life insurance is a policy that can benefit the family of an employee in case the latter dies. The benefits are given in a lump sum to the beneficiaries of the policy.

It is important to let the employees know that the beneficiaries can claim the benefits upon the employee’s death.

Most employers give life insurance coverage that is equal to the employee’s annual salary. However, according to Joe Hadzime, \$150 is the average cost an employer pays for life insurance on the first \$50,000 wages.

• Paid Time Off (PTO)

Paid Time Off includes vacation leave, sick leave, federal holidays, maternity leave, and paternity leave. This is not mandated by the Fair Labor Standards Act (FLSA) in the U.S., but most companies include PTO in their list of employee benefits.

When an employee files for PTO, the salary or wage will still be the same since it’s a paid leave, but the total hourly employee cost will increase for employers.

If you want to include this as your employee benefit, make sure to have a system that can help you track the paid leaves of your workers. You can make use of PTO tracking software for an easy application and approval of leaves and tracking of workers who are taking their time off.

• Long-term Disability Insurance

Long-term disability (LTD) insurance is a policy that assures income protection for workers in case of disability, an illness, or an accident. Through LTD, an employee will get a portion of his/her income if unable to work due to disability.

However, work-related injuries or accidents are not covered by LTD because workers’ compensation insurance already covers this.

According to Hadzima, companies pay an average LTD of \$250 for a \$50,000 wage.

• Retirement Plans

Many employers set 401k plans as retirement savings for their employees. The employees can decide whether to let their employer contribute a part of their salary to the individual account of their retirement plan.

Some companies give employers a contribution to the retirement fund by matching up the percentage of the employee’s contribution to the plan. Based on Vanguard’s How America Saves 2021, the average percentage an employer can match on the employee’s retirement fund is 4.5%.

Let’s try a sample computation of some of the non-mandatory payments to get the total employee cost. We will still use Anne’s basic salary as an example.

 Type of Non-mandatory Payment Amount  (Base Salary: \$50,000) Health Insurance \$7,739.00 Dental Insurance \$500.00 Life Insurance \$150.00 Long-term Disability Insurance \$250.00 Retirement Plan \$2250.00 Total \$10,889.00

The total non-mandatory cost that the employer will pay for Anna’s employee benefits is \$10,889.

Let’s add this to the basic salary and the total mandatory cost that was computed earlier.

 Expense Amount Basic Salary \$50,000 Mandatory Cost \$4,454.50 Non-mandatory cost \$10,889.00 Total \$65,343.5

The total employment cost for Anna’s employment, inclusive of mandatory and non-mandatory benefits, is \$65,343.5.

Overhead costs are the costs that keep your business running. These are regular payments that are not related to direct labor or materials. Since this is part of the total production costs, overhead costs are included in estimating labor costs.

The cost may vary depending on the type of business you have. The standard overhead costs may include:

• Rent collection – the fees covering the office space you rented for your employees. When your company grows, the larger the office space you need, the higher the rental fee.
• Utilities – includes the electrical, water, and internet bills for your office.
• Office supplies – are the tools you supply for your workers needed to perform their job (e.g. computer, papers, etc.)
• Operating costs – fees for various operating costs, such as payroll, vary depending on the total workers you have.
• Offsite overhead – includes costs incurred even if the employee is not working in the office. Examples include internet allowance for those who are working from home.

Now, let’s have a sample computation for an hourly paid person. The computation for hourly workers includes total hours worked per year, annual employee labor cost, annual overhead fees per employee, annual mandatory fees, and non-mandatory fees.

Let’s say that the total hours Mike worked per year is 2,000 hrs. We get the annual labor cost by multiplying Mike’s total hours worked per year by the hourly rate. In this case, Mike’s rate is \$25 per hour. His annual labor cost is \$50,000.

Since Mike’s

annual labor cost is \$50,000, we will use the calculated payroll taxes and non-mandatory payments above, which are \$4,454.50 and \$10,889, respectively.

Let’s assume that the annual overhead cost is \$10,000. We divide it by the 50 workers employed in this year. The annual overhead cost per employee is \$200.

 Expense Amount Labor cost \$50,000 Mandatory \$4,454.50 Non-mandatory \$10,889 Overhead cost \$200 Total \$65,543.5

We will divide the total annual employee cost (\$65,543.5) by the total hours worked per year (2000) to get the true cost of an employee per hour. In this case, the result is \$32.77.

Although Mike is earning \$25 per hour, the actual employee cost is \$32.77 per hour.

Companies must use a time tracker system for accurate tracking of the number of hours worked by each employee. Through time tracking, employers will know who is working overtime. If workers do unplanned overtime, the overtime pay adds to their total compensation and will increase employee costs.

Conclusion

Understanding the exact employee costs helps business owners in budgeting, estimating project costs, predicting profitability and making reasonable financial decisions necessary for business growth.

One common ground in computing the exact cost of an employee is tracking employees’ time and productivity regardless if they are salaried or hourly paid. TimeCamp is the best tool to help you with that.

TimeCamp efficiently and accurately tracks workers’ time and productivity. It also provides necessary reports to give you insights into your business. Don’t worry about additional costs because the tool has a free version packed with great features.