Why Prime Cost Matters For Restaurants And How To Calculate It
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Labor costs are one of the highest expenses that most businesses contend with. Only rent and mortgage payments rank higher. In fact, in the restaurant business, labor costs can average 30-35 percent of total revenue.
That’s a large sum of money leaving your business each year. In addition, labor costs count heavily when determining your prime cost (cost of goods sold plus labor costs), which is a key metric for efficiency.
But what are labor costs, exactly? How do you calculate them? And how can you streamline the management of your labor costs so you have time to grow your business?
The experts at Sling will answer those questions and show you an easy way to lower your labor costs so you can keep your business on the road to success.
At first glance, labor costs may seem like just hourly or salaried wages. But in actual fact, labor costs include such expenses as:
Basically, consider anything even remotely related to employee wages as a labor cost.
What that means for you, then, is that while you may pay your servers $15 per hour, your actual labor costs are much higher because you have to factor in all the other expenses. Here’s how to calculate your fully burdened labor cost.
For this explanation, we’ll set up a hypothetical employee with the following details:
This example only deals with one employee, but you can scale it up to accommodate as many employees as you have.
Now we’ll use the above information to calculate labor costs.
When an employee works full time, they will potentially work 2,080 hours in one year (40 hours x 52 weeks).
So you’ll start with this equation:
Gross Pay = Pay Rate x Gross Hours
Gross Pay = $15/hour x 2,080 hours
Gross Pay = $31,200
You’ll never know exactly how many times an employee will be absent, but you can hazard a pretty good guess. If you have past records for other employees, average their absentee numbers together and apply that number to a new employee.
Let’s say you come up with an average of 10 days lost because of holidays, vacation, and illness. Convert that estimate to hours with the following equation:
Hours Not Worked = 10 days x 8 hours
Hours Not Worked = 80
Now subtract those hours not worked from the total hours worked from the first step (2,080).
Net Hours Worked = Gross Hours – Hours Not Worked
Net Hours Worked = 2,080 – 80
Net Hours Worked = 2,000
Remember, labor costs include expenses other than just wages. Insurance, bonuses, taxes — all of these items have an impact on what you pay your employees. Here’s how we’ll break it down for this example:
Add those numbers together and you get $4,000 in additional expenses associated with your employee’s labor. Take that number and add it to your employee’s gross pay to determine annual payroll labor cost.
Annual Payroll Labor Cost = Gross Pay + Other Annual Costs
Annual Payroll Labor Cost = $31,200 + $4,000
Annual Payroll Labor Cost = $35,200
That’s how much you’re actually paying out for your employee to work every year.
You know your employee’s base pay rate ($15 per hour in this example), but it’s essential that you calculate their actual hourly labor cost using this formula:
Actual Hourly Labor Cost = Annual Payroll Labor Cost / Net Hours Worked
Actual Hourly Labor Cost = $35,200 / 2,000
Actual Hourly Labor Cost = $17.60 per hour
That number tells you that when all the other variables are factored in, you’re paying your employee $17.60 per hour of actual work.
We mentioned this briefly, but labor costs factor heavily into determining your prime cost. What is prime cost, and how do you use labor cost numbers to calculate it? Let’s take a look.
The formal definition of prime cost is: All the direct costs and expenses associated with producing a product or performing a service.
Labor costs are a big part of the expenses mentioned in that definition. But they’re not the only variable. Direct material costs — a.k.a. cost of goods sold (or COGS, for short) — also contribute to your business’s prime cost.
COGS include any and all supplies and materials (raw or otherwise) that your business consumes during the manufacturing of a product or the delivery of a service.
Before you get overwhelmed by the thought of trying to assemble all of the costs associated with bringing your product to market, it’s important to note that only direct costs contribute to your prime cost.
For example, a business that produces widgets would not include material costs such as transport, delivery, and facility utilities as part of their cost of goods sold (because they are indirect costs rather than direct costs).
Similarly, labor costs would only include the wages the business pays to workers who contribute to the hands-on assembly of the widget.
You would not include expenses like design fees, marketing fees, or manager wages. Those fees — though still considered labor costs — are indirect costs rather than direct costs.
Prime cost is important because it shows you what you have left in the coffers after paying two of the largest expenses in your business: labor costs and costs of goods sold.
Of course, it doesn’t include indirect costs such as office expenses, rent/mortgage payments, or administrative salaries, but it will give you a quick idea of the profits you stand to make on your product or service.
If your prime cost is too high (because your labor costs are out of control), you may not have enough capital leftover for the indirect expenses that keep your business running but that aren’t part of the equation we’ll discuss in a moment.
For example, if your prime cost is 75%, you only have 25% left for indirect expenses. That means that for every dollar coming in from selling a product, $0.75 goes back to production, leaving you $0.25 for other expenses.
A 75% prime cost isn’t terrible, but it could be better. The ideal range to strive for is between 55% and 60%.
Now that we’ve discussed the theory behind how labor costs factor into prime cost and why it’s so important, let’s do a bit of math to see it all in action.
Prime cost can be divided into three unique metrics:
It doesn’t matter which one you set out to calculate, they all come back to the labor costs numbers you found earlier. Here’s how.
The equation for prime cost is:
Prime Cost = Direct Labor Costs + Direct Material Costs
With this equation in mind, let’s walk through a hypothetical calculation: A production manager wants to know how business ran in April, so they sit down to figure the factory’s prime cost for that month.
First, they crunch some numbers to find that the business spent $10,000 in labor costs during the month in question.
Second, they examine their inventory and discover that the business accrued another $10,000 in direct material costs.
Third, they plug those numbers into the equation above:
Prime Cost = Direct Labor Costs + Direct Material Costs
Prime Cost = $10,000 + $10,000
Prime Cost = $20,000
But that’s not the end of the story. To really see what went on in the business, the production manager needs to compare the labor costs and material costs to the total sales for the month.
To help you see how your labor costs compare to total sales, use the following equation:
Prime Cost As A Percentage Of Sales = (Prime Cost / Total Sales) x 100
To illustrate, let’s continue with the example from the previous section.
The production manager reviews the records and finds that total sales for April were $60,000. They then plug that information into the equation along with the prime cost number.
Prime Cost As A Percentage Of Sales = ($20,000 / $60,000) x 100
Prime Cost As A Percentage Of Sales = 0.33 x 100
Prime Cost As A Percentage Of Sales = 33%
From that number, the production manager can see that 33% of the money brought in went toward labor costs and material costs, leaving 67% left over to pay for the indirect expenses.
Does that set the business on track for a profit? The production manager needs to figure out one more number to tell. It involves direct labor costs, direct materials costs, and the other indirect costs that go into bringing the product to market.
All the other indirect costs that don’t contribute to prime cost can be lumped into a single category: overhead.
Overhead is all money spent to sustain the business but that doesn’t contribute to “hands-on” production.
Overhead expenses are referred to as indirect because they are not part of business activities that generate income — they support the activities that generate income, but they don’t affect it as much as labor costs.
It’s important to note that every business has a unique set of overhead costs, and no two businesses will be exactly the same.
The uniqueness of overhead costs highlights the importance of assembling the figures for your business rather than basing them on another business’s numbers.
Here’s how our hypothetical production manager would use their labor costs, costs of goods sold, and prime cost metrics to figure out this final number.
First, they would find what the business paid for indirect expenses (overhead) for the month of April. It was $30,000.
They then plug that number into the prime cost percentage equation, which is:
Prime Cost Percentage = (Prime Cost / Overhead) x 100
Prime Cost Percentage = ($20,000 / $30,000) x 100
Prime Cost Percentage = 0.66 x 100
Prime Cost Percentage = 66%
This number tells the manager that the prime cost (labor costs + materials costs) is 66% of the total overhead.
Armed with these numbers, the production manager then has more insight into how the business is working and how they can go about lowering labor costs to increase profits.
Lowering your labor costs doesn’t mean you have to pay your employees less. In fact, there are better ways to decrease one of the biggest expenses your business deals with. Here are a few tips to help you get control of your labor costs.
Planning your schedule well in advance is one of the best ways to lower your labor costs over the long term.
We recommend creating your employees’ work schedule at least a month in advance. This gives you plenty of time to review, tweak, and perfect the hours worked in order to minimize labor costs while still covering all shifts.
It also gives your employees time to find substitutes for days they can’t work so you’re not left short-staffed.
Calculating labor costs can be a laborious task. There are so many moving parts — who can work when, part-time vs. full-time, pay rates, overtime — it’s easy to get lost in all the numbers and become overwhelmed.
Plus, there’s the fact that once you have a schedule that works, something inevitably comes up that requires changing one or more pieces. And once you alter one variable, all the other variables and calculations usually change as well.
You can avoid the need to recalculate all your numbers every time you change the schedule by tabulating labor costs as you schedule.
Scheduling software like Sling lets you see how much you’re spending on labor in real time. It all but eliminates the extra step of creating your own labor cost report for each month and streamlines the entire scheduling process.
A rotating shift is a scheduling system in which employees move through a cycle of working the day shift, the night shift, and any swing shifts that may be necessary.
For some businesses, the rotating schedule may be first shift, second shift, third shift. For restaurants, the rotating schedule may be opening shift, lunch shift, and dinner/closing shift.
It doesn’t matter what you call them, the concept is still the same. One week, team A (or employee A) works the opening shift, team B works the lunch shift, and team C works the closing shift.
The following week, team A works the lunch shift, team B works the dinner shift, and team C works the opening shift.
Incorporating a rotating shift into your scheduling has several advantages:
For more information on shift work and how it can help you control labor costs, take a moment to read our article, Shift Work: What It Is And the Industries That Use It.
Training your employees to be proficient at their jobs is essential for the success of your business. Training them to be proficient at another job as well can help reduce your stress and keep labor costs low.
For example, imagine that you have two employees who can work the hostess position — employee A and employee B. Employee A gets sick and can’t work on Thursday, but employee B is very near overtime hours.
You want to keep labor costs low, so instead of asking employee B to work extra hours, you bring in a part-time employee (employee C). You train them to work as hostess and then schedule them to fill in for A and B when their hours get too high.
Monitoring overtime hours is another essential way to keep labor costs low. If left unchecked, overtime hours can quickly become a huge drain on your budget and affect your bottom line for the worse.
It’s imperative to keep your employees’ overtime hours as low as possible so they don’t get out of control. The best way to do this is with software like Sling.
Sling lets you view total time worked as you schedule and gives you reminders when an employee’s hours stray into overtime territory.
Another way to keep labor costs low is to establish and reinforce clock-in rules and regulations.
One such regulation should state that an employee’s shift will begin at the scheduled time (e.g., 9 a.m.) rather than when they clock in (e.g., 8:45 a.m.). Fifteen minutes may not seem like much, but, over a two-week period, it can add up to significant overtime hours.
Of course, employees are allowed to clock in early for work — and get paid for that time — but only if they have your permission first.
Everyone has emergencies that lead to absenteeism at one time or another.
But if allowed to get out of hand, absenteeism can become a bad habit for your employees that affects employee engagement, company culture, labor costs, and, eventually, your bottom line.
You can reduce absenteeism by instituting strategies that promote good attendance. Here are a few ideas:
The best way to combat out-of-control absenteeism is to get to the root of the problem. Is your employee having trouble finding a babysitter? Are medical appointments monopolizing their time? Is school getting in the way of their work schedule?
When you solve the core issue that causes absenteeism, both you and your employee will be happy.
All managers, regardless of industry, must deal with employee retention and turnover. It’s just a fact of business life. But when employee turnover becomes a habit in your business, it can seriously affect your labor costs.
To improve employee retention, deal with turnover head-on and make it a cornerstone of your business strategy. Here are several suggestions to get you started:
By incorporating these tips into the way your team works, you’ll be able to retain the skilled employees you need and keep your labor costs under control.
Every team needs standard operating procedures to guide them in their work. These can be as simple as what to say when answering the phone or as complex as how to operate computer hardware and software.
Whatever they are, standard operating procedures play an integral role in how your team works — both together and apart.
Once you’ve calculated labor costs for your business, examine the way your team works and adjust any standard operating procedures that might bring your labor numbers down.
It can also be beneficial to adjust standard operating procedures that might improve efficiency, productivity, accuracy, and engagement as these also affect labor costs.
For example, you might consider implementing regulations and procedures that limit distractions, such as repeated cell phone use and email interruptions.
Or, you might upgrade the tools your team uses on a regular basis to help streamline repetitive tasks and make them easier to start and finish.
Regardless of what standard operating procedures you choose to adjust, it all starts with observing your team in action.
Take this opportunity to watch your team perform their duties, paying particular attention to what distracts them from the work, what tools might improve the process, and how you can lower labor costs in the process.
Analyzing labor trends in your business isn’t as difficult as it may sound. With the right record-keeping, it just means reviewing past schedules to see what worked and what didn’t.
Perhaps one week last year you scheduled three employees but customer traffic demanded that you call in a fourth (who was already close to overtime hours) to help out. Could that amount of customer traffic repeat itself? It’s possible.
Armed with this information, you can create a schedule that addresses the issue without asking someone to work overtime or going over your labor budget.
So how do you go about implementing these tips without cutting into the time you spend on other tasks? The answer might surprise you.
The best way to manage and lower your labor costs is to use a suite of software tools like Sling.
Sling gives you incredible control over your schedule so you can quickly and easily create schedules one month, two months, even six months or more in advance.
And the built-in artificial intelligence automatically reminds you of requested time off, double bookings, and overtime hours so there’s less back-and-forth once you’ve completed the schedule.
Sling even lets you optimize labor costs by setting wages per employee or position so you can see how much each shift will cost you. You can keep track of your labor budget and receive alerts when you’re about to exceed those numbers.
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This content is for informational purposes and is not intended as legal, tax, HR, or any other professional advice. Please contact an attorney or other professional for specific advice.