Direct Labor
refers to the salaries and wages paid to the workers directly involved in manufacturing products or performing services
Direct labor refers to the salaries and wages paid to the workers directly involved in manufacturing products or performing services. The work these workers perform should be related to a particular task.
For a company in the services sector furnishing different services to the guests, direct labor is the work performed to give the services to the guests directly.
Some examples of service sector businesses are:
- Software companies
- Restaurants
- Gyms
- Auditing companies
- Consulting companies
The work is more labor-intensive for a company in the manufacturing sector that produces different products than in the services sector. Here direct labor is related to the employee's contribution to improving the manufacturing process, making it more cost-efficient.
If a group of employees performs the work and cannot be associated with a particular worker, the wages paid in such cases are indirect. However, direct labor is essential while evaluating the total production cost of any project, as it constitutes a significant portion of the project.
The cost of labor per employee in the manufacturing sector depends on the following factors:
- Process of manufacturing the product, whether it is labor intensive or not
- The complexity of the manufacturing process
- Productivity and efficiency of the worker, greater efficiency implies greater wage
- Amount of risk that the workers face in the process of manufacturing
Generally, if the complexity of the product manufactured is high, requiring the use of advanced equipment, the cost of labor is high. If the workers are subject to greater levels of risk in the manufacturing process, like in a nuclear plant, the direct labor cost is higher.
More labor-intensive manufacturing processes, like steel production, involve high labor costs. However, automation and streamlining manufacturing steps can help reduce labor costs.
Mechanical assembly of objects through welding and other processes are highly labor intensive, resulting in higher direct labor cost. While the processes like metal stamping, die casting, and injection modeling are low labor content processes, requiring low labor costs.
Key Takeaways
- Direct labor refers to the salaries and wages paid to the workers directly involved in manufacturing products or performing services.
- While evaluating the cost of labor, companies generally consider factors such as regular working hours, overtime pay, healthcare and insurance, employee training and development costs, payroll taxes and social security expenses, and pension plans.
- Companies can use direct labor as cost drivers to allocate the overhead expenditures to the production process.
- Overhead expenses are indirect costs that are not connected directly to any particular final product but are used in the production process of intermediate goods hence must add to the overall cost of production.
How to Measure Direct Labor
In a manufacturing or services company, labor can be of two types:
1. Direct Labor
The laborers working with different materials, either manually or using machines, are called direct or productive laborers. The wages of such workers are decided based on their role in the manufacturing process. The salaries given to the direct laborers are called direct labor costs.
2. Indirect Labor
The employees not directly involved in the manufacturing process but assisting the direct laborers in performing their duties are called indirect laborers.
The salary given to these workers is called indirect labor cost. Their wage is not decided based on the job they undertook but on the number of products produced in the given period.
While evaluating the cost of labor, companies generally include the following costs:
- Salary attributed for the regular working hours
- Bonus amount for overtime working hours
- Healthcare and employment insurance
- Employee training and development costs incurred during employment
- Payroll taxes and other social security expenses
- Pension plans after retirement
The hiring company should include all the costs it incurs in hiring and keeping the employees while calculating the direct labor cost.
Here the insurance amounts, payroll taxes, and social benefits costs are not directly in the form of in-hand salaries but the cost of retaining the employees in their company by providing them financial security for future emergencies.
Most companies have a fixed rate of per-hour work based on the hierarchy of positions. The per-hour wage of employees increases as they reach higher positions in the company with each promotion.
This standardized per-hour wage estimates the cost incurred by hiring the employee the company expects in normal conditions, assuming sufficient economic prosperity with no signs of recession.
To illustrate this concept, let's consider an example of a steel-producing factory. Suppose there is a steel-producing factory in your locality. By researching, you find that the labor cost for every hour of work in the steel-producing factory is $50 for the laborers.
If the company produces 500 tons of steel in a given period and it takes 3 hours on average to produce a ton of steel, the direct labor cost incurred by the company will be $75,000 ($50 x 500 x 3).
In the above example, we have not considered the effect of overtime hours, insurance premiums, payroll taxes, and other social benefits costs while calculating the labor cost.
NOTE
Generally Accepted Accounting Principles (GAAP) are a collection of accounting rules and standards in financial reporting and modeling. The purpose of GAAP is to maintain transparency and consistency in financial reporting across all companies and businesses.
According to the GAAP rules, companies can use direct labor as cost drivers to allocate the overhead expenditures to the production process.
Overhead expenses refer to the indirect costs that are not connected directly to any particular final product but are used in the production process of intermediate goods hence must add to the overall cost of production.
These overhead costs are then allocated to the final products using cost drivers. We can divide the total overhead costs by the direct labor cost to get the value of the cost driver.
Direct labor also depends on the number of workers required to produce a particular product or the number of working hours utilized to produce one unit of the product.
Suppose an accountant computes the ratio of the overhead costs to direct labor costs as $19 per hour. So the cost driver here is $19. Hence the company will allocate $19 of the overhead costs per hour of direct labor to the production output.
How to Calculate Direct Labor Cost per Unit
The amount incurred by the business as direct labor cost is significantly influenced by the effectiveness of the workers participating in the production process.
The method of computing the labor cost per unit of goods produced is as follows:
1. Calculate the hourly direct labor rate
To get the hourly rate of direct work, we must first determine the worker cost per unit of production, which is dependent on the following variables:
- The hourly wage for the employees
- Payroll taxes of the workers
- Social and fringe benefits offered by the company to retain the workers
By dividing the entire value of social benefits and payroll taxes by the number of hours worked during a specific payroll period and then adding that result to the employee's hourly compensation, one can calculate the hourly rate of direct work.
For example, suppose the employees' work time in a steel manufacturing company is 30 hours per week. The wage earned per hour is $20. The employees also get $80 of fringe benefits and $50 as payroll taxes. The total amount of benefits and taxes is $130 (80 + 50).
On dividing this amount by 30, the number of working hours per week, we get a value of 4.33. We now add this value to the hourly wage($20) to get the direct work hourly rate. Hence the desired value is $24.33 (20 + 4.33).
2. Calculate the total hours of direct labor
Direct labor hours refer to the number of direct working hours required to produce one unit of a particular product. We can calculate this value by dividing the total direct working hours required to produce a particular amount of the finished products by the number of finished products manufactured.
For example, suppose a steel-producing firm requires 100 hours to produce 5 tons of steel. So the time required to produce one-ton steel will be 20 hours(100/5). So the direct labor hours are 5 hours.
3. Calculate the per unit cost of labor
The per unit labor cost can be evaluated by multiplying the direct labor hourly rate (as calculated in step 1) by the time required to complete the manufacturing of one product unit (as calculated in step 2).
Suppose we discussed the same steel manufacturing firm in the first two steps. The firm's hourly labor rate is $24.33, and it takes 20 hours to manufacture one ton of steel. Hence the per unit labor cost will be $486.6 ($24.33 x 20).
4. Compute the variance between the standard and actual cost of labor
All companies fix a standard direct labor cost against which they compare their actual direct labor costs. The variance between the two indicates whether the current direct labor cost is favorable for business. The variance can be obtained by calculating the difference between the standard and actual direct labor cost per production unit.
The company will likely spend more than anticipated to generate one unit of output if the actual direct cost of labor per unit of production exceeds the standard direct cost of labor per unit of production. Hence the current cost of labor is unfavorable for the company.
Suppose the actual direct cost of labor is lower. In that case, it implies a lower cost to produce one unit of output than the standard value, making the current cost favorable, profitable, and financially feasible for the company.
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