Labor cost usually makes up a large portion of the total cost that entities incur to operate their business. It consists of all employees and workers related expenses such as workers’ remunerations, benefits and associated payroll taxes etc.
In both manufacturing and service organizations, the total labor cost is often categorized as direct and indirect labor cost. Both of these types of labor cost need to be properly traced and calculated. This categorization is crucial for numerous reasons; for example, it helps in measuring employees’ productivity, determining product cost and price, gauging business profitability and drafting correct financial statements. Let’s see what is the basic difference between direct and indirect labor cost.
Direct labor cost
Definition and explanation
In manufacturing entities, direct labor cost is the cost associated with production workers and includes salaries, wages, remunerations and fringe benefits paid to such workers. Production workers (also known as direct labor workers) are the workers who actively handle and run the actual production process in a facility. They apply their skills and knowledge to physically convert, transform or alter raw materials into finished goods in a production process. Production workers may work under any employment status; they may be employed as full time, part time and temporary workers or may be hired to accomplish some casual work through a special employment contract. Machine and equipment operators, assemblers, welders and painters working in manufacturing facilities are all examples of direct labor workers and remunerations paid to them form part of the entity’s total direct labor cost.
Any expense or cost caused by non-production workers like office, administrative or security personnel etc. can’t be regarded as direct labor cost. These employees are not categorized as direct labor workers because they are ordinarily not responsible to set up, run or maintain any production process.
Direct labor cost elements
In addition to basic wages, an entity’s direct labor cost includes any costs and expenses needed to hire and keep direct labor workers in the organization. These costs and expenses take the form of relevant federal and state taxes, contributions and benefits provided by employers for the support and wellness of workers. Due to this reason, an entity’s total direct labor cost is often much higher than just the basic production related wages which are paid to workers as their remunerations.
Typically, the following items are made part of an entity’s overall direct labor cost:
- Basic production wages (both normal and overtime)
- Associated payroll taxes
- State and federal unemployment taxes
- Medical, health and life insurance
- Workers compensation insurance
- Entity’s contribution towards pension
- Any other cost(s) incurred related to and for the benefit of direct labor workers e.g., recruitment, training and skill enhancement programs etc.
In service providing entities, direct labor cost is the remuneration paid to employees who perform core activities needed to deliver a particular service to clients plus any applicable items mentioned in the above list. Examples of direct labor employees in service industries include:
- accountants and tax consultants in an accounting and tax consultancy firm like PWC and Blue & Co.
- auditors in an audit firm like KPMG
- web developers in a web development company like Cubix and Iflexion.
- content writers and search engine optimizers in a content marketing and SEO firm like Hoth and WebFX.
- software developers in a software development company like Dreamztec Solutions and Side Brench and
- advertising and marketing experts in a digital marketing company like Mayple and Beyond etc.
In manufacturing context, direct labor is a prime element of total manufacturing cost (also known as product cost and inventoriable cost). Direct labor cost is a common component of both prime cost and conversion cost formulas. When direct labor is added to the direct materials cost, we get the prime cost figure and when it is added to the manufacturing overhead cost, we get the conversion cost figure. The summation of all three manufacturing costs (i.e., direct materials, direct labor and manufacturing overhead) equals the entity’s total manufacturing cost. The following formulas represent relationships among these manufacturing costs:
Prime cost = Direct materials + Direct labor
Conversion cost = Direct labor + Manufacturing overhead
Manufacturing/Inventoriable/Product cost = Direct materials + Direct labor + Manufacturing overhead
Since the direct labor is regarded as purely a variable manufacturing cost, it should vary with the output volume produced by the entity.
Application of direct labor cost – measurement and journal entry
An entity’s total direct labor cost largely depends on skill level and motivation of its direct labor workers. Highly skilled and motivated workers exhibit enhanced efficiency and contribute towards controlling and reducing the total direct labor cost of the entity.
Many companies use standard costing approach to apply direct labor cost to their production. Under standard costing, they compute an expected per unit labor cost, typically known as standard direct labor cost per unit. This per unit standard cost is established after taking into account the relevant past data and all expected working and economic conditions within the industry. To arrive at standard direct labor cost per unit, we need to follow the two steps given below:
- Step 1: compute standard direct labor rate in dollars
- Step 2: compute standard direct labor time required to complete a single unit of product
Once the standard direct labor rate and standard direct labor time to complete a single unit of product (the two steps given above) have been found, they are multiplied together to obtain the standard direct labor cost per unit which is further multiplied by the total number of units produced to obtain the standard direct labor cost to be applied to production. Consider the following example:
Marshal company’s standard direct labor rate is $5 per hour and a unit of its product takes 2 hours to complete. Compute the standard direct labor cost of the company if it produced 5,000 units during the month of March 2021.
Computation of standard direct labor rate per unit:
Standard direct labor per rate hour × Standard direct labor time per unit
= $5 × 2 hours
Computation of standard direct labor cost to be applied to production:
Standard direct labor rate per unit × Number of units produced
= $10 × 5,000 units
Marshal company would make the following journal entry to charge standard direct labor cost to production:
Work in process…..50,000 [Dr]
Salaries and wages payable…..50,000 [Cr]
Comparison of actual and standard direct labor cost
The marshal company’s standard direct labor cost for the production of 5,000 units in March is $50,000 which needs to be compared with the actual direct labor cost incurred to produce this output. The comparison of actual and standard direct labor cost gives a favorable or unfavorable total direct labor variance. For example, suppose, the Marshal company finds that it has incurred an actual direct labor cost of $52,000 to produce its March output of 5,000 units. The total direct labor variance of $2,000 (=$52,000 – $50,000) would be unfavorable because the actual direct labor cost is higher than the standard direct labor cost applied to production. This total variance can be further analyzed at a deeper level by computing sub-variances like direct labor rate variance, direct labor efficiency variance and direct labor yield variance.
Indirect labor cost
Definition and explanation
Indirect labor cost is an entity’s labor cost associated with its workers and employees other than direct labor workers. This is the cost related to those workers and employees who don’t actively participate in converting, transforming or altering raw materials into finished output. The indirect labor workers and employees don’t themselves produce any product but they exist to ensure smooth functioning of the entity as a whole by supporting those who work in production and other areas.
Subcategories of indirect labor cost
In manufacturing businesses, indirect labor cost is subcategorized as: (i) production related indirect labor cost and (ii) administrative indirect labor cost. This subcategorization is very important because production related indirect labor cost goes to manufacturing overhead and from where it ultimately becomes part of the total product cost like direct materials and direct labor. Examples of production related indirect labor include employees working as production supervisors and quality controllers and those responsible for activities like purchasing, handling and managing raw materials etc. The journal entry to record production related indirect labor cost is given below:
Manufacturing overhead…..XXXX [Dr]
Salaries and wages payable…..XXXX [Cr]
The administrative indirect labor cost, on the other hand, is treated as period cost and is expensed in the period of incurrence. Personnel working in accounting, marketing and engineering departments are some examples of administrative indirect labor employees.
In service businesses, the cost associated with employees who don’t have a close hand in entity’s actual service delivering process is considered as indirect labor cost. For example, salaries and benefits paid to receptionist, office boy and security guard working in an attorney’s office would be treated as indirect labor cost.
Like direct labor, a significant part of total indirect labor cost consists of fringe benefits, employer’s contributions and payroll taxes etc.