The cost of labour is often one of the biggest items on the income statement of many businesses (for small businesses as well as large ones), going up to 70% of the total operating expenses of some.
Yet, many companies don’t know if they are spending too little or too much on their payroll.
For example: Is 70% too much or is 10% too little?
Because of the importance of human resources to a firm’s success, it is not strange that many want to know what percentage of expenses should payroll be. Pay too little and risk losing your staff to competitors; pay too much and risk having a lower profit margin that will stunt growth.
The short answer is there is no golden number that works for every firm.
Instead, every industry tends to have a typical payroll-to-revenue or payroll-to-operating-expenses ratio. Consequently, every firm can only determine if their payroll expenses are too little or too much by using industry standards as benchmarks.
In this article, we will help you determine what percentage of expenses should payroll be by considering the unique features of your industry and how that should inform your decisions. We’ll cover:
- The payroll-to-revenue ratio
- The payroll-to-operating-expenses ratio
- Benchmarking PTR and PTOE ratios
- Deriving business insights from the PTR and PTOE ratios
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1. The payroll-to-revenue ratio
The payroll-to-revenue ratio (also known as payroll percentage) is a popular productivity ratio that helps to measure how much of the company’s gross revenue is attributable to its payroll or labour costs (including wages and salaries, payroll taxes, employee benefits and other incentives, payroll processing cost, health insurance, disability insurance, life insurance, pensions plans, etc).
Suppose that Firm A spent AED 500,000 on payroll in 2024 and earned AED 5,000,000 in gross revenue in the same period. Its payroll to revenue ratio in 2024 will then be 10% ([500,000/5,000,000] * 100).
Another way to understand this ratio is to see it as a form of ROI – return on investment in payroll. That is, every AED 1 spent on payroll returns AED 10, or a 10x return.
The payroll-to-revenue ratio is one useful measure that business owners can employ to ascertain if they are getting the best results from their spending on human resources.
For example, suppose Firm B spent AED 1,000,000 on payroll in the same year and also earned AED 5,000,000 in revenue. Suppose again that Firm C spent AED 200,000 on payroll and earned the same revenue.
Given this data, Firm B has a payroll-to-revenue ratio of 20%; for every AED 1 spent on payroll, there is an AED 5 return, or 5x ROI. Similarly, Firm C’s payroll to revenue ratio is 4%; that is, for every AED 1 spent, there is an AED 25 return, or a 25x ROI.
All of this shows that Firm A is making better use of its payroll spending compared to Firm B and worse use compared to Firm C. In essence, the lower the payroll-to revenue-ratio, the better – but it’ll ultimately depend on your competitors and your industry.
Additionally, this number can be a useful (though not standalone) way to see if a company’s labour costs are too much or too little. For example, other factors held constant, Firm B seems to be spending too much on payroll compared to its competitors while Firm C seems to be spending too little.
2. The payroll-to-operating-expenses ratio
The payroll-to-operating-expenses ratio (also known as the staff cost ratio) measures what percentage of a company’s total operating expenses goes into payroll spending. The staff cost ratio formula is payroll cost/total operating expenses.
Operating expenses are business expenses incurred in the ordinary or normal business operations; they are also known as SG&A (selling, general, and administrative expenses).
Suppose that Firms A, B, and C spent a total of AED 2,000,000 on operating expenses in 2024. Their payroll-to-operating-expenses ratio (given the information in the previous section) will be 25%, 50%, and 10% respectively ([payroll spending/operating expenses] * 100).
Like the payroll-to-revenue ratio, a firm can use payroll-to-operating-expenses ratio to ascertain if it’s spending too much on payroll. All other factors held constant, Firm B seems to be spending too much on payroll compared to A and C while C may be spending too little compared to A and B.
One of the “other factors” mentioned above is the payroll-to-revenue ratio itself. If Firm X has 50% staff cost ratio to Y’s 30% but also has 10% payroll-to-revenue ratio to Y’s 40%, then X really doesn’t need to bother about its higher payroll cost since it is being more than compensated for by the higher revenue.
3. Benchmarking PTR and PTOE ratios
When it comes to the payroll-to-revenue ratio (PTR) and the payroll-to-operating-expenses (PTOE) ratios, a better way for a company to determine if its numbers are healthy or not is to compare them to an industry standard.
Benchmarking PTR ratios
Companies with a PTR of between 15% and 30% are often considered to be doing okay irrespective of the type of business they are in.
Nevertheless, it is often the case that there are some industries (consider companies in the service industries, e.g, law firms, financial advisory firms) where PTR does exceed 30% because human minds are the very heartbeat of the business.
Therefore, a better way to measure one’s performance is still to compare it to an industry standard.
According to Klipfolio Metric, a business performance measurement company, the following PTR ratios are typical in these industries:
- Beauty parlours: 44% or AED 2.27 revenue for every AED 1 spent on payroll
- Construction: 20% or AED 5 revenue for every AED 1 spent on payroll
- Healthcare: 45% or AED 2.22 revenue for every AED 1 spent on payroll
- Hospitality: 30% or AED 3.33 revenue for every AED 1 spent on payroll
- Insurance: 9% or AED 11.11 revenue for every AED 1 spent on payroll
- Manufacturing: 18% or AED 5.56 revenue for every AED 1 spent on payroll
- Restaurants: 30% or AED 3.33 revenue for every AED 1 spent on payroll
- Retail: 20% or AED 5 revenue for every AED 1 spent on payroll
- Science and technology services: 39% or 2.56 AED for every AED 1 spent on payroll
Based on these data points, insurance tends to have the best ROI on payroll while healthcare tends to have the worst.
More importantly, companies should use these industry standards to set benchmarks against what they can measure their own PTR.
For example, suppose Firms A, B, and C above (with PTR of 10%, 20%, and 4% respectively) are all in the insurance industry (with 9% average PTR). In that case, both Firms A and B (with B doing worse than A) are underperforming while Firm C is doing better than the industry standard.
Benchmarking PTOE ratios
“Usually, companies prefer payroll to be 10% to 20% of operating expenses,” according to Wiki Accounting.
“This percentage may be higher for companies in a labour-intensive industry. Sometimes, it can go up to 30%-40% of operating expenses. Some companies may also outsource several supporting functions. For these companies, payroll will be 5%-10% of operating expenses. However, their operating expenses will still reflect the outsourcing.”
The main point here is that labour-intensive industries tend to have higher PTOE than others. Similarly, service-based industries will typically have higher PTOE than goods-based industries.
To continue with the industries highlighted in the previous section, beauty and parlour, science and technology services, hospitality, insurance, and healthcare will tend to have the higher PTOE (the 30-40% range) while construction, manufacturing, restaurants, and retail will have lower PTOE (the 10-20% range).
4. Deriving business insights from the PTR and PTOE ratios
Interpreting PTR ratios
Once a firm compares its PTR ratio to the industry standard, it can generate insights that can be important to productivity and efficiency.
To continue with our example, Firm B with 20% PTR, which is too high compared to an industry standard of 8%, has a big employee productivity issue. It’s spending too much on payroll for the revenue it is earning. Other companies in the industry are earning the same revenue with less payroll cost or the same revenue with less payroll cost.
Firm B can reduce its workforce and get the remaining workers to maintain the same revenue (by using various automation technologies) or keep its workforce at the same level but use various measures (using performance-based remuneration, providing better technology that other companies are using, making workers happier) to make them more productive (and create higher revenue).
On the other hand, Firm C with 4% PTR may consider increasing its payroll spending to reward the employees for their productivity and avoid losing them to competitors. Regarding the latter, if employees of Firm C found out that for the same revenue, Firm A is spending more on its workers, they may be tempted to leave.
In this regard, Firm B is actually the most ideal company – its 10% PTR is closest to the industry average. It might not be saving as much money as Firm C but it’s also less likely to be at the risk of high labour turnover.
The Human Capital Hub summarises the point well: “An attempt to lower the payroll expenses can result in the company losing its key employees or failing to attract top talent as a result of poor remuneration. Both of these can then carry over into a fall in morale and productivity and thus profitability. On the other hand, if the expense is not monitored correctly, the company could become less profitable, and in extreme cases fail to meet its other expenses. Thus a balance needs to be found.”
The balance is to be found in sticking closely to the industry standard.
Interpreting PTOE ratios
In a previous section, we also saw that Firms A, B, and C have 25%, 50%, and 10% PTOE respectively. Suppose that the industry average is 30%.
Here, Firm B is spending too much on payroll compared to other operating expenses. This might be because it has too many employees than is typical for its industry or it is paying remuneration that is far too above industry average.
This might not be a problem if the company also has a higher PTR ratio that compensates for the higher POTE ratio. However, if the PTR ratio differential is not as high as the PTOE ratio differential (does not compensate for it) and its total operating cost is not less than the industry standard, then Firm B will have a lower profit margin (bottom line).
Conversely, Firm C, with 10% POTE ratio, is spending too little on payroll costs as a percentage of total operating costs. This might be because it has a smaller workforce than the industry average (thus overusing its workers) or pays less than the industry average. Any of these two reasons can put it at the risk of higher-than-average employee turnover.
Firm A seems to be in a better place because it is closer to the industry standard of 30% POTE ratio. Firms B and C should also work to get closer to this benchmark; Firm B by reducing its workforce without reducing its PTR or by maintaining the same workforce while increasing its PTR and Firm C, by increasing the number of workers or increasing the remuneration of the current workforce.
How reducing the cost of doing payroll can help
Reducing the cost of doing payroll (administrative costs, which are different from employee salaries and wages) is one step that companies can take in response to the insights they generate from comparing their PTR and PTOE ratios to the industry standards.
For example, Firm B above, with too high PTR and PTOE ratios, can reduce its payroll spending by using a more cost-effective payroll management system, leading to lower PTR and PTOE ratios.
Also, a smart and efficient payroll management system will also provide the data that companies can use to calculate their PTR and PTOE ratios and compare them with industry standards.
Finally, a flexible payroll management system might help companies like Firm B implement a performance-based remuneration system that will help them increase PTR (thus getting more value from their payroll spending). In fact, Firm C can also use the same remuneration system to ensure that increasing its PTOE ratio does not cause its PTR ratio to rise (that is, the higher spending on payroll is leading to higher revenue or at least keeping revenue where it is).
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With this platform, you can gain complete visibility into every element of your payroll and collect important data that will help you improve it. You can also tweak your payment structure to get the most efficient one, all at a low cost.
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Takeaways
- Labour cost is often one of the most significant items on a company’s income statement.
- Companies need to know if they are paying their workers (part-time and full-time employees) too much or too little.
- One way to do this is to calculate their payroll-to-revenue and payroll-to-operating-expenses ratios and then compare them to an industry benchmark.
- This comparison will help them generate important business insights that will help improve payroll management.
