As a company grows and hires workers to help run operations, business owners might be surprised to learn that processing payroll costs more than just the employee’s monthly salary.
On top of employee wages, they’re also responsible for their portion of the employees’ benefits costs, payroll taxes, and payroll services.
Simply put, payroll expenses can have a significant impact on a company’s profitability, with additional implications for its tax reporting requirements.
In this guide, we’ll cover what payroll expenses are, how to calculate them, and best practices for tracking them effectively.
What is payroll expense?
Payroll expenses are the costs employers incur to employ and compensate their workforce.
As we’ll cover in further detail below, payroll expenses aren’t just the total amount of employee paychecks in a given period. This cost includes wages, employee benefits, employer-paid taxes, commissions, bonuses, and any payroll administration costs.
In other words, payroll expenses encompass both the total amount that employees are paid, plus what it costs the business to run payroll.
Importance of tracking payroll expenses
Payroll expenses typically make up a significant portion of a company’s costs. According to one estimate, most businesses spend upwards of 30% of revenues on payroll expenses.
Thus, tracking and managing payroll costs effectively is crucial for accurate financial reporting. With such a large impact on a company’s bottom line, teams rely on this reporting to make informed decisions about hiring activities, employee compensation, and general efforts to improve profitability.
Key components of payroll expenses
Here’s a closer look at the individual components that make up a company’s total payroll expenses:
Gross wages
The first portion of payroll expenses is gross wages. This is the amount of pay the employees or contractors receive in the form of hourly wages or a salary.
The total amount of wages for all workers in the company will likely be the largest portion of the company’s payroll expenses.
Employer-paid taxes
There are also taxes that employers must pay on each employee’s behalf, including:
- FICA taxes: Used to fund federal programs like Social Security and Medicare. 6.2% of an employee’s gross wages is deducted to pay for Social Security, and another 1.45% is deducted for Medicare. The employer must pay an equivalent total percentage, 7.65%, on employee wages to cover its portion.
- SUTA taxes: The State Unemployment Tax Act (SUTA) is the portion of employee wages that goes to support the state unemployment program. The exact tax rate and other specifics of this obligation vary by state.
- FUTA taxes: The Federal Unemployment Tax Act (FUTA) is the employer’s obligation to fund unemployment insurance. The current FUTA tax rate is 0.6% on the first $7,000 of a worker’s gross wages.
Employee benefits
Employers may offer benefits for full-time employees to attract talent and meet their legal obligations, depending on their size. This might include benefits like health insurance, life insurance, paid time off, and retirement savings.
If so, employers may withhold a portion of employee wages to cover a portion of the program cost. Any additional costs the employer pays is considered a payroll expense.
Let’s say an employer offers to pay $400 per month for an employee’s health insurance premium. This counts as a payroll expense. If the employee chooses a plan that is $550 per month, the employer will contribute $400. To cover the remaining $150, the employer will withhold this amount from the employee’s wages, which is not a payroll expense for the company.
Other related expenses
Teams may record payroll processing costs as a payroll expense. This may include any costs the business incurs to run payroll, such as fees paid for payroll software or outsourced payroll processing services.
Payroll expenses vs salary expenses
Are payroll expenses the same thing as salary expenses? While the two terms overlap in certain areas, they do represent two distinct costs.
More specifically, salary expense refers to the total wages a worker receives for their labor in a given period. In contrast, payroll expenses are a broader category that encompasses salary expenses on top of other costs the business incurs to compensate workers, including payroll taxes, benefits costs, and payroll processing fees.
Payroll expenses vs payroll liabilities
Payroll expenses are also not synonymous with payroll liabilities. Payroll expenses are reported on the income statement in the period that they are incurred, whether or not the company has paid for them yet.
Alternatively, payroll liabilities are reported on the balance sheet and represent payroll costs the company is still obligated to pay, like wages employees have earned in the current pay period, but won’t be paid for until a future payroll run.
How to calculate payroll expenses
Given the various components that make up payroll expenses, it can be hard to picture how this calculation works without seeing it in practice. Here’s a quick walkthrough of how to calculate payroll expenses.
Step 1: Gather employee compensation information
The first step is to compile any wage-related data for the workers who will be paid in the period.
This includes the hours worked and the rate for hourly workers, the base salary for salaried employees, and any other forms of compensation, like bonuses or commissions.
Step 2: Calculate gross wages
Next, calculate and sum each worker's gross pay. For salaried workers, this involves dividing their annual salary by the number of pay periods in a year. If employees are paid bi-weekly, divide their salary by 26 to find their gross wages for the current pay period.
For hourly workers, multiply their hourly wage by the total number of hours worked in the period. Add any overtime, bonuses, or commissions that employees may have earned to determine their total gross wages.
Step 3: Figure employer-paid taxes
Once you have the total gross wages for the workforce, determine how much the company will owe in payroll taxes. Here’s a reminder of the applicable tax rates for employers:
- FICA: 7.65% of gross wages
- FUTA: 0.6% on the first $7,000 of gross wages per employee
- SUTA: rates vary by state
Step 4: Include the cost of benefits
As mentioned above, employers may offer to cover all or a certain portion of the benefits packages for employees. The employer’s total contributions to these programs are considered payroll expenses.
Step 5: Consider payroll processing fees
Anything the company spends to process payroll, hire external payroll specialists, or pay other related expenses will also be considered a payroll cost. Add this to the other expenses calculated thus far to find the total value.
Common pitfalls to avoid when calculating payroll expenses
Accurately calculating payroll taxes and staying on top of reporting month after month can seem like a daunting task. Here are some common mistakes to avoid:
- Overlooking employer-paid taxes: Growing businesses running payroll for the first time may be surprised to learn about all the taxes they must pay on top of employee wages, including FICA, SUTA, and FUTA.
- Counting employee withholdings: Remember that the employees’ portions of FICA taxes and any withholdings from gross wages for benefits are not considered payroll expenses for the employer. Only the company’s share of FICA taxes and contributions to benefits should be included.
- Misclassifying workers: Be careful about accurately classifying workers as employees or contractors to ensure compliance with tax guidelines and required benefits. Misclassifying employees as contractors, whether on purpose or accidentally, can result in penalties and back taxes.
- Ignoring administrative costs: Indirect expenses, such as payroll software subscriptions or payroll services fees, are considered payroll expenses and should be included in the calculation.
Managing payroll expenses effectively
To reiterate, payroll expenses can make up a large portion of a company’s total costs. Thus, teams are often interested in ways to strategically manage and control these costs without letting employees or operations suffer from aggressive cost-cutting efforts.
First off, teams should consider using payroll management software to ensure better efficiency with each payroll run and transparency into payroll costs. This helps teams have a better idea of what their existing payroll costs are for budgeting purposes without relying on manual updates every pay period.
Further, modern payroll solutions help teams streamline this workflow without hiring additional staff as the company grows or needing to outsource the function to a third-party provider. These efficiency gains enable teams to keep payroll costs from ballooning as the company grows, without needing to directly target employee wages or benefits.
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Frequently asked questions
How do payroll expenses affect cash flow and profitability?
Payroll expenses are reported on the income statement, directly impacting a company’s profitability. Additionally, they require cash outflows to pay for employee wages, employer tax obligations, and payroll processing costs. All things considered equal, as payroll expenses go up, profits and net cash flows will go down.
How to reduce payroll expenses without hurting employees or operations?
Companies that want to reduce payroll expenses without cutting employee pay and benefits or laying off workers should focus on streamlining payroll processing costs. This might include migrating to a more cost-effective payroll software or outsourcing payroll processing to a third-party.
Should payroll be outsourced to save time and costs?
Deciding whether to outsource payroll or handle it internally depends on a number of factors, including staffing levels and skills, industry needs, and payroll services costs. There is no correct answer that applies to all businesses. For instance, this might be a good solution for small teams without in-house payroll experts.
Which accounts should payroll expenses be recorded under?
Payroll expenses are typically recorded under the wages and salaries expense account and the payroll tax expense account. If these expenses are not paid for immediately upon incurring them, recording a payroll expense may also cause an increase in short-term liabilities accounts, like wages payable, taxes payable, and benefits payable.
What percentage of revenue should payroll expenses ideally be?
The general rule is that payroll should make up 15 to 30% of a company’s gross revenues. Companies may fall above or below this range depending on their industry, business model, and development stage.
What is an example of a payroll fee?
An example of a payroll fee is if a company has a small internal team and decides to outsource payroll processing to a third-party provider for a small fee each month. The amount paid to the payroll provider would be considered a payroll fee.
