Businesses need to be able to estimate the cost of labor in order to make informed decisions about their budget and operations. In this article, we will discuss forecasting labor expense. We will cover wages and benefits, as well as payroll taxes. By understanding these costs, businesses can better plan for the future and make sure they are able to afford the employees they need to grow and succeed!
Why It Matters
Forecasting the cost of labor is important for any business. Forecasts help businesses plan ahead and get an idea of what their costs might be in the future. They allow companies to budget accordingly and manage the business’ financials to the expectations of management or investors.
For many businesses, especially service businesses, the cost of labor can be the single largest expense. Forecasting this expense is especially important for planning the business’ financials and making sure that the company can operate profitably.
Knowing how to forecast labor expenses will help you better manage your business’s finances, so let’s get started!
Breaking It Down
When you work on any forecast, you need to step back and break the forecast down into pieces. What are the drivers behind the forecast? For example, if you are forecasting labor expense, two drivers could be:
-The number of employees needed to meet demand (people/hour)
– Hourly compensation rate per employee ($/hour)
Now, instead of forecasting something generic like labor expense, you can focus on figuring out the number of employees needed as well as their rate.
Once we have those, the forecast is simple. Forecasted labor expense = Forecasted employee hours * Forecasted hourly rate. This is a lot easier to work with.
The Forecasting Process
Step 1: Determine What You Need to Forecast
We’ll need to predict the following components in order to produce a cost of labor forecast for a typical service firm with hourly employees:
- Employee hours
- Hourly rate
- Overtime premium, if applicable
- Overtime hours
- Payroll taxes
- Medical benefits
Step 2: Collect Inputs and Assumptions
For each of the components from step 1, you will need to collect the inputs and assumptions behind them. For example, employee hours may be driven by the demand for your service/product as well as how many employees are required to meet that demand.
If you are a new business, you may need to estimate things like hourly rates based on what you think competitors are paying or what you believe is a good rate in your industry and region. If you are an existing business, you might want to consider historical data.
Step 3: Layout the Forecast Model
Once you have determined what to forecast and collected the inputs, it is time to start building a model. Forecasting models can be as simple or as complex as you want them to be. For example, if we’re forecasting labor expense for two employees at $20/hour with no overtime or benefits (assuming you are an LLC), the spreadsheet for your model would be really simple.
On the other hand, if you are forecasting labor expenses for 1,000 employees across a region of stores, you will need a more complex model with more details.
Step 4: Run and Adjust the Forecast
Once your model is set up, you simply need to run it and adjust the inputs as needed. You will want to do this on a regular basis, especially if your business is growing or changing. Forecasting is not a one-time event; it should be done regularly to ensure that your numbers are accurate.
Step 5: Review and Summarize
You should look at your forecast results to ensure they make sense and summarize them in a way that works for your business. For example, if you are forecasting labor expenses on a monthly basis, you may want to do quarterly and annual views. If you are forecasting by store, you may want to view by region.
Let’s Walk Through An Example
Download this workbook so you can follow along with the example!
Forecasting Labor Expense For a Restaurant
Let’s walk through a basic labor expense forecast. We will look at a restaurant with an hourly workforce that is subject to overtime.
First, let’s lay out what we need to forecast. In this case, we have three weeks of actuals data. We want to forecast the following three weeks of labor expense. And we want to forecast hourly wages, overtime wages, payroll tax, and medical benefits. Our forecast P&L looks like this:
Next, let’s lay out the drivers behind this forecast. Under Forecasting Process above, we laid out the following drivers:
- Employee hours – we will look at actuals, and also check with our restaurant manager
- Hourly rate – we will use the average of actuals
- Overtime premium – this will be 50% as required by law
- Overtime hours – we will look at actuals, and also check with our restaurant manager
- Payroll taxes – for our jurisdiction, this is 7.65% on any wages paid
- Medical benefits – For our company, this is 15% on hourly wages only. Many companies will update the rates quarterly or annually, so make sure to always double check
Laying out the drivers expands our forecast like this:
Notice that I have already populated the P&L with formulas. We arent going to enter anything into the P&L itself, we are going to update the drivers which will in turn flow through the forecast.
We know overtime premium, payroll taxes, and medical benefits because they are fixed rates. Hourly rates are the next easiest, we will use an average rate of $17.00 based on history. For employee hours, the operations team expects week 4 to be as slow as week 3, but weeks 5 and 6 will look like weeks 1 and 2. We will carry week 3’s hours for week 4, and then average the other two weeks.
Here is our final forecast:
Tips and Tricks
Finding Data And Assumptions
Forecasts are only as good as the data and assumptions you put into them. So where can you find solid data? If you have an existing business, the first place to look is your financial system. Historical data is one of the best inputs to a forecast. You can also work with your operations teams to understand what it will take to deliver a certain level of performance.
For a new business or new product line with historical info, you will have to dig a bit deeper. Economic data and market research are your best bets. This can include digging into resources like the Consumer Product Index (CPI) for inflation or studying your competitors.
Step Back And Do A Gut Check
As you get into the weeds of your forecast, it is important to step back and ask yourself, “Does this make sense?” Think about how the forecast looks year-over-year and sequentially. Do you have the capacity and workforce to even deliver the forecast? Do the trends seem reasonable or are there unusual outliers in the forecast?
It is critical to sanity-check your work to ensure you put out a great product
Build For the Future
When working on a forecast, do yourself a huge favor and build it for the future. Well, obviously a forecast is for the future, but I mean the model itself. If you are running a forecast today, you are likely to run the forecast again. Make sure the model is dynamic enough to pull in new actuals and roll forward for future time periods. Avoid hardcoding, and try to link everything up to data tables. Make it clear which periods and cells are actuals and which are forecast.
This may take some extra time to set up, but it will really pay off down the road.
Forecasting labor expense is important for any business. It’s a lot easier when you break the forecast down into its components and use a clear process. By following these tips, and referencing the example above, you can produce an accurate forecast for your business’ labor expenses!
Have any questions? Are there other topics you would like us to cover? Leave a comment below and let us know! Make sure to subscribe to our Newsletter to receive exclusive financial news right to your inbox.