Direct organisation expenses as a percentage of operating expense.
Direct compensation cost / Operating expense * 100
Direct Compensation Cost Operating Expense Rate measures direct compensation costs (wages and other taxable benefits) as compared to total operating expenses. A result of 40 per cent means that direct wage costs make up 40 per cent of the organisation’s total operating expenses.
Compensation costs are usually a major, if not the largest, operating expense item in an organisation’s income statement. However, it is often difficult to assess an appropriate market value for human capital, despite its importance to business operations and to employees.
For these reasons, most employers keep a close watch on compensation costs to monitor trends and ensure those trends are consistent with competitive labour market realities and desired labour shifts.
By comparing the line item of compensation costs to the whole of operating expenses, organisations can monitor for expense creep in which wage costs slowly but consistently increase over time relative to other operating expenses.
Such a trend, when intentional, can represent an upskilling of the workforce, overall labour inflation or an improvement in market comparison ratios. When unintentional, an upward trend may simply represent loose managerial controls on wage programs.
However, trends must be analysed closely to understand root causes for results, as upward or downward trends may also be caused by changes in other operating expenses. For example, if wage costs are decreasing but other expenses are decreasing at a faster rate, then this measure will experience an upward trend.
For greatest accuracy, organisations should source compensation data from payroll data tables, categorising pay codes into base, variable, overtime and other wage components. If these data are not available, an approximation can be made from financial ledger items or job table fields related to salaries and bonuses. Operating expense is typically derived from such financial ledgers.
Employers often analyse Direct Compensation Cost Operating Expense Rate by organisational unit and location to help monitor wage trends within various areas of the organisation. This measure is also useful when disaggregated into subcomponents of base pay, variable pay, etc.
This measure does not provide an indication of how closely an employer ‘s compensation costs match the external labour market or how satisfied employees are with compensation. It also does not indicate the actual magnitude of compensation costs or how absolute compensation costs change over time.
Organisations may set relative targets for Direct Compensation Cost Operating Expense Rate based on their benefits, philosophies and strategies, labour market trends, workforce wage and skill mix, and workforce planning needs.
For example, an employer aiming to provide compensation on par with talent competitors might target the median among talent competitors with similar cost structures, while an employer aiming to manage wage dollars tightly might target the 251h percentile.
Organisations are also likely to set absolute targets based on common-sized historical income statements and financial budgets and forecasts. The ranges for such absolute targets vary widely based on industry cost structure norms.