How To Create a Payroll Budget: A Step-by-Step Guide

Payroll is a significant business expense for most organizations. In fact, payroll budgets (including benefits, wages, and taxes) can make up as much as 70% of total spending for many businesses. But how do you determine how much to set aside for your organization?

In this article, we’ll explain what a payroll budget is and why you need one. Then, we’ll provide step-by-step instructions to help you create one that meets your business needs.

What is a payroll budget?

A payroll budget estimates and records all the expenses associated with compensating and onboarding employees. Gross wages, employee benefits, and taxes are some examples of expenses your company may need to account for in your budget. Some companies also include the cost of paying independent contractors to simplify total labor cost calculations.

Why are payroll budgets important?

You should create a budget for all of your business’s critical functions. As one of the most significant expenses, human resources tops the list. We dive into some of the many reasons your company should concentrate efforts here:

• Labor costs can vary significantly. Unlike rent, mortgage, and insurance, labor costs can change daily. This is especially true for companies hiring hourly employees instead of salaried workers. An accurate payroll budget can account for these variations to ensure your company covers its expenses.
• Your company might face penalties for late payments. Your business may receive some clemency for late bill payments but face severe penalties for paying wages late. For example, California charges up to $200 plus 25% of unpaid wages. Failing to pay associated costs, such as employee and employer taxes, can bring additional penalties and fees.
• Compliance takes planning. Your company will be in a much better position to ensure compliance with regulations if it can estimate financial obligations. Understanding payroll’s place in your cash flow can also ensure the correct allocation of expenses to meet those needs.

4 steps for creating a payroll budget

Human resources professionals work closely with the finance team to create payroll budgets. Both admin functions often have conflicting goals, making the process more complex. The HR manager typically wants bigger budgets to attract better workers and retain top performers. Meanwhile, the CFO is usually looking for ways to reduce business expenses.

Understanding this dynamic is a critical first step in navigating the process of creating an accurate payroll budget. Here are some additional measures to ensure your success.

4 steps for creating a payroll budget:

1. Determine your payroll expenses
2. Set a budget
3. Break down the budget by department or employee
4. Review and adjust the payroll budget regularly

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1. Determine your payroll expenses

Payroll expenses include all the compensation-related liabilities your company must handle. Identify all expenses to ensure you have a comprehensive budget. The Small Business Administration (SBA) estimates that total payroll liabilities are 1.25 to 1.4 times an employee's wages.

The main payroll expenses to include in your budget are:

• Gross wages. Salaried employees typically receive a fixed wage. However, hourly employees may have more variable income, so your payroll team should estimate staffing requirements, the number of hours, and potential overtime pay. Compensation paid to contractors may also fall under this category.
• Payroll taxes. You’ll have to pay each employee’s applicable federal, state, and local payroll taxes. In the US, examples include Social Security, Medicare, and a federal unemployment tax (FUTA). You’ll typically pay some taxes out of pocket and withhold others from employee paychecks.
• Benefits. Your company may provide health insurance, 401(k) plans, paid leave, or other benefits to attract and retain workers. You must include all benefit expenses in your budget.

2. Set a budget

Experts offer recommendations on the percentage of revenue they believe companies should spend on labor costs. Businesses spending 30% or less of gross revenue on payroll expenses are typically in the safe zone.

Some examples that deviate from the general rule include:

• Service-based businesses can spend up to 50% of gross revenue on labor costs and remain profitable
• Retail businesses typically have labor budgets of up to 20% of gross revenue
• Highly automated industries may set budgets up to 10% of gross revenue

Here’s an example of how your company can use its gross revenue to decide on a total figure for the payroll budget. Let’s say Build Bridges provides data privacy compliance assistance to multinational corporations. It brings in a gross income of $5 million each year. As a service provider, it can reasonably expect to pay up to $2.5 million ($5,000,000 x 0.5) in payroll costs.

After setting a budget, you must determine where your current expenses fit. You may need to look for cost-cutting solutions if your payroll costs are over budget (e.g., using automation software to streamline work processes and reduce overtime hours). If you have room in your budget, you might seize the opportunity for expansion or keep the extra as a buffer.

3. Break down the budget by department or employee

Next, determine which departments you expect will lead to the highest payroll costs and plan accordingly.

• Executive compensation. Startup CEOs earned an average salary of $150,000 in 2022. Compare this to a median salary of $58,563 for all U.S.-based full-time employees in the same year. Account for these differences in pay rate when budgeting for payroll.
• Departments. You should also determine which departments will result in the highest value for the company. Using the Build Bridges consulting example, the company may spend most of its payroll budget on compensating consultants and account managers. These are the company’s core workers.
• Individual compensation. Your HR professionals should work with the operations manager to determine job functions and split them between roles. After completing the personnel plan, your HR manager can determine how many to hire for each position and set the appropriate salary based on market rates and the company’s budget and needs.

Track payroll expenses at the macro and micro levels to cover all the bases. Measuring and analyzing data at all levels provides the necessary information to take corrective action (like hiring freezes). It also makes it easier to adjust payroll budgets when your teams or departments expand.

4. Review and adjust the payroll budget regularly

Labor costs are constantly changing. Regularly review and update expenses to account for these changes. Pay increases, seasonal demand, or new labor laws might be some causes.

For example, a state could change its company headcount requirement for paying workers’ compensation. Keep up with these changes to ensure you have the cash to fulfill your financial obligations.

So, how do you review and adjust your payroll budget to ensure it meets business needs? Some best practices are:

• Schedule regular reviews and assign someone to the task. Job duties can fall by the wayside if they don’t have specific deadlines and an assigned worker. Formalizing the process ensures these reviews occur and are taken seriously.
• Establish a process for addressing change requests. When your company’s needs change, it can trigger higher payroll costs. For example, your operations manager may need 10 more workers to handle a new product launch. HR may need to submit this request for approval.
• Use data analytics tools for payroll reviews. Evaluate analytics tools offered by payroll software providers like Upwork Payroll, Gusto, or ADP. Review reports to determine how well your personnel plan aligns with your organizational goals and overall budget.

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Tips for managing payroll costs

Payroll costs are inevitable, but they’re also manageable. Some ways to manage payroll costs include:

• Hiring contractors. You can reduce the complexity of payroll costs by hiring contractors instead of employees. Contractors manage their own taxes and don’t typically receive benefits.
• Outsourcing payroll functions. Payroll leaves very little room for mistakes, but there are many opportunities to make them. If you’re a startup, consider outsourcing payroll services to reduce any risks.
• Using templates or guides for setting pay rates. Payroll software may include templates for setting pay rates. Conduct research through the BLS and job sites to determine the exact salary based on experience and location. Use these templates as a guide when setting pay rates for new employees.
• Investing in payroll software. Payroll software can make it easier to keep accurate records, calculate taxes, and create reports. Using this software can also be less time-consuming than manual methods like Microsoft Excel.
• Considering the value of each role. Hiring the best talent is expensive. Review job functions carefully to determine when to bring in experience and knowledge versus when to train someone in-house.
• Reassessing your benefits package. Shop around for benefits providers. For example, one insurance broker or provider may charge significantly lower premiums and other costs than the one you currently use. However, cheaper doesn’t always mean better.
• Streamlining new employee onboarding. Minimize onboarding costs by streamlining processes as much as possible. For example, you might consider automating the onboarding process by providing online training material through a learning management system (LMS), creating a digital onboarding checklist, or using automated email to send to new hires.

Payroll budget FAQ

Payroll budgeting is a complex area of business management, so you likely have additional questions. These are some of the most common.

What are some common mistakes to avoid when creating a payroll budget?

Payroll errors can be costly. They can also affect employee trust and contribute to high turnover. Common payroll budget mistakes include:

• Failing to classify W-2 employees versus 1099 independent contractors correctly
• Failing to account for all employee compensation costs, such as bonuses and reimbursements
• Overestimating or underestimating the number of employees hired or needed
• Failing to consider changes in tax rates and employee compensation from the previous year
• Failing to account for employer-paid payroll taxes, which can significantly impact the budget
• Failing to review and adjust the budget regularly based on actual payroll data and business changes
• Failing to review existing payroll records that cover current payroll costs properly

How often should a payroll budget be reviewed?

Some industries have relatively stable pay rates and don’t experience seasonal spikes. Managers at these companies might only need to review the payroll budget quarterly or semiannually.

If your company operates in a more dynamic environment, however, consider monthly or quarterly reviews. Regardless of the economy or your business’s stability, you should review pay rates and compensation packages for all workers at least annually.

Should small business owners include themselves in the payroll budget?

Not all business owners take a regular paycheck from their businesses, so it depends on how you compensate yourself.

• Employee―yes. If you are a W-2 employee, you should include yourself in the payroll budget. This ensures the team can account for income taxes and other payroll expenses they must withhold from your check and your company must pay on your behalf.
• Independent contractor―it depends. If you pay yourself as a 1099 contractor, it depends on how you account for other freelancers working for the company. Include yourself in the payroll if you would include other contractors. Otherwise, you may need to create a separate expense account for your compensation.
• Distributions, dividends, or owner’s draw―no. Let’s say two sisters own the Build Bridges consultancy firm: Nicole and Sasha Bridges. After the company settles its monthly bills, the sisters split 60% of the business profits between each other. The remaining 40% gets reinvested into the company. These withdrawals aren’t included on the payroll, but the accountant shows them on the balance sheet.

Find talent to help with your payroll budget

Creating a payroll budget is a crucial step in the business planning process. An accurate budget makes it easier for you to assess your cash flow and make informed decisions.

It also ensures your business prioritizes employee compensation packages and guarantees you pay employees and independent contractors on time. Prompt payments help with compliance and business relationships.

You’ll want to take a multidisciplinary approach to reviewing labor needs and staying within the organization’s financial capabilities. The most complex step of the process involves handling the varying taxes affecting employee wages, how to apply them, and when to remit them.

Simplify this by outsourcing payroll to experienced professionals as contractors or full-time employees. But how do you find professionals you can trust with such complex and critical tasks?

Upwork makes it easy. We’ve created a list of our platform’s 27 top payroll freelancers. Some companies prefer having a full-time payroll professional; we have you covered there, too. Check out our Full-Time program.

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This article is intended for educational purposes and should not be viewed as legal or tax advice. Please consult a professional to find the solution that best fits your situation.