What Percentage of Sales or Gross Revenue Should Go Toward Payroll?

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 costs and revenue and more easily compare your labor costs to those of 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 Is Payroll as a Percentage of Revenue?

Payroll as a percentage of revenue, or 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.

Key Takeaways

• Calculating payroll costs as a percentage of revenue helps employers find the sweet spot between a bloated payroll that eats at profits and a penny-pinching payroll that hinders efficiency and growth.
• A strong payroll percentage varies considerably, based on industry, business model, growth stage, and other factors.
• Calculating payroll as a percentage of revenue is a simple formula.
• To be sure they plug the right numbers into the formula, employers should address several challenges that can warp the data.

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% to 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.

Payroll as a Percentage of Revenue 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: 8% to 20%
• Manufacturing: 12% to 30%
• Construction: 20%
• Technology 20% to 30%
• Restaurants: 25% to 30%
• Hospitality: 30%
• Professional, scientific, and technical services: 39%
• Healthcare and social assistance: 41%
• Beauty salons and barber shops: 44%

Generally, the range within an industry reflects the market position of the business. For example, labor costs are typically a smaller percentage of revenue in a casual restaurant than they are in a fine dining establishment.

What Is Labor Margin?

Another way to look at the relationship between labor costs and revenue is known as labor margin. In simplest terms, while payroll as a percentage of revenue reveals how much labor costs a business, labor margin reveals how much money that labor makes for the business.

Like payroll as a percentage of revenue, labor margin is a simple calculation:

Labor margin = Revenue attributable to labor – Direct labor costs / Revenue attributable to Labor x 100

Although any business can determine its labor margin, the metric is used most often in businesses in which labor is a major cost driver, such as construction or skilled services. Consider a plumbing business, for example. To make the math easy, suppose that in a typical month the business earns $10,000 and pays its employees $4,000. Calculating payroll percentage ($4,000 / $10,000 = 40%) indicates that labor costs the company 40% of its revenue. The company would then calculate the labor margin like so:

Labor margin = ($10,000 – $4,000) / $10,000 x 100 = 60%

This shows that labor generated a 60% gross profit for the plumbing business.

A business that knows its labor margin can use the data in several contexts, including:

• Informing pricing strategies and cost controls
• Costing jobs in construction, staffing, and field services
• Assessing the profitability of labor-intensive services

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

Using Payroll Percentage to Assess Employee Productivity

Parallel to labor margin, 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 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.

Common Payroll-to-Revenue Challenges

As noted, the formula for calculating payroll as a percentage of revenue is simple. But experts note that too often businesses fail to fully consider factors that impact the numbers used in that calculation. Several challenges can complicate the process of determining accurate numbers, including:

• Revenue variability: When revenue fluctuates due to seasonality, project timing, or market conditions, the payroll-to-revenue ratio can become misleading. For example, suppose a retailer’s December holiday season revenue was $200,000, but in January it was half that. Nothing changed in staffing, but the ratio doubled due to revenue drop. Businesses can compensate for those swings by calculating payroll percentage over three-, six-, or 12-month rolling periods. They can also compare a monthly snapshot to historical trends.
• Overhead costs: Payroll is a significant part of a company’s expenses, but it doesn't exist in isolation. It’s crucial to consider payroll within the context of total operating expenses, which include rent, utilities, insurance, marketing, and other overhead costs. Failing to account for these overhead expenses can lead to an incomplete understanding of the true cost of running the business. Remember, a healthy business needs to generate enough revenue to cover not just labor costs, but all operating expenses while still maintaining a profit margin. Regularly analyzing these relationships can help prevent financial strain and support long-term success.
• Ineffective scheduling and hiring: Even with perfect headcount and fair pay, bad scheduling makes payroll inefficient because it inflates labor costs without improving output. Signs of scheduling problems include high overtime costs, low employee productivity per shift, staff seesawing between being idle or rushed, and frequent call-outs or schedule changes. Companies can meet these challenges by switching to demand-driven scheduling, using scheduling software, and cross-training employees so that staff can be reassigned during slow times.
• High employee turnover: Employees quitting to seek greener pastures is one of the most damaging factors that inflate payroll—especially when businesses don’t track the actual cost of replacing employees. Experts say that many businesses measure hiring expenses strictly in direct costs (such as advertising) while overlooking such indirect costs as lost productivity. Employers can work to reduce turnover by improving onboarding and engagement, forging growth opportunities for employees, and using exit interviews to pinpoint why people leave.
• Misclassified employees: Treating workers as independent contractors when they should be employees or wrongly grouping employees as exempt vs. non-exempt can distort payroll costs and lead to fines and penalties. Setting aside the legal risks, misclassification can also result in understated labor costs, skewed comparisons, and faulty cost allocation. Employers can avoid misclassification by reviewing jobs using IRS and Department of Labor criteria, including contractor costs in labor efficiency analyses, and tracking labor data consistently across departments. If employers remain unsure how to classify correctly, experts advise seeking legal advice.
• Overly general tracking: Some employers track only total payroll, without breaking it down by department, location, or project. Doing so limits the usefulness of payroll for decision-making. Companies can use departmental or unit-level tracking to pinpoint specific problems.

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 eight ways to achieve at least one of those goals:

1. Build variable employee incentives tied to increases in quarterly revenue (for sales groups) or increased production (for factory employees).
2. 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.
3. 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.
4. 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.
5. Evaluate your talent pool. Make sure you have the right mix of skill sets 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.
6. Use flexible labor options, such as part-time, freelance, or temporary help, to handle workload surges without adding to your fixed costs.
7. 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 healthcare costs.
8. Find automation opportunities. Examine business processes and functions that consume a lot of labor hours and seek ways to automate them.

Manage Payroll Effectively With NetSuite

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. NetSuite SuitePeople human resource management solution integrates seamlessly with NetSuite financial management 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.

Understanding and managing your payroll as a percentage of revenue is vital for maintaining a healthy, profitable business. While there’s no one-size-fits-all ideal ratio, regularly analyzing this metric can provide valuable insights into your company’s financial health and operational efficiency. By addressing common challenges, implementing strategies to optimize your payroll percentage, and using financial management tools, you can strike the right balance between labor costs and revenue generation. Remember, the goal isn’t just to minimize payroll costs, but to maximize the value and productivity of your workforce while maintaining sustainable growth and profitability for your business.

Payroll Percentage FAQs

What percentage of revenue is payroll?

The percentage of revenue spent on payroll (which includes not only wages, but also benefits and taxes) varies widely by industry and business model. Payroll as a percentage of revenue can be as low as 8% or as high as almost 50%, and businesses can still be profitable. For example, service-based companies tend to have much higher payroll percentages than product-based companies.

What is a good revenue-per-employee ratio?

There is no definitive ratio because a “good” revenue-per-employee ratio depends on the company’s industry, business model, and growth stage. As examples, annual revenue per employee may be as low as $50,000 in a fast-food restaurant or as high as $600,000 in a law firm or consulting practice. That said, higher is generally better because it suggests greater productivity, more effective pricing, or wise use of capital.

What is the standard employee turnover ratio?

Turnover varies significantly by industry, job type, and geography. Still, experts say that annual turnover of 10& to 20% is healthy in most industries. Turnover of less than 10% may not actually be healthy because it may mean that the company isn’t bringing in new talent. Except in situations in which churn is expected, such as fast food establishments, turnover of greater than 50% almost always indicates a problematic, unhealthy culture.