Calculating Labor Costs For ROIEric Barnes
March 11, 2013 — 4,008 views
Return on Investment (ROI) is often associated in financial reporting as a ratio of the amount of return over the amount invested. It is also an indicator when looking at ROI and ROE in terms of evaluating leverage of a company among other valuable information. In terms of projecting a possible outcome on a proposed project, calculating ROI is a critical step in determining the viability of the execution of that project. Essentially, but calculating an ROI and providing a time frame of when a company may see the return on the capital it invests can determine if the project is even worth doing or at a minimum, when the company may break even from the investment. Also, it is a valuable component to gain the confidence of stakeholder's interest in the project. In short, calculating ROI for a project is a key first step in the project management and project execution process. It is also an essential part of the Six Sigma management strategy used by many corporations worldwide.
One key component of this process that is often undervalued or overlooked is the calculation of labor in the overall costs of the project. In looking at how ROI for a project is calculated, it is evident that including labor costs into the project as a key resource, such as computer hardware/hardware or any other types of equipment is essential. There are a few methods to consider when calculating labor costs as a component to ROI.
First, it is important to understand the ROI calculation of a project. This can be broken down at a high-level into the following components:
ROI = [(Financial Value – Project cost)/Project costs x 100
Many people view the financial value component of ROI as an intangible or subjective value. It does not need to be. The key is to break the project down into known values, defining those values and then compare those to what is expected from the project. These values have the same main components: time, volume and dollars or costs and these apply to both the current value and the projected value once the project is implemented. This results in the following equation:
Financial Value = TVDPresent State – TVDFuture State
Where T = Time, V = Volume or quantity units, D = costs
This value of calculating ROI is where our labor costs come in. Note, there may be a component of labor in the Financial Value calculation as it can be a quantity unit if the project will have ongoing recurring labor costs. However, since there is always labor associated with any project, you should always have labor in the Project Costs Calculation.
The Project Costs variable calculation is comprised of two variables, Work Decomposition Over Time and Cost of Required Work. Work Decomposition Over Time is essentially the Project Management Tasks components that have been valued as detailed as possible over time. For example, picture all of the tasks associated with building a simple wooden box. There is a time to design the box, determine the materials to be used and to draw out a pattern. There is the period to purchase materials, there is a period to deliver the materials, a period to construct, a period to detail the structure, etc. For each of those tasks, there are costs associated but in order to assign these dollars, the Work Decomposition over time is essential. Often a project management tool is used to do this break down such as a Ghatt chart, process flow diagram or Work Breakout Structure (WBS) is used to define the all tasks and associated tasks.
Next, the Cost of Required Work are applied. For each task, an evaluation of costs of ALL resources associated with that task should be evaluated and applied. These include: Resources (type and quantity needed), Hours work is to be performed, Wage rate per resource (more on this in a moment), capital costs ( equipment, hardware/software costs), and any lease/rental costs. Basically, anything that will expense money to the project at that task should be included. This is where we apply cost to labor to the calculation and how to best determine what to include.
What Labor Costs To Consider
Labor costs can vary from project to project. Some projects will be executed using internal resources (i.e. full time employees), others may be bringing in an outside contractor and still others that may use a combination of both. You may even have labor associated with the project long term, like a resource who will be responsible for the management and execution of the final result once it is completed, essentially a recurring costs. In all of these cases, it is important to apply the right metric to the costs calculation of your ROI.
How to determine Full-Time Equivalency (FTE)
First, it is important to figure out how many Full-Time Equivalent (FTE)s will be utilized on the project. This can be done either per task as stated above or through hours of work effort during the course of the project. However they are derived, they should be broken down to a final number for the project.
Each company will be different depending on the number of working days they operate in a year. For example, a company where an employee works an eight-hour day for a five-day week, works 52 weeks out of the year, which equates to 2080 hours per year. The daily average for these employees would be 8 hours. So for every 8 hours of work effort would equate to 1 FTE, in this example. However, companies where the average employee works 4 days a week or 10 hours a day, the FTE would be 10. The importance is the measurement of the labor work effort to the project.
Next, you will want to take the project labor hours estimated and divide that by the hours available during the period of the project. For example, if the estimated labor hours for the project is 4000 hours, but the duration of the project is 6 months or 960 hours, then:
FTE = 4000 / 960 = 4.2
This means to reach the project goal based on projected hours, you would need a minimum of 4.5 FTEs. The half could be resource that would only work on the project part time.
The important thing to come out of the calculation is the number of dedicated or Full-Time resources needed to reach the project goal.
How to determine FTE Costs
Evaluating internal employee costs can be tricky and is often complicated by various company rules regarding sharing of salary and benefits information with non-direct supervisors. This usually results in a battle between project managers and HR in try to determine an accurate accounting of labor that will be associated with a project. However, there are a few things a company can do to make this part of the process easier as well as cut down the interdepartmental stress.
First, it is important to set a standard method of calculating a Full Time Employee or a Part Time Employee labor impact to the company in the form of an expense, at least at this point. The final ROI will provide the employee's benefit to the project results, but at this stage the evaluation is on costs, not benefits of the expense.
Also, it is advisable to get the weekly employee costs by using the following equation:
WEC = (Base Salary + [Base Salary * percentage Benefit costs]/Number of pay weeks in the year) <annual numbers>
Typically, payroll will run through the company's fiscal year. Some will run on a calendar year. Again, check with your payroll or HR department to determine the number of pay weeks they may use. I addition, payroll may run weekly or by-weekly. Whatever the frequency, the pay frequency is what is needed to calculate WEC accurately.
Using real numbers, suppose an employee gets paid a base salary of $65K per year with company benefits of approx. 20K added to that base. The percentage HR provides is 31%. The normal work week hours for salary in the company is 40 hours per week. Pay weeks for the year or 26 (by-weekly):
Step 1: Calculate WEC
WEC = ($65,000 + [$65,000 x .31]) / 26
WEC = $3,275 per paycheck for one FTE
Step 2: Calculate the Cost per FTE
Cost per FTE = WEC /Total Hours worked
<NOTE: there are 80 hours for this calculation since the total hours per paycheck are for a by-weekly pay period>
FTE = $40.94 or $50.00
So, for every 1 hour of work for this FTE, the cost would be $40.94 per hour.
Step 3: Incorporate all FTEs for the duration of the project
Total Labor Costs = Number of FTEs * cost per FTE * number of work hours for project
Using the numbers from the calculations previous calculations:
Total Labor Costs = 4 * $50.00 * 960.00
Total Labor Costs = $192,000
But, what about that half of FTE that was calculated for the project? That half can be handled in several ways. One, it can be rounded up making the total number of FTEs 5 verse 4. The advantage of doing this is to give some buffer in the estimation so that if the project goes over a bit, there is some extra funding available if the project gets approved. The other reason is that if the project gets submitted and during the approval process, the review board requests some cuts in the project, this would be an area that can be reduced without a significant hit to the labor line.
Also, not all FTEs would use the exact same labor costs. Suppose in this project, some FTEs are specialist and the their costs are the $50.00 per hour but that others are $45.00 per hour and maybe part-time workers are $30.00 per hour. Each of those costs should be accounted for in calculating the labor costs. So, using these factors as an example, assume the half hour is a part time worker, the calculation would then be:
Total Labor Costs = (4*$50.00 + .5*$30.00)*960 = $206,400.00
Important item to note, the .5 does not necessarily equate to a part-time worker, it equates to the amount of time a resource is applied to the project. The example could have just as easily used a FTE for the .5 factor stating that that FTE was only working half the time of the duration of the project than other the other resources above.
Key points to remember:
- Be conservative in your labor numbers – When calculating FTEs, be sure to have put enough "rain days" in the project tasks calculations. This means to take into account possible areas where delay in the project can occur, such as waiting for equipment, weather, approval process, permits, etc. If there are dedicated resources on a project, task dependencies such as this can drive up costs on labor since labor is usually still expending even though no work is being done.
- Be accurate on costs – This simply means, try to make sure there are good labor numbers in the costs analysis. If averages are used, be sure to round up. Again, there is always opportunity to work down costs as you work through the estimate, but don't start off with a low number as there is rarely, if ever, an opportunity to work the estimate back up.
- Understand your company benefits costs – This is one key item that more often than not gets overlooked for the reasons stated previously, however, for an accurate ROI, these costs should be added in the equation.
Wrapping It Up, Apply Labor Costs Back Into ROI
Remember, from the ROI calculation,
ROI = [(Financial Value – Project cost)/Project costs x 100
Labor will be a component of total project costs which would also include items like equipment, administration costs, permits, etc. But, if there are recurring costs to both the original state and future state of the project, the same techniques used to calculate labor costs can be used in the financial value calculations as well for a different set of labor resources. The duration of that labor would be used at the Time (T) component with the labor costs per total FTE being part of the cost (D) value as applied to total units produced (V).
Mr. Barnes is a graduate from Texas A&M University in Corpus Christi, TX with a Bachelor of Science Degree in Computer Science and a minor in Mathematics. Since the early 1990s, Mr. Barnes has worked in a variety of I.T. related fields including digital imaging, telecom and cellular communications, medical business systems and petroleum. Mr. Barnes has managed various size I.T. teams dealing with all aspects of I.T. including networking, desktop support, QA and custom programming & development.