Why Including Labor Costs in Gross Margin is a Bad Idea in Your Management Accounts

As a business owner, you might have come across advice suggesting that you include labor costs in your gross margin calculation when you are looking at your management accounts. I recently watched a podcast where this was recommended, but based on my nearly 20 years of experience as a chartered accountant, I believe this approach is flawed. In this blog post, I'll explain why this method doesn't work well for most businesses and share a better alternative.

Understanding Gross Margin

First, let's clarify some terms. Gross margin, also known as gross profit or margin, is calculated as sales minus direct costs. While there are technical differences among these terms, for small businesses, we can use them interchangeably.

Direct costs are those that vary directly with sales volume. For instance, if your sales increase, your direct costs should also rise proportionately. This relationship helps you understand the true profitability of your products or services.

The Problem with Including Labor Costs in Gross Margin

Including labor costs in your gross margin can obscure your financial analysis. This is because most employees today are on fixed salaries rather than hourly wages. This means that their costs don't vary directly with sales volume. For example, if you hire a new full-time employee, your labor cost increases regardless of your sales. This inconsistency disrupts the correlation between sales and direct costs, making it harder to gauge your true gross margin.

This then leads to complex Analysis as when you include labor costs in gross margin, you need to remove them again to understand your actual gross margin. This additional step complicates your analysis and can lead to inaccurate conclusions about your business performance.

If you are not sure how your current P&L is structured or whether your gross margin is being calculated correctly, the free Finance Health Check will give you a clear answer. Claire looks at your actual numbers and tells you exactly what is working, what is not, and what needs to change. Book your free Finance Health Check

Recommended Approach: Separating Costs for Clarity

To avoid these issues, I recommend structuring your profit and loss statement more effectively:

1. Sales and True Direct Costs: Calculate your gross margin using only true direct costs, excluding labor costs. This will give you a clearer picture of how your sales relate to your direct costs and help you understand your gross margin percentage accurately.

2. Detailed Expense Categories: Instead of lumping all expenses into a single "admin" category, break them down into more specific categories. This is especially important for labor costs.

• Marketing Costs: Include all expenses related to promoting your business.

• Sales and Production Costs: This category should encompass all costs related to producing and selling your products, including labor costs for your production or warehouse staff.

• Property Costs - This could include rent, rates, utilities etc

• Administrative overheads - This should include all other costs, including the salaries of any admin staff you have.

Conclusion

Getting your P&L structure right is not a minor detail. It is the foundation of every decision you make.

When labor costs sit in the wrong place, your gross margin tells you the wrong story. You might think a product line is profitable when it is not, or assume your pricing is fine when it is actually eroding your margins month by month. Most business owners only discover this when they finally get a proper set of management accounts in front of them and see the real picture for the first time.

If your accounts have grown organically, structured around whatever felt sensible at the time rather than what actually gives you useful information, the chances are this is already affecting how clearly you can see your business.

The Finance Health Check is a free review of your actual numbers. Claire looks at how your P&L is currently structured, identifies where the reporting is obscuring rather than revealing what is happening, and gives you a clear view of what needs to change.

Not sure where your finances actually stand?

Most business owners reading this know something isn't quite right, but aren't sure if it's a cash problem, a reporting problem, or something else entirely. The Finance Fitness Score tells you in 3 minutes, with a personalised action plan at the end.

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