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. Additionally, if a company’s operations are relatively stable, direct labor cost should include all employer- paid insurance costs, holiday and vacation pay, and pension and other retirement benefits.

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 will rise if the company takes extra work and fall if production decreases. In this circumstance, 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.

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