Previously,  we talked about estimating direct material for a product based business, now we shift our attention to direct labor. There are two main factors one must consider when deciding how much labor is needed to meet the sales forecast. Every business must consider:
  1. Number of hours needed
  2. Price per hour

Number of hours needed: The automate versus hire decision

Every business faces a decision when it comes to labor. The big question is how much should I automate or how much should I hire? When a business requires a large amount of labor, the business is known as labor intensive. On the other hand, a business that uses more automated equipment is known as capital intensive.

Choosing to be labor or capital intensive both have their good and bad side. Over the long run, automation saves payroll expenses, and is more reliable. However, it is not as flexible as hiring labor. Labor is trainable and can better adapt to change to the external environment. A capital intensive business will need a bigger investment to adapt to change.

It is easier for a highly automated/ capital intensive business to spend more time than necessary trying to save a concept that is failing. On the other hand, a labor intensive business can gather its workforce and initiate change much quicker. I personally think to be successful in today’s world, you need a good balance of both labor and capital. Leaning too heavily on one to the detriment of the other, is taking unnecessary risk.

The decision to automate versus hire, will affect the number of hours you need to hire. The more manual labor you hire, the more supervisors you need and the more complex to manage. So taking your time to decide the right balance is crucial. Once you decide your sales forecast, decide the right amount of automation versus labor hours that will be required to meet that forecast.

Number of hours needed: Skilled versus unskilled labor

Efficiencies increase with experience. An experienced labor set will cost more per hour but require less hours to complete the same task. For example, let us say you need an accountant and you hire Macy a recent college graduate with no experience. Because of her lack of experience you pay her less per hour. However, Macy could end up costing you more by increasing the amount you have to pay an experienced accountant to fix all the mistakes she made, all the delinquent fees you have to pay and let’s not forget the fines for missed obligations. So on one end, it looks like you saved money by hiring Macy but on the other end, you spent more than you would have spent if you just brought someone experienced.

Number of hours needed example

We summarize number of direct labor hours as follows:

Direct labor hours = Number of hours needed to bring sales forecast to reality * percentage discount for skilled labor set

In our previous example, My Cake Shop predicted it was going to sell 1,000 units. To figure out the number of hours I need to bring this forecast to past, I will need to:

  1. Figure out all processes I need to produce the number of cakes in my forecast. It will be most beneficial if I have written step by step processes.
  2. Figure how much I should automate versus do manually: For “My Cake Shop”, I decide that it will make sense to automate the icing process and manually do the other steps. There is no right or wrong answer, you just have to look at where you are headed in the long run and what makes sense for your business.
  3. Figure out the skill set needed: Now that I know that I do not have to hire to ice the cake, I just need to figure out how many labor hours I need to make 1,000 cakes without icing.  First of all, I have to take a look at the level of skill needed. This will determine the total hours I need to hire.

Take a look at my estimation for “My Cake Shop” below:

Looking at the table it looks like hiring a level 5 skill to meet my labor needs will be most cost efficient. However, before I decide, I have to take into account how good my training process is and the learning curve effect.

In “My Cake Shop”, I have an excellent training program which can take a level 1 and turn them into a level 3 after making 200 units. So here is my new estimate based on my processes and taking into account the learning curve effect:

So just by having a good training program, I can reduce my total cost of hiring and get the same efficiencies as hiring level 5s. I enjoy an 8% discount on labor cost as a result of improving the skill set of my staff.

When you have clearly defined processes, and the job does not need lots of intuition or advanced education, it generally will cost you less to hire basic skills over the long run.

Price per hour

Price is affected by the supply of skilled labor. The wider the pool of candidates you can pull from, the lower the hourly wage you pay. Jobs that do not need an employee to be physically present can pull from a much wider range of candidates. The more candidates you can pull from, the lower the rate you will have to pay and vice versa. Moving your business to a location with a wide pull of candidates will drastically lower your total labor cost. Also, digitizing your work breaks down geographic boundaries.

Price per hour can be calculated as follows:

Price per hour = Average market price * premium for skill sets with limited supply

Price per hour: Average market price

The biggest factor that affects your cost of labor, is what the market is currently paying for that skill set. For example, the average hourly market rate for labor in the bakery industry in my area is as follows:

Because the minimum skill level I need in my bakery requires no formal schooling or experience, the pool of candidates I can pull from is so much wider. This makes it easier to attain the market hourly rate.

Price per hour: Premium for skill sets with limited labor

What of the opposite was true? That is, the minimum skill level needed required years of schooling, for example; a doctor.  In that case, my labor pool is more limited and the price per hour will significantly go up.

Let us assume my bakery needs someone to decorate cakes. And let us assume that the art of decorating was a very rare skill. In my community only 5 people possessed that skill, as a result, I will have to add a premium for the scarcity of the skill. So if I pay $18/ hour for a level 5 skill, the decorator will most likely expect $22/ hour.

One way to counteract the limited pool in the local market and bring price down is to find ways to digitize work.  In my bakery, I could hire someone outside of my community to make the design. I then program the design into my automated icing machine which works like a 3D printer.  In that way, I get very unique designs for half the cost.

In fields like accounting or medicine, this trend is becoming more common. By digitizing work, the labor force supply is increased and the hourly rate is decreased.


Industrial age training no longer suffices. We are in a new age which requires a new way of thinking. The world is no longer limited by geographic boundaries.  There is a big shift taking place in the labor market. Its time for a thinking reboot! The next time you want to hire, think of these sets of equations: