Managing small business payroll often involves a delicate balance between maximizing revenue and limiting labor costs. If you have more employees than you need—or you pay them more than necessary—your payroll costs will eat into profitability. On the other hand, failing to hire enough employees may restrict your revenue growth.
One way to help achieve the right balance is to examine your payroll costs as a percentage of revenue. Analyzing this ratio, called the payroll percentage, can help you optimize cost and revenue and more easily compare your labor costs to other companies’.
What Is Payroll?
The total cost of your workforce, including employee salaries and wages, taxes and benefits, is known as payroll. Running payroll is the process of calculating the total earnings for employees, making the appropriate deductions, paying corresponding taxes and distributing payments. Payroll software helps automate this process. It can also integrate with other business software solutions, such as accounting software, to overcome accounting and payroll challenges. Payroll is one of the largest recurring expenses for most businesses, so keeping payroll costs down while not losing productivity or sales is a common issue for small businesses.
What Are Payroll Percentages?
Payroll percentage is your payroll cost as a percentage of sales revenue. A high payroll percentage may signal that you’re spending too much on payroll. It’s a useful metric to evaluate and can help guide decisions about how much to spend on payroll like when to hire new employees, raise wages or even cut back when necessary. The ratio is also sometimes called the payroll to sales percentage, payroll to revenue percentage or labor cost percentage.
What Is Labor Margin?
Labor margin is another way to look at the relationship between labor costs and revenue. It’s the difference between sales revenue and the cost of the labor required to generate that revenue, expressed as a percentage of revenue.
How to Calculate Payroll Percentage
To find your payroll percentage, calculate total payroll expenses and divide by gross revenue. Then multiply by 100 to convert the result into a percentage. Be sure to use the same time period for both expenses and revenue.
Payroll percentage = (Total payroll expenses/gross revenue) x 100
For Example: Sammi’s Sandwich Shop generated $400,000 in gross revenue and spent $120,000 in total payroll costs last year. The formula for calculating the payroll percentage looks like this:
Payroll percentage = ($120,000/$400,000) x 100 = 30%
Gross revenue in this formula should exclude any charges that you collect and pass through without a markup, such as sales taxes and freight charges.
Total payroll expenses include gross pay, plus the employer’s share of payroll taxes and the employer’s contributions to any other benefits. Your payroll software may calculate your fully loaded payroll expenses. The items included in payroll expenses may include:
- Commissions and bonuses
- Owner draws
- Vacation pay
- Health and life insurance
- Employer retirement plan contributions
- Auto allowances
- FICA taxes (Medicare and Social Security)
- Other state or local taxes
- Unemployment insurance
- State disability insurance
What is a Good Payroll Percentage?
There is no easy answer to this question. Payroll percentages vary by industry, company size and revenue level. The key is to find a balance between revenue and payroll costs that works for your business.
Many businesses operate with payroll percentages in the 15–30% range. But labor-intensive service-based businesses may have much higher payroll costs of up to 50%, and still remain profitable.
While analyzing payroll percentage can be useful, it’s important not to lose sight of your broader business goals. For example, you may consider adding staff to fuel long-term growth, even if there’s a negative short-term impact on your payroll percentage. Conversely, cutting staff may negatively impact your business overall. Small businesses may want to build in spare labor capacity to cover for employees that take sick time or are unable to work for other reasons. Along with keeping an eye on payroll percentage, there are other key metrics and ratios to help provide insight into your company’s financials.
Using Payroll Percentage to Assess Employee Productivity
Your payroll percentage can be a useful indicator of employee productivity, especially in labor-intensive businesses. The way productivity is measured depends on the industry, but generally it’s defined as revenue per employee. For factory workers, employee productivity might be measured as the number of widgets each employee produces per hour. Since productivity is often related to revenue, the payroll to sales percentage can be an indicator of employee productivity. If the payroll percentage rises, it means that the company is generating less revenue per employee, which may be a warning sign that productivity is decreasing.
How do Payroll Percentages Vary by Industry?
Payroll percentages vary greatly by industry: a highly automated factory or oil refinery may have a much lower payroll percentage than a labor-intensive restaurant or professional services firm. Here are some examples of typical payroll percentages by industry:
- Retail: 10% to 20%
- Manufacturing: 12%
- Construction: 20%
- Hospitality: 30%
- Restaurants: 30%
- Professional, scientific and technical services: 39%
- Health care and social assistance: 41%
- Beauty salons and barber shops: 44%
The U.S. Census Bureau provides much more detailed information broken down by industry and state, based on data from millions of businesses. Reporting services and trade journals track statistics for certain industries, such as restaurants and health care.
How to Use the Percentage for Promotions and Raises
Your payroll percentage can provide a useful starting point for determining how much to pay employees. As the business grows, you may want to budget for future promotions or raises that maintain the payroll to revenue percentage within a targeted range. If your payroll percentage is below the average for your industry, it could mean that you need to raise wages to avoid losing staff to competitors—or it could simply indicate that your business is much more efficient because it makes better use of automation. Payroll percentage is only one of the factors to consider when determining whether to raise wages.
8 Ways to Reduce Your Payroll Percentage
To reduce your payroll percentage, increase revenue or reduce payroll costs—or if possible, do both. Here are some ways to achieve at least one of those goals:
- Build variable employee incentives tied to increases in quarterly revenue (for sales groups) or increased production (for factory employees).
- Improve productivity with rewards for staff performance. A merit-based bonus, special recognition or a day off can boost employee productivity, helping to increase revenue without a corresponding increase in payroll costs.
- Cross-train employees to cover for each other if a staff member is out or if the whole team needs to pitch in on a rush order or project.
- Study your business’s capacity. Do you have lulls in staff activity, which might indicate you could deploy people more efficiently? Or is your workforce stretched beyond capacity, which suggests there’s potential to increase revenue? Are you spending more on overtime than it would cost to hire additional staff? You may be able to make adjustments that reduce your payroll percentage.
- Evaluate your talent pool. Ensure you have the right mix of skillsets among your staff and that your workforce is adequately trained. Review employee turnover rates, since high staff turnover can reduce productivity and increase hiring expenses.
- Use flexible labor options such as part-time, freelance or temporary help to handle workload surges without adding to your fixed costs.
- Control employee benefit costs. Shop around for cheaper health insurance, implement effective wellness plans and offer a mix of health plans with high deductibles to help control your health care costs.
- Find automation opportunities. Examine business processes and functions that consume a lot of labor hours and seek ways to automate them.
Payroll expenses are a large part of your operating expenses, so it’s vital to monitor them closely. Your payroll percentage can help you determine the right balance between revenue and labor costs to maximize your bottom line. For the most accurate and streamlined payroll processing and entry, use payroll processing software. Robust payroll software also integrates seamlessly with accounting solutions, providing all your financial and payroll data in one environment for easier access and analysis. Additionally, insightful reporting and dashboards will give you access to payroll percentage calculations, along with other key financial measures.