Direct labor cost

Direct labor costs are costs that can be precisely and unambiguously attributed to a given cost object. Physical observation can be used to measure the quantity of labor used to produce a specific product or provide a service. The direct labor cost of making a product includes the cost of transforming raw materials into a product.

Examples of direct labor costs:

• Wages for supervision
• Wages for foremen
• Wages for labors who are actually engaged in operation or process

Direct labor costs in general

Costs that are assigned to cost objects can be divided into two broad categories and can be further divided into four subcategories:

• Direct costs
• Indirect costs

Both categories can be further divided into:

• Direct and indirect materials
• Direct and indirect labor costs

In this article the direct labor costs are discussed. Direct labor costs are costs that can be specifically and exclusively identified with a particular cost object.

More in detail direct labor cost is the total wages or salaries paid to direct labor personnel. Direct labor cost should include basic compensation, production efficiency bonuses, and the employer’s share of Social Security and Medicare taxes.

Identifying direct labor costs

Direct labor costs consist of chargeable hours that can be specifically identified with individual customers. To help to track direct labor costs, different methods can be used, for example, job cards and time sheets.

Job cards are a source document that records the amount of time spent on a particular task and the employee's hourly rate so that direct labor charges can be assigned to the relevant cost object.

Time sheets are source documents that record the time an employee spent on specific duties and can be used to assign direct labor costs to the proper cost object.

The role of direct labor costs on decision making

Determining the direct labor costs that are relevant to short-term decisions depends on the circumstances. When a corporation has temporary excess capacity and the labor force has to be maintained in the short term, the direct labor cost will be the same regardless of the alternative decision made. Therefore, the direct labor cost will be irrelevant for short-term decision-making.

In contrast, when casual labor is utilized and workers can be employed on a daily basis, a corporation can change the employment of labor to the exact level required to satisfy production demands. The cost of labor rises if the company takes extra work and falls if production decreases. In this case, the labor cost will be an important factor in decision-making. When total capacity exists, and additional labor supplies are not accessible soon, there is a severe labor shortage.

Challenges of direct labor costs in accounting

As with materials, some labor costs that theoretically are considered direct are treated as indirect. One reason for this treatment is that specifically tracing certain labor costs to production is inefficient. A second reason for not treating certain labor costs as direct is that doing so could result in erroneous information about product or service costs.

Examples of such costs are:

• Idle time
• Overtime premium
• Fringe benefits

Idle time means situations when there are machine break downs, material shortages or power failure. The labor costs incurred during idle time are ordinarily treated as manufacturing overhead cost rather than as a direct labor cost. Most managers feel that such costs should be spread over all the production of a period rather than just the jobs that happen to be in process when breakdown or other disruptions occur.

The overtime premium paid to all factory workers (direct labor as well as indirect labor) is usually considered to be a part of manufacturing overhead. Overtime or shift premiums are usually considered overhead rather than direct labor cost and are allocated among all units. On some occasions, however, overtime or shift premiums should be considered direct labor cost. If a customer is in a rush and requests the job to be scheduled during overtime or a night shift, those overtime or shift premiums should be considered direct labor cost and attached to the job that created the costs .

Labor fringe benefits are made up of employment-related costs paid by the employer and include the cost of insurance programs, retirement plans, various supplemental unemployment benefits, and hospitalization plans. The employer also pays employer’s share of Social Security, Medicare, workers’ commission, federal employment tax, and state unemployment insurance. Fringe benefit costs should be treated as direct labor cost, but the time, effort, and clerical expense of tracing this cost might not justify the additional accuracy such tracing would provide. Thus, the treatment of employee fringe benefits as indirect costs is often based on clerical cost efficiencies.

Examples of Direct labor cost

• Wages of production line workers: Wages paid to production line workers include salaries, hourly wages, overtime wages, and the cost of benefits. These wages are directly associated with the production of goods and services and are therefore considered direct labor costs.
• Overtime wages of workers: Overtime wages paid to workers for additional hours worked are typically considered direct labor costs. Overtime wages are based on the rate of regular wages, plus an additional amount for the extra hours worked.
• Training costs for workers: Training costs for production line workers are also considered direct labor costs. These costs include the cost of training materials, as well as the salaries of trainers and other personnel involved in the training process.
• Fringe benefits: Fringe benefits such as health insurance, vacation time, and disability insurance are typically considered direct labor costs. These benefits are typically provided to production line workers and other personnel directly involved in the production process.

Advantages of Direct labor cost

The advantages of direct labor costs include:

• Improved accuracy of cost calculation in production processes - direct labor costs are easily traceable and can be precisely measured, allowing for more accurate costing of products.
• Increased transparency of costs - direct labor costs provide a clear picture of the labor costs associated with producing a product, allowing for better decision making when it comes to cost control.
• Easier identification of areas of inefficiency - direct labor costs can be used to identify areas of inefficiency in the production process, allowing for better resource allocation and improved productivity.
• Improved quality control - direct labor costs provide an indication of the labor spent on a particular product, allowing for better quality control and improved customer satisfaction.

Limitations of Direct labor cost

Direct labor costs have several limitations. These include:

• They do not account for the cost of training and developing employees, which can be an important factor in the production process.
• They do not account for the cost of materials or equipment used in the production process.
• They do not account for the cost of supervision and management, which can be a significant factor in the production process.
• They cannot be used to measure the total cost of producing a product or service, as other cost categories such as overhead and administrative costs must also be considered.
• They are not an accurate measure of productivity, as they do not account for the time required to complete a task or the quality of work produced.

Other approaches related to Direct labor cost

Direct labor cost is a critical component of the production process that can be precisely tracked and analyzed. Other approaches to direct labor cost include:

• Standard Costing: Standard costing involves establishing a fixed cost per unit of production, and adjusting it periodically to reflect changing labor costs, cost of materials and other factors. The cost of direct labor is allocated to each product based on the number of labor hours required to produce the product.
• Activity-Based Costing: Activity-based costing is an accounting method that assigns costs to specific activities performed within the production process. It allows for the allocation of direct labor costs to the activities that are the most significant contributors to the cost of a product.
• Job Order Costing: Job order costing is a method of accumulating costs for each individual job or unit of production. Direct labor costs are allocated to each job based on the amount of labor hours required for its completion.

In summary, direct labor cost is an important component of production that can be tracked and analyzed using standard costing, activity-based costing, and job order costing. These approaches provide insight into the cost of labor and enable companies to adjust their production processes accordingly.

Footnotes

Direct labor cost — recommended articles

Direct expense — Conversion cost — Indirect labor costs — Normal cost — Indirect labor — Variable overhead efficiency variance — Productivity report — Absorbed costs — Allocated cost

=References

• Drury, C. (2017). Management and Cost Accounting. Cengage Learning.
• Jain P., Bhati A. (2015), Cost Accounting and Cost Control System in Textile Industry in India, Department of Accountancy and Business Statistics. Jaipur.
• Kinney, R., M., & A. Raiborn, C. (2011). Cost Accounting: Foundations and Evolutions, Eighth Edition. Cengage Learning.

Author: Annija Petersone