Payroll Budgeting: The Essentials Your Small Business Needs to Know

June 8, 2021
Payroll Budgeting: The Essentials Your Small Business Needs to Know
Payroll is a significant and recurring employer expense, which can cut into the profit margin if improperly managed. Small businesses, especially, need to be on guard, as studies show that most small businesses frequently struggle with cash flow issues. The key is to not overspend or underspend on payroll — and a payroll budget is essential to achieving this objective. But what should you put in your small business payroll budget? Your current year’s payroll is a good place to start. You can loosely use the current information as a guide for the next year’s payroll budget. We say “loosely” because changes will need to be made. While the specifics of a payroll budget vary by small business, there are some typical inclusions — such as base wages and salaries, overtime, employee benefits, incentive pay, payroll taxes, payroll administration costs, and unexpected expenses.

The key is to not overspend or underspend on payroll — and a payroll budget is essential to achieving this objective.

Base wages and salaries

This is the forecasted amount that you will pay each hourly and salaried employee. It does not include any additional compensation, only base pay. When budgeting base wages and salaries, consider:
  • Projected market rates for all positions
  • Foreseeable employee terminations, such as employees who are nearing retirement
  • Additional staff that may be required
  • Pay increases and adjustments for the next year
  • Operational needs that may cause changes in work hours, wages, and salaries
  • Mandatory pay changes that could be forthcoming, such as minimum wage increases

Overtime or premium pay

This section is irrelevant if:
  • Your nonexempt employees do not work overtime, and you do not see that changing
  • You do not provide premium pay, which is typically given to employees who work undesirable hours — such as nights, weekends, or holidays
Otherwise, you must account for overtime or premium pay in your payroll budget. Factors influencing these costs include:
  • Federal or state overtime pay rates
  • Double-time pay if required by company policy or state law
  • Differential/premium pay for employees who work outside normal business hours
Keep a watchful eye on overtime costs; they can spiral out of control if not closely monitored.

Employee benefits

Make sure to consider the following employee benefits when calculating your payroll budget.

Mandatory benefits

Most states require employers to carry workers’ compensation insurance. In some states, employers must offer paid sick leave, disability insurance, or paid time off for specific reasons (such as voting or parental leave). Also, some cities and counties require paid sick leave or paid time off to some extent. Mandatory benefits regulations are always on the horizon, so be sure to consider any pending legislation that could impact your payroll budget.

Voluntary benefits

Voluntary benefits are given at the employer’s discretion, which means you have more leeway in terms of what to offer. Commonly, voluntary benefits include:
  • Medical, dental, and vision insurance
  • Life insurance
  • Supplemental insurance
  • 401(k) plan
  • Flexible spending account
  • Health savings account
  • Health reimbursement arrangement
  • Employee assistance program (EAP)
  • Stock options
Budgeting for voluntary benefits can be complex, because there are various moving parts. Ultimately, you must examine your current offerings and determine which ones to add, keep, or remove. Budgeting tips for voluntary benefits
  • Beware of eliminating benefits prematurely. For example, if a benefit is currently underutilized, that does not necessarily mean your employees do not (or will not) need it. Before you get rid of it, investigate the reason behind the lack of participation.
  • Assess the dollar cost of providing each benefit and verify whether you’re getting value for your money. Ideally, you want affordable and competitive benefits that will help you attract and retain talent.
  • Focus on benefits that are important to your employee population. These benefits do not have to be extravagant. Many small businesses maintain their competitive position even though they offer only a few benefits. The trick is to focus on quality not quantity. For example, a robust small business benefits package may consist of health insurance, 401(k), paid time off, and an EAP (which costs employers around $12-$40 per employee per year).
  • Review your benefits contributions — such as 401(k) matches. Then, decide whether changes should be made.

Incentive pay

Incentive pay, such as bonuses and commissions, is a potent tool for motivating employees. But if you’re operating on a tight budget, incentive pay may seem out of reach. Remember, you can incentivize employees in non-financial ways — such as through recognition, team building activities, and flexible work schedules. That said, be careful when putting incentive pay on the chopping block; it could backfire and cause morale to plummet. For instance, if your employees are used to getting a holiday bonus every year, it might be better to reduce the amount rather than taking it all away.

Payroll taxes

Payroll taxes are a core component of any payroll budget. Even if you have only 1 or 2 employees, you must pay your share of payroll taxes on wages paid to those employees.
  • On the federal side: Employer payroll taxes include Social Security tax, Medicare tax, and federal unemployment tax.
  • On the state side: Employer payroll taxes include state unemployment tax, and possibly other state taxes or local payroll tax.
Keep in mind that your payroll tax rates may change in the next year.

Payroll administration

How are you capturing employees’ work time and processing payroll? Are there more efficient ways of administering these tasks? You must address these questions when budgeting for payroll. If your timekeeping and payroll systems are labor intensive, they’re likely holding you back. It’s probably time to upgrade to an integrated system — which will automatically transport employees’ time into the payroll system plus help you get payroll done faster and more accurately. If cost is a concern, price tiers and free payroll tools are available. Scrutinize everything influencing payroll administration costs, including your payroll processing model. Then, figure out what changes should happen and allocate funds accordingly.

Anticipate the unexpected

If the COVID-19 pandemic has taught us anything, it’s that disasters can strike without warning, and preparation is instrumental to weathering the storm.

Be sure to budget for unplanned disruptions — such as unexpected employee terminations, replacement personnel, and payroll disturbances caused by disasters or inclement weather.

Be sure to budget for unplanned disruptions — such as unexpected employee terminations, replacement personnel, and payroll disturbances caused by disasters or inclement weather. Remember to leave room for potential cost increases, as estimates/quotes and rates received today may differ come next year.

How much should you spend on payroll?

The general consensus is that payroll should be no more than 20-30% of the company’s gross revenue. However, experts say that in certain industries (such as service businesses) payroll costs can be as high as 50%, without harming profitability. Generally though, the recommended benchmark is 20%-30%. As your business grows, your payroll expenses will rise, due to the need for additional resources. Even then, try to keep your payroll costs reasonably low — because the less you spend on payroll, the higher your profit margin.
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