The Art and Science of Calculating Employee Costs and Value

There’s an old HR joke that goes, “HR would be so much easier if we didn’t have to deal with people.”  

While dealing with people is not easy, HR professionals also have additional responsibilities to manage. One example of this is calculating employee costs and value. It is a formidable challenge for both the HR and Finance department. This goes beyond just compensation and benefits. There are several intangible factors like creativity, engagement, innovation, collaboration, and many more that are equally important but difficult to measure. 

However, HR has access to data related to the unquantifiable side which can be combined with the data captured by the Finance team. This can be done before the calculation of employee costs so that all sides are included while allowing both the departments to identify any potential issues. 

Why HR and Finance Must Join Forces 

Calculating the cost of an employee has traditionally been the task of the finance department alone – and it doesn’t have to end there. HR, on the other hand, was conventionally viewed as people-oriented and not a domain to do with numbers or data. This fallacy has led businesses to believe that HR will never be able to perform any broader functions outside its administrative role. On the contrary, HR has always had data that either went unused or was not exploited adequately. The example below explains how they can use the data they have: 

For example, a software development company with a large workforce noticed that the training costs have significantly increased for over 6 months. The company arranged frequent training programs that focused on all the skills it thought necessary. However, the finance department  

A few reasons as to why the finance team could not identify the root cause: 

• Could access only general payroll and compensation information 
• No access to employee training and development (program costs, participation rate, feedback, ROI

HR was able to provide significant insights into the training programs. They identified that the frequency of training programs was high, employees didn’t wish to participate, and the program didn’t focus on their skill gaps. With this data, both HR and finance team was able to identify: 

• Training programs that were less effective 
• Programs with low ROI 
• Training costs (materials and instructor fees) 
• Employee skill gaps, areas for improvement 
• Participation rate 

After HR and finance pooled their data, they followed these steps to manage training costs and improving overall employee value: 

• Identified skill gaps and focused on training critical skills that move the company forward 
• Estimated the current ROI and identified areas of cost savings without sacrificing training quality 
• Cut down on the frequency of training and development programs 
• Consolidated training programs and opted for online programs  
• Encouraged participation and improved employee engagement  

By collaborating and sharing data, the root causes of high training costs were identified. HR and finance were able to work together to improve the financial outcomes of the business. By bringing down the costs of training and improving ROI, the company has noticed an overall decrease in employee costs and an increase in the value generated by employees as well. 

The following are the steps the company took to align HR data with the finance function for an overall analysis of employee costs: 

Complement the incomplete information Finance has 

While finance may only be limited to information related to salaries, benefits, training, and other quantifiable costs, they do not have access to indirect or qualitative indicators like reasons for turnover, employee satisfaction and engagement. This is where HR steps in. HR has access to employee-specific data that affects employee costs and other areas as well. Data like these complements the incomplete information finance has.  

Combine data to drive business goals and facilitate action 

Just gathering data is not enough. HR must approach the finance department after analyzing reports on employee costs and identify any missing gaps. For example, the reports may show that the costs of recruitment, training, and turnover are very high when compared to other expenses. One reason for such high costs could be due to poor work-life balance or less career development opportunities – ultimately leading to turnover. Both the departments can combine the data to generate reports and insights which can help the organization take informed decisions to improve the same. 

Take into account the costs employees are making 

There will be certain costs incurred by employees to work at a company. Ignoring such costs can lead to financial liability. Take Amazon, for example. In 2019, it had a high employee turnover in regard to its warehouse workers. HR identified the reason to be the performance management review system that immensely pressured employees to achieve unrealistic goals, leading to long work hours, skipping bathroom breaks, and giving up any medical treatments in fear of losing their jobs. While these are non-measurable, they are still real costs to the workers which provide deeper, actionable insights. 

Identify other factors that affect employee costs 

Other factors are vacation and pay rates higher than necessary, low productivity due to learning periods, insurance premiums, compensation payments, certifications, mandatory training, etc. 

Move in the direction of KPIs 

When presenting the proposal to the organization regarding the new budget plans to implement engagement or career development programs, HR must clearly articulate the benefits of investing in employees and how everything ties up to their respective KPIs like revenue, customer satisfaction, etc., to finance as well as the business leadership. 

Once all sides are counted, the next step covers the actual calculation of employee costs. 

Employee Costs, Calculation, and Management 

Employee cost is the spending of an organization to employ and maintain people. It includes salary, allowances, incentives, overtime payment, welfare funds, and other employee benefits. Calculating employee costs usually falls under the function of the Finance department but HR also plays a key role in this process. Some companies may prefer using specialized systems or consulting services to calculate employee costs. To calculate these costs, there are relevant metrics companies must use.  

Employee cost calculation: Balancing the art and science 

When it comes to calculating employee costs, the common metrics looked at are salaries, recruitment, benefits, training, etc., and fall under ‘science’ as they are objective, and data driven. On the other hand, non-measurable indicators can be referred to as ‘art’ as they are mostly influenced by feelings and opinions. Most companies fail to include the ‘art’ such as employee satisfaction, engagement, loyalty, and other non-measurable indicators. While these are non-financial, ignoring them can lead to higher employee costs.  

Andrew Fastow, former CFO of Enron, encourages businesses to uncover issues related to the intangible aspect and lays importance on: 

“Identifying non-financial risks before they become financial liabilities” 

He notes that any problematic issues must be identified before they start costing more than the financial costs. 

 All the relevant metrics that must be considered are: 

Quantitative metrics 

1. Salary and wages. Salary is the monthly or annual cost the company is willing to pay for in exchange for services provided. The salary offered should attract and retain talent. It includes base salary, bonuses, benefits, etc. 

 2. Recruitment costs. These are the expenses incurred to recruit employees. For example, expenses for job postings, recruiting software, background checks, time spent on the process, and other tools/advertisements. These costs are incurred before an employee even joins the company. 

4. Employee benefits. Employee benefit packages are critical to attract talent. Includes health benefits, reimbursements, paid leave, retirement plans, insurance benefits, etc. which are mandatory costs for the company. 

5. Training costs. Companies must not ignore the cost to train new hires when employing them. They must also consider the low productivity levels during the training period. Both time and effort must be included.

6. Overhead expenses. Covers utilities (electricity and water), rent, office supplies (laptops, pens, papers, and other tools), and other expenses required to perform at the job.  

Qualitative indicators  

Qualitative indicators include: 

• Employee satisfaction and engagement 
• Culture and work-life balance 
• Career development 
• Recognition and rewards 
• Communication, employee empowerment, and wellness 

All of these are tied to the first indicator, satisfaction and engagement. When employee engagement and satisfaction levels are low, it could eventually lead to higher employee turnover because of unhealthy workplace culture, insufficient career opportunities, no recognition, rewards, and other reasons. Losing employees can cost around 2 times more than their salary. The company’s recruitment costs will go up because of job advertisements, training, etc. 

How to calculate employee cost? 

Calculate the basic salary of the employee. It is the compensation received in exchange for work but does not include any additions or deductions. Mandatory costs include any additional benefits to the employees like social security, medical care, insurance, etc. Overhead costs refer to utilities, rent, office supplies, and other expenses. Hiring costs may cover training expenses along with recruitment and onboarding costs. Overtime and sick costs refer to overtime payment and cost of replacements. The formula to calculate the cost of an employee is: 

Employee costs = Base salary + mandatory costs + hiring costs + overhead costs + overtime/sick costs 

Companies may choose to calculate employee costs on an individual basis, group, or department basis. The above formula can be applied when calculating per employee or per group. For example: 

Base salary = $50,000 

Mandatory costs = $6000 

Hiring costs = $1000 

Overhead costs = $8000 

Overtime and sick costs = $3000 

According to the formula, Employee costs = Base salary + mandatory costs + hiring costs + overhead costs + overtime/sick costs, the total employee costs would be $68,000 per year.    

Some companies prefer to group employee costs per year and then divide the total costs per variable by number of employees.  

Is Upskilling a Cost or an Investment? 

Upskilling refers to the process of teaching new skills or developing the current skills of employees through training, coaching, and mentoring. Upskilling is both a cost and an investment. It majorly depends on the outcome of upskilling and moves from being a cost to an investment. Initially, it is more of a cost but with time the ROI outweighs the cost. It is associated with various other costs like: 

• Training materials, courses, instructional videos, and manuals 
• Cost of hiring a trainer and sessions 
• Rent, training facilities, equipment, and technology 
• Travel and accommodation costs 

The expenses associated with upskilling vary according to departments and the program’s nature and scope. The assets required to upskill employees can be categorized into 4:  

Direct costs = cost of hiring trainers + all training materials + travel and accommodation expenses + training supplies 

Indirect costs = Salaries during this period + replacement costs + administration and management costs + rent + cost of technology + additional equipment upgrades + other investments  

Opportunity costs = Lost revenue during the period + cost of missing other business opportunities + cost of delayed projects  

Make sure not to add department specific costs in advance for technology and equipment. Training and development may include costs specific to departments. When upskilling costs are identified, they can be added to the employee cost formula:  

Base salary + mandatory costs + hiring costs + overhead costs + overtime/sick costs + upskilling costs

Employee Cost Breakdown by Department 

Employee costs are also largely influenced by departments. An employee hired in a sales department may cost the company more than an employee hired in the marketing department. For instance, an organization will have to consider incentives, commissions, and travel expenses apart from basic salaries and benefits for sales employees. Such costs could be higher than a marketing employee whose costs are associated with advertising and other campaigns. In addition to salaries and benefits, other department costs that also must be considered are: 

Sales Department: 

A growing company plans to hire new salespeople and invest in sales tools and equipment. It plans to hire 10 salespeople with a base salary of $50,000 per year. After adding up the benefits (Around $20,000), the total cost per employee is $70,000 per year. The company decides to offer incentives and commissions to reward good performance. Incentives, bonuses, and commissions add up to $8000 annually. Considering that the salespeople in this company travel frequently and host trade shows, the company estimates around $12,000 (Including accommodation) incurred per employee. Sales departments that rarely travel or host any trade shows may notice an overall low costs. Lastly, the costs for sales technology and equipment added up to $5000.  

In this company, the total employee cost for the sales department is $95,000. For 10 salespeople, the total cost would be $950,000. 

A sales department’s employee costs = Travel (Vehicle expenses and business travels) + Accommodation + FOB (Freight on Board) + Commission and other incentives + Sales tools and equipment + Sales development expenses + other role-specific sales expenses  

Marketing Department: 

A tech startup focuses on online marketing and hosts events to promote their products. It plans to hire a new Marketing Specialist to help manage their online marketing campaigns and events. To manage online marketing campaigns, the marketing specialist will incur costs for the company for paid advertising, content, and email marketing campaigns. Apart from this, the new employee will also need access to technology or software related to social media, email, and analytics to track the success of campaigns. The marketing specialist will be responsible for planning and implementing events, which is associated with other costs like rentals, promotional materials, catering, travel expenses, and so on.  

Adding up: Base salary + benefits + advertising and promotion costs + marketing tools and technology + event costs + any incentives 

Let’s assume that the overall salary (including benefits and bonuses) is around $60,000 

Advertising and promotion costs = $10,000 per year  

Marketing tools and technology = $15,000 

Event costs = $20,000 

Total employee costs = $105,000 

A marketing department’s employee costs = Advertising and promotions + Printing + Marketing technology + Market research + Event expenses + Travel + Agency fees + Other costs   

Finance Department: 

A medium-sized manufacturing company plans to expand its finance team and decides to hire an employee to manage the company’s payroll and ensure compliance with financial regulations. Apart from his salary, the new employee will need access to special payroll software to manage payroll. As per his compliance responsibilities, the company estimates costs for creating compliance reports, programs, and other fees. Based on this information, the costs are: 

Basic and benefits = $35,000 

Payroll software = $3000 

Compliance = $4500  

Total costs = 42,500 per year.  

A finance department’s employee costs = Specialized accounting software + Auditing costs + Compliance costs + Payroll processing + Consulting fees + Other costs 

IT Department: 

For example, a company hires 3 new cybersecurity professionals. Their responsibilities include installing antivirus software, firewalls, and other security tools. The company designs a training program for the new employees to ensure that they have the necessary skills, knowledge, and capabilities to protect the company’s data and systems.  

Basic salary and benefits = $40,000 

Cybersecurity tools and software = $10,000 

Training programs = $5000 

Total cost per employee = $55,000 

An IT team’s employee costs = Training + Hardware costs + Specialized software for IT + Hardware upgradation and maintenance costs + IT licenses + Telecommunications equipment + Cybersecurity costs + Travel + Compliance costs + Any subscriptions  

Human Resources Department: 

A company wants to hire a new HR manager. With increased use of HR technology and recruitment costs, the company estimated around $4000. The new HR manager requires training in specific HR tools and software. Additionally, the company decides to invest in HRIS and help the new employee continue education.  

Salary, benefits, and bonuses = $40,000 

HR software and tools = $5000 

Training and education = $8000 

Total employee costs = 53,000 

An HR department’s employee costs = HR technology and software + Compliance and legal costs + Training and development + Recruitment costs + Employee programs + Other costs  

 After identifying upskilling and departmental cost, the new employee cost formula can calculate the real cost of an employee. 

Employee costs = Base salary + Mandatory costs + Hiring costs + Overhead costs + Overtime/sick costs + Upskilling costs + Department costs  

Are layoffs the only solution to cut employee costs?  

Most organizations these days turn to laying off employees as their first resort because they want quick results and to increase their level of competitiveness in a changing market. However, laying off employees should be a last resort as it significantly decreases the morale and productivity of the remaining employees while also damaging the company’s reputation. Some of the cost-cutting measures other than layoffs are: 

• Implement hiring freeze or salary freeze 
• Reduce salaries, office costs, employee benefits, and other operational costs. 
• Consider reducing quantifiable costs 
• Reduce turnover and absenteeism 
• Upskilling  
• Reduce work hours 
• Offer early retirement 
• Manage operational costs 

Employee Value: 

Employee value, or value of an employee, refers to the worth an employee brings to the organization. It could be in the form of revenue, performance, productivity, sales, etc., depending on the business. But they are not enough to give a complete picture of an employee’s value.  

There are several other factors organizations will have to consider like employee loyalty, goodwill, etc., which are important but difficult to quantify. There are many ways an organization calculates its value of employees. Some of the most used ones are: 

Employee value = The firm’s net income/number of employees 

This method of calculation is heavily unreliable as it only shows the average number for all the employees but does not reveal the real value per employee. It is a misleading and oversimplified way of measuring the employees’ value.  

However, this type of method is ideal when companies have very few employees and the profitability of the firm has been heavily dependent on the contributions of individual employees. In such cases, the businesses’ net income can be tied to the number of employees.  

Employee value = Employee costs – employee assets  

This is a simplified way to calculate employee costs. It doesn’t consider other qualitative factors, but this method of calculation is most ideal for companies with a focus on cost management or if they are running on thin profit margins. Employee assets refer to the skills, knowledge, and expertise the employees bring. If the assets outweigh the costs, it is said that they bring significant value to the company and if the costs outweigh the assets, the employee is considered a liability. 

Employee value = Current performance + future potential – emotional expensiveness  

While the above formula considers employee costs, it does not cover the true cost of an employee. This formula includes the current value an employee brings to the table, the potential to take on new and different challenges, and their emotional expensiveness. According to an article by Forbes, the current and future potential can be gauged via assessments that contain a series of questions an employee has to answer. These assessments can be verified via a 360-degree feedback system.  

Emotional expensiveness refers to employees who bring down the energy, value, and talent of other employees and the organization by being judgmental, resisting change, etc. Such employees can be identified by methods like peer reviews, surveys, performance evaluations, etc., which must be further validated by other employees. 

A Dual-Sided Approach to Measuring Employee Value 

Wells Fargo is a well-known multinational financial services company. However, it was involved in a cross-selling scandal in 2013 that has tarnished its reputation to this day.  

Employees were under the pressure of Wells Fargo’s executives to cross-sell products and meet unrealistic quotas to enhance sales and revenue. The situation took an ugly turn when employees created around 1.3 million savings accounts for customers without consent by using their own contact information on forms and moving money out of existing accounts into new ones to reach their sales goals. In the end, customers found out and the company had to pay $2.7 billion. The CEO, John Stumpf, was forced to resign.  

This incident certainly tells that relying on just financial metrics to measure or bring out the value of an employee will never work. In this case, it led to unethical and negative behavior. Had Wells Fargo focused on non-financial metrics as well to measure their value, they could’ve increased their bottom line without facing such grave consequences.  

How to Keep Both Sides of the Coin Shining  

Not just Wells Fargo but most companies do not take a holistic approach when it comes to measuring and improving the worth an employee brings to the company. They solely focus on short-term financial gains, leading them to ignore the qualitative, or the ‘perceptual’ side, of employee value measurement. To take a more balanced method, organizations must consider the two sides: 

• The data-driven side 
• The perceptual side 

The Data-Driven Side 

As the name implies, the data-driven side is more of a financial metric most organizations use to measure their employee value. This involves gathering quantifiable data related to the performance, skills, and productivity of an employee. Some of the methods used to calculate the value of an employee are: 

Revenue Per Employee (RPE): This metric is used to calculate the revenue generated per employee. The formula to calculate is  

RPE = Company revenue/Number of full-time employees

It is mostly used by service-based industries that rely heavily on their employees to generate revenue. And it is used by product-based companies to identify areas to improve. This method is also often used by investors and analysts to compare profitability between companies. 

Net Promoter Score (NPS): NPS is not a direct method of measuring employee value but can be used to quantify an employee’s contribution to customer satisfaction. This method is most suitable when there are specific employees responsible for customer interactions or product development.  

= % of promoters (score of 9-10) – % of detractors (score of 0-6) 

Return on Investment (ROI): ROI calculates the value generated by an employee after investing in their training, development, compensation, etc. Total cost refers to the employee costs and total benefits refers to increased sales, cost savings, profits, etc., contributed by an employee. 

= (Total cost – total benefits)/Total cost 

Employee Lifetime Value (ELTV): ELTV measures the value an employee brings over the course of their employment cycle. It takes into account their present and future contributions to the company.  

= Positive value an employee brings – total annual employee cost 

Performance reviews and OKRs: Certain metrics are used in performance reviews and OKRs to measure the value of an employee. If employees are meeting their objectives, they are said to be delivering significant value to the company. These are relatively easy to quantify. Companies like Google use OKRs and performance reviews to quantify their employees’ value.  

The Perceptual Side 

The data-driven side is not enough to determine the value of an employee. There are other intangible factors that give a holistic view of employee value measurement. This may also include non-financial metrics. Perceptual can also be referred to as the qualitative or soft side. The perceptual side includes: 

• Skills assessments  
• Leadership, decision-making, and teamwork 
• Future potential 
• Emotional expensiveness 
• Innovation, ideas, and engagement 
• Initiative taking 
• Loyalty  
• Customer satisfaction 
• 360-degree feedback 

The perceptual side is measured via surveys, focus groups, interviews, and performance reviews. They cannot be relied upon completely as they are subjective and influenced by various external factors. A balance of both data-driven and perceptual approaches gives a complete picture of employee value. 

For example, an employee may deliver high profits (data-driven metric) but if they are emotionally expensive (qualitative factor) and affect the productivity of others, their overall value to the company may be lower than another employee who generates lower profits but is not emotionally expensive. 

HR’s Strategic Role in Leveraging Employee Value Equation 

The Employee Value Equation is used to measure the value of an employee by estimating their current and future potential. It is used to maximize human potential by combining both quantitative and qualitative factors. With HR’s evolving roles, business leaders often wonder: 

Can HR only be labeled as a ‘cost-center’, or can they really step up their game to transform into a profit center? 

In fact, HR has always been contributing to the revenue, and organizations are just beginning to identify the value they provide through management of employee retention, talent, productivity, etc. They do this by leveraging the value of employees. They do it by: 

Capitalizing on the qualities that matter: HR can work with managers to redefine KPIs that include innovation, leadership, and other factors along with customer satisfaction ratings and other numbers. It can also help build a culture of recognition and rewards for meeting their newly defined KPIs. By working closely with managers, HR can help in leveraging the value of employees and drive success through feedback, coaching, and development opportunities. 

Going beyond OKRs and performance reviews: When the right employee is not put in the right position, it reduces value and productivity. HR can see beyond OKRs and performance evaluations and can place talent in the right place. Individual success is maximized, and value is increased. 

Encouraging HR and finance to work as business partners: Enable transparency among employee costs, skills, and strategy. Consider investing in a system that integrates finance and HR to manage workforce and plan performance. This integration helps understand the relationship between employee revenue drivers and other triggers to help connect the workforce with strategic goals. Data transparency is required across all areas of the business.  

Connecting HR with data, systems, and finance: Revenue generation usually begins with the sales department, but most companies end there. Most organizations wouldn’t expect HR to assist in this process through employee data alone. Apart from performing its traditional role, HR can exploit the myriad of employee data to understand what drives sales conversion rates. This requires access to the sales data of target employees.  

After understanding the drivers/triggers, HR can improve the operating units that prevent employees from participating and sustaining their performance. This connects employee data with business outcomes while also fostering a business relationship between Human Resources and business development leaders. 

 For example, when the HR team at Adobe Systems realized that the performance review system, which relied on a standard ranking and rating system, was forcing employees to resign, they eliminated the annual review system.  

Employees would be rated only once a year and no more than 15% of a team can be rated as a ‘high performer’. In addition, the ratings determined the compensation and promotional decisions. Employees couldn’t figure a way out of the system and realizing that their efforts weren’t counted, they chose to leave. Every year during the review period, the productivity levels were very low and after that period, the attrition rate rose sharply. 

Donna Morris, the VP of HR, conducted internal surveys and interviews to properly understand the problem. The company then introduced a new compensation and reward system along with frequent feedback. In fact, it also adjusts its compensation plans every year. The outcome is increased morale and a 30% decrease in voluntary turnover.  

While the outcome is positive, it’s important to note that behind the scenes HR had access to a variety of data to understand the triggers of such low unproductivity and turnover. It also worked with the finance team to assess the costs and benefits of successfully implementing the new reward and compensation system. The collaboration between these two departments played a critical role in ensuring the success of the project. 

Putting the Pieces Together 

It has always been a challenge to manage the workforce throughout the employee life cycle – especially the modern workforce. A system is essential to collect the data from HR metrics. It is essential to identify areas of improvement to drive business outcomes. HR Analytics is a solution to Human Resources that provides data to enhance practices and improve employee experience.  

Keka’s HR Analytics software helps take data-driven decisions by providing insights into each department’s workforce, generating instant reports, compensation and attrition analytics, and many more. Signup for a free trial.