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Payroll costs are costs related to compensating the people working for your business, including full-time employees, contractors, and wage earners.

Most businesses operate with a payroll-to-revenue ratio of less than 30%. Though some labor-intensive service businesses can operate profitably with payroll costs of up to 50% of revenue. The ratio varies by industry—the key is to find a ratio that works for your business.

In this article, we talk about the expenses included in payroll costs and how you can manage them effectively to minimize them.

What’s included in Payroll costs?

Payroll costs include the base salary or wages as well as taxes and benefits. Here’s an overview of the types of expenses that add to your payroll costs:

Salaries, wages, and contractor payments

Salary, wages, and payments (to employees, wage earners, and contractors, respectively) make up the biggest chunk of your payroll cost. Here’s the difference between the three types of payments:

  • Salaries are paid to full-time employees. You pay employees working full-time a fixed amount each month regardless of the number of hours they work.
  • Wages are paid to hourly workers, including any overtime pay, based on the number of hours they work.
  • Contractor payments are payments to third parties for fulfilling a contractual obligation towards your company. For example, you might outsource bookkeeping to a freelancer. The payment to this contractor is added to your payroll costs.

The costs here also include expenses related to making payments. For example, paying via  paper checks or direct deposit might involve costs like delivery or transaction fees.

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Payroll taxes

Your share of the payroll taxes is included in the payroll costs. Federal taxes include:

  • The Federal Insurance Contributions Act (FICA) mandates Social Security and Medicare contributions. The current tax rate for social security is 6.2%, and for Medicare, it’s 1.45%.
  • The Federal Unemployment Tax Act (FUTA) rate is 6%. You get a maximum of 5.4% credit of FUTA taxable wages when you file Form 940 - Employer’s Annual Federal Unemployment Tax Return. The credit reduces the effective FUTA rate to 0.6%, but the rates and rules might differ based on your state.

Employee benefits

Expenses you incur to provide employees with benefits like insurance or paid time off are added to payroll costs. The type of benefits differ from company to company, but here are some common employee benefits:

  • Health insurance
  • Wellness programs
  • Workers’ compensation
  • Paid time off
  • Employee training
  • 401(k)
  • Pension plans.

Are Tax and Benefits Withholding Added to Payroll Costs?

No. Withheld funds aren’t an expense.

As an employer, you must withhold the employee’s share of state and federal income tax. You might also withhold the employee’s contribution towards insurance premiums or other benefits.

When you withhold these amounts, you act as an agent of the government or third party to whom the amount is to be paid.

You’re not incurring that expense out of your pocket but out of the employee’s compensation, and that’s why it doesn’t add to payroll costs.

How to Lower Payroll Costs

You can lower payroll costs just by managing them well, efficiency and oversight are key. Let’s talk about the best ways to lower payroll costs:

Manage Overtime

Overtime can often balloon up into a high payroll cost.

Employees might have to work extra for a new project or during a busy week. And that’s normal.

Overtime adds up when employees stay late a few minutes every day. Before you know it, you’ll have multiple employees qualifying for an hour (maybe more) of overtime during the pay period.

You can lower overtime costs by setting up alerts in your HR software or employee scheduling software.

When you receive an alert about an employee’s normal working hours ending, try and assign any pending tasks to another staff member to avoid overtime costs.

Reduce Turnover and Avoid Overstaffing

Understaffing leads to attrition and higher turnover. High turnover can wipe out a big chunk of your profit—research suggests the cost of turnover can range from 30% to 200% of the leaving person’s salary.

But don’t err on the side of hiring too many people in-house. Overstaffing is as big a problem as understaffing in terms of payroll costs.

The key is finding the right balance. It’s tough to be in a perpetual equilibrium—but you can maintain balance by:

  • Cross-training employees: Don’t jump straight to hiring when you identify a skill gap. Train staff members who can take on the additional workload and have a related skill set.
  • Building relationships with contractors and freelancers: When cross-training is not practical, fall back on your network of contractors and freelancers so you never hit a dead end.

Use Payroll Software

Payroll software helps automate various parts of running payroll.

For example, payroll solutions can automatically calculate taxes and insurance premiums. This reduces the need to dedicate human resources to payroll, which helps lower payroll costs.

Software solutions can auto-generate reports that provide a summary and breakdown of payroll costs. Insights from payroll software help identify areas that could benefit from optimized use of human resources.

For example, when making some cuts, you should carefully look at the amount you’re spending on benefits. If you’re in a cash crunch, consider putting the wellness program on hold for a while.

Payroll tax returns involve filing various forms where accuracy is critical. Payroll systems can make tax filing a breeze by auto-generating forms like:

  • Form 940: For filing the annual federal unemployment tax (FUTA)
  • Form 941: For quarterly reporting of federal income taxes and FICA to the IRS
  • Form W-3: For reporting the total wages and tax withholdings
  • Form 1096: For year-end reporting of money paid to independent contractors using 1099 forms

Outsource Payroll Processing

The next best option to using software is outsourcing payroll.

Investing in software and dedicating a staff member to operating the software can be time-consuming and expensive if you’re a small business owner.

Outsourcing payroll is a simpler alternative where you pay the service provider a per-employee fee to manage all payroll-related tasks.

The monthly fee depends on various factors like the total number of employees, frequency (weekly, biweekly, or monthly), and service add-ons you select.

Once you hire an offline and online payroll service, you won’t have to dedicate someone to managing payroll or training them. And you benefit from the payroll service provider’s payroll management experience.

The key to ensuring outsourcing works in your favor is selecting a reliable payroll company whose pricing matches your budget.

Toward Smooth, Efficient Payroll

Continuous learning and improvement are critical to efficient payroll management.

Payroll management comes with multiple challenges. The payroll tax structure might change, or the labor market could push your payroll costs higher.

When these challenges come knocking, you need the right tools and information to mitigate their impact on your bottom line.

To be well-prepared for challenges, equip yourself with a payroll software solution and subscribe to the People Managing People weekly newsletter to keep yourself updated with all things HR and leadership.

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By Finn Bartram

Finn is an editor at People Managing People. He's passionate about growing organizations where people are empowered to continuously improve and genuinely enjoy coming to work. If not at his desk, you can find him playing sports or enjoying the great outdoors.