For many businesses, particularly those in the service industry, such as restaurants or manufacturing companies that are labor-intensive, the cost of payroll is the single largest line item on the profit and loss statement. Therefore, these are costs that must be budgeted and must be monitored for progress.

What Are the Key Elements of Payroll Administration?

The two key elements in establishing an effective payroll administration system are first, setting company policy regarding pay and, second, determining how often payroll will be done and who will do it. These are the decisions made by the business owner, and they should be well thought out, not just made on the run.

Establishing Time Off Policies

Unless you are utilizing union labor and subject to a negotiated contract, the parameters (within the law) of payroll are yours to set. You will likely negotiate vacation time with new employees and ultimately set a companywide standard, such as one week after the first year, two weeks after year three, and three weeks after year five. It is best to be conservative going in; you can always loosen the policy, but it is almost impossible to take time back once it has been given.

The same goes for paid holidays such as Thanksgiving, Christmas, and so on. Decide how many you can afford, and be conservative. The day after Thanksgiving is appreciated because it makes a four-day weekend, but it is not necessary. The last portion of these “time off days” is sick time and personal leave. Find out what is typical in your type of business; you want to be competitive to attract the right people, but again be cautious in the beginning.

Consider this: If you give two weeks’ vacation, five holidays, and five sick or personal days, that is a total of 20 days. The work year is 260 days long, and that means that almost 8 percent of your labor costs is being paid for nonproductive time. As we go along and look at other benefits, you will see how expensive employees are—far beyond the wages you think you are paying. Remember this when setting budgets.

Getting the Payroll Processed

If you have a small number of employees and a good computer system, you can do your payroll processing in-house. But much as I don’t like to spend money outsourcing, I would tend to outsource payroll even for one person—it is tedious and distracting. As your numbers grow and the type of information you want gets more complicated, sending this task out to an outside service makes even more sense.

Make sure that the person who tracks and transmits your payroll keeps accurate records; the use of a time clock is one good way to be sure all hours worked are correctly maintained. Vacation days as well as paid time off should be scrutinized to be fair to both employer and employee.

Benefits Can Be Costly: Keep to a Budget

Without adding anything extra, your payroll is increased by approximately 24 percent by the cost of vacations, FICA (Social Security) contribution, unemployment insurance, and statutory workers’ compensation insurance. But that does not end many benefit packages that may also include health (including dental) insurance, life insurance, and perks such as car expenses, which may be required in certain circumstances. This can add up in a hurry and, if not controlled, may make the company unprofitable or uncompetitive.

Again, be cautious at the outset because adding benefits is far easier than trying to reduce them. Full health coverage for a family can easily cost $1,250 per month, or $15,000 per year. For an employee earning $40,000 per year, this is a 38 percent add-on and would increase the benefits to a total of 62 percent (24 percent established by vacation, tax, and other insurance), making the cost closer to $65,000. This is a fairly high place to start unless you are working in a competitive situation for specific skills or talents. However, many employers require employees to pay a portion of their health insurance. In fact, requiring employees to pay half of the amount is not uncommon.

But even if you require employees to pay for half of health insurance, you are still looking at a 19 percent additional expense on a $40,000 base salary. Added to the 24 percent established by vacations, tax, and insurance, you are still at a total 43 percent extra, or a total cost of about $57,000.

The issue of company cars as a benefit is a difficult one as well. The total cost can be substantial and remains fixed, regardless of the productivity of your employees, because the cost isn’t tied to any set level of sales. Why not start with a reimbursement plan (mileage and perhaps a gas card), and if the cost seems to be justified, you can consider the car as well; just remember that insurance will also be a cost, as will maintenance, parking, and all other incidentals.

For many companies, payroll for both direct and indirect labor is the largest line item. Remember that there are costs beyond the pay itself, and keep them in line by creating and sticking to a budget.

Payroll Taxes

Keep in mind that you must budget for those taxes that are add-ons to your payroll. First are the U.S. federal FICA taxes, which are for Social Security and Medicare. They are currently 6.2 percent and 1.45 percent, respectively, for each employer and employee share. The Social Security portion is only withheld on individual earnings up to $117,000 wage base per year. The Medicare tax is held against all earnings, and there is an additional supplementary Medicare tax of 0.9 percent against all earnings over $200,000 per year.

In addition, you will need to pay a tax to your state government for your contribution to the unemployment fund. This tax rate will depend upon the status of your account and will go either up or down over time, depending upon how many previous employees collect from the fund.

Know how much all these payroll taxes are and when these payments are due and take great care that you have set aside the money to pay them. It is a serious mistake not to pay your taxes on a timely basis. The late fees for not filing and not paying can be enormous and add up to a 50 percent penalty on the taxes you owe. Once this unbudgeted and unaccounted cost is added to a company’s expenses, profits go out the window and cash flow is strangled. And trying to avoid payments won’t work because the taxing bodies have strong powers of enforcement behind them. This is a situation to avoid at all costs.

Yes, you can calculate and pay all your payroll taxes yourself, but I strongly advise against it. It takes time and it is aggravating work. Instead, I would pay for one of the payroll services that, if it is processing your payroll for a small fee, will also pay your payroll taxes for free or a very nominal fee. Such services can benefit by deducting your payroll tax payments every time you do payroll but not pay them until they are due, which payroll services are highly efficient at.

Finally, on a more upbeat note, I will emphasize that hiring a great employee can make all the difference for your business. And you can’t let all the extra costs of hiring employees keep you from hiring people, because you need people, good people, to build a successful business.

This presentation on payroll and labor costs was largely based on the book I published, Streetwise Finance and Accounting by Suzanne Kaplan.

Takeaways You Can Use

  • Adding benefits is far easier than reducing them.
  • Hiring a payroll company is money well spent.
  • Not paying your payroll taxes is even more serious than not paying your income taxes.