When a business has employees it will have to account for the cost of those employees. In the next part of this section we will look at the journals required to record the payroll but we will first explain some of the terms used when talking about employee costs.
Gross pay is the total to be paid to an employee or employees. It includes any basic pay for the time they have worked together with any commissions, bonuses and overtime before any deductions from pay are taken into account.
Net pay is the amount of gross pay left after all deductions are taken into account.
Deductions from pay
Deductions from pay are amounts that an employer will deduct from employees’ gross pay, of which there are two main categories:
- Mandatory deductions
- These are deductions from pay that the employer is legally required to make. Examples include, PAYE income tax, Employee National Insurance Contributions, student loan repayments and attachment of earnings orders (where a Court orders an employer to deduct payments from an employee’s pay in order to pay a debt)
- Voluntary deductions
- These are deductions from pay where the employee has the option whether or not they are made. Examples include union subscriptions, charitable donations, health insurance and gym memberships. Employee pension contributions would also be classed as voluntary as employees can opt out of paying them (although the default position is that they will be deducted unless the employee opts out).
Payroll cost (or “wages expense”)
The payroll cost, or wages expense, of a business is the total cost incurred by a business as a result of paying employee wages. It is calculated as:
- Gross pay; plus
- Employer’s National Insurance Contributions; plus
- Employer’s Pension Contributions; plus
- Benefits paid for the business’ employees, for example, if an employer pays the cost of health insurance for its employees
Illustration: Calculating payroll cost
Details of a payroll are shown below
In order to calculate the payroll cost for the business we would identify those costs borne by the employer excluding those costs that are paid by the employees out of their gross pay. The payroll cost for the above business will be the gross wages plus the employer’s NI plus the employer’s pension contributions as shown below.
PAYE tax, employee’s NI, employee’s pension contributions, Court attachment orders and trade union subscriptions are amounts paid by the employees out of their gross wages and are therefore excluded from the calculation.
Illustration: Calculating net pay
Details of a business’ payroll for a month is shown below
As mentioned above, net pay is the gross pay less all employee deductions. For the above example it would be calculated as follows:
Employer’s NI and Employer’s pension contributions are not taken into account in the above calculation as they are paid for by the employer and are not deducted from the employees’ gross pay.
Illustration: Calculating gross pay and payroll cost from net pay
Sometimes in an exam question, you might not be given gross pay and must instead use the other information given to calculate this and the total payroll cost.
A business’ payroll data is given below:
In order to calculate the gross pay (and then the payroll cost) we would start with net pay and then add back all the mandatory and voluntary deductions made from the employees’ pay as follows:
Once gross pay is calculated we can then calculate the payroll cost for the period by taking the gross pay and adding the other costs incurred by the employer. For our example it would be calculated as shown below.
Illustration: Calculating the amount payable to HMRC
Part of the payroll cost will be paid by the business to HM Revenue & Customs. The amounts to be paid will include the PAYE income tax, all types of National Insurance (employer’s and employees’) and any Student Loan repayments deducted from pay. For our above example the amount to be paid would be:
Illustration: Calculating the amount payable to the Pension Fund
Both employee and employer pension contributions will in due course be paid to Pension Funds for their safekeeping and investment on behalf of the employees. The amount to be paid will be:
In the next part of this section we will look at how we use journals to record the payroll information in the General Ledger.