Notes by Idrees Safi

MA1, Chapter 3

In this Chapter:
1. Labor Cost
2. Direct Labor Costs
3. Indirect Labor Costs
4. Methods of Payment
5. Change in Remuneration Method
6. Labor Payroll
7. Labor Documentation
8. Labor Cost Bookeeping

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 Labor
Cost
Direct Indirect

Labor Cost
Labor Cost Labor Cost

Direct Labor Indirect Labor

Basic Pay Basic Pay

Labor cost refers to the total expense a company incurs to Direct Labor Indirect Labor

pay its employees. It’s broadly classified into two categories: Over Time Overtime

Direct Labor Over Direct Labor Over

Time Primium Time Premium
(Specific) (Genral)

1. Direct Labor Cost Idel Time

2. Indirect Labor Cost Bounus

Traning,
Allowances, Sick
Pay....

Direct Labor Costs

Direct labor costs are the wages paid to employees who are directly involved in the production
process. These employees work on manufacturing a specific product or providing a specific service,
and their work can be traced directly to a particular product or job.

1. Direct Labor Basic Pay

This is the base wage or salary paid to workers who are directly involved in the production or
assembly of a product or the delivery of a service.

Example: A worker assembling smartphones in a factory earns $15/hour. This wage is a direct labor
cost because it directly relates to the production of the smartphones.

2. Direct Labor Overtime

When production workers work beyond their regular hours, they are often paid overtime, which is
usually at a higher rate (such as 1.5x or 2x the regular hourly wage).

Example: If the smartphone assembly worker works an additional 10 hours in a week at an overtime
rate of $22/hour, this overtime pay is still a direct labor cost since the worker is still directly involved
in making the product.

3. Direct Labor Overtime Premium (Specific)

This is an extra amount paid to direct labor workers for working overtime on a specific job or high-
priority project.

Example: If the smartphone company has a rush order and pays an additional $5/hour for overtime
on this specific order, this premium cost is a direct labor cost.

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Indirect Labor Costs
Indirect labor costs are wages paid to employees who are not directly involved in the production of
goods or services but whose work supports the production process. These costs cannot be easily
traced to a specific product or job but are still necessary for the production process to run smoothly.

1. Indirect Labor Basic Pay

This is the wage or salary paid to employees who are not directly producing the goods but are
involved in supporting roles like supervision, maintenance, or quality control.

Example: A quality control supervisor earning $20/hour inspects products but doesn’t actually make
them. Their salary is an indirect labor cost because it supports production but cannot be traced to a
specific unit.

2. Indirect Labor Overtime

This is overtime pay for employees in indirect roles, such as maintenance or supervisory staff, who
work beyond their regular hours.

Example: A supervisor working extra hours to oversee production earns an overtime rate of
$30/hour. This cost is indirect because the supervisor’s work affects the whole production process,
not specific products.

3. Direct Labor Overtime Premium (General)

This refers to an overtime premium paid to workers for general overtime work, not linked to any
specific project or product. Since this premium applies generally and cannot be traced in a unit of
production, it classified as an indirect cost.

Example: Workers are paid an extra $3/hour for general overtime work across the factory, not
related to any particular product. This premium cannot be traced to a specific product, so it’s
considered indirect.

4. Idle Time

Idle time refers to the period when workers are paid but not producing anything due to factors like
machine breakdowns, power outages, or delays in material supply.

Example: If workers in a factory are paid for 2 hours of idle time while machines are down, this
payment does not contribute directly to any product, making it an indirect cost.

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5. Bonus

Bonuses are additional payments made to employees based on

overall performance, profit-sharing, or the success of the company. Bonus
These payments are made to all employees (Group Bonus) or
individually. Individual
Group (Premium Bonus)

For inividuals who

For all employees
Calculation of Premium Bonus: like Eid Bonus,..
show extra
efficiency.

1. Time Allowed – Time Taken = Time Saved

2. Bonus = Time Saved × Basic Rate/hr × Percentage of Bonus

Methods of Payment

Methods of Payment

Fixed Pay Hourly Pay Piecework Pay

Employees are Payment is based Pay is based on the number

paid a fixed on the number of of units or pieces an
amount regardless hours worked. The employee produces.
of hours worked or more hours an
output. This could employee works,
be a monthly or the more they
yearly salary. earn. Minimum
Stright Line (Rate) Differencial
Guranted

Employees are Employees are

Employees are paid different assured a
paid a set amount rates depending minimum level of
for each unit on the level of pay even if their
produced, production, often output is low,
regardless of how with higher rates ensuring some
many units. for increased level of financial
output security.

Fixed Pay
Employees are paid a fixed amount regardless of hours worked or output. This could be a monthly or
yearly salary.

Example: A manager earning $50,000 annually regardless of how many hours they work.

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Hourly Pay
Payment is based on the number of hours worked. The more hours an employee works, the more
they earn.

Example: A retail worker earning $15 per hour and working 40 hours a week would make $600.

Piecework Pay
Pay is based on the number of units or pieces an employee produces.

Under Piecework Pay:

Straight Line (Rate)

Employees are paid a set amount for each unit produced, regardless of how many units.

Example: A baker getting $1 for each loaf of bread produced.

Differential

Employees are paid different rates depending on the level of production, often with higher rates for
increased output.

Example: A worker earning $1 per item for the first 50 items, and $1.50 for every item after that.

Minimum Guaranteed

Employees are assured a minimum level of pay even if their output is low, ensuring some level of
financial security.

Example: A worker earning $500 per week regardless of how many units they produce, but with the
potential to earn more based on output.

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Costs:
Fixed Cost:

Fixed Pay: The cost remains constant regardless of hours worked or output (e.g., salaries).

Variable Cost:

Hourly Pay: The cost fluctuates based on the number of hours worked.

Piecework Pay (Straight Line): The cost depends on the number of units produced.

Semi-variable Cost:

Piecework Pay (Differential): The cost is partly fixed (base rate) and varies based on production
levels.

Piecework Pay (Minimum Guaranteed): A fixed minimum cost, but additional payments vary with
output.

Change in Remuneration Method

Steps:

1. Calculate the current cost per unit:

This means finding out how much it costs to produce one unit of a product or service with the
current method of paying employees (e.g., hourly, salary, or piece-rate).

Example: Let's say workers are currently paid hourly. If they make 10 units in an hour and the wage
is $20 per hour, then the current cost per unit would be:

Howerly wage 20
Cost per unit = = =2
Units produced∈ an hour 10
So, the current cost per unit is $2 per unit.

2. Calculate the revised cost per unit:

This step involves recalculating the cost per unit if you change the remuneration method (for
example, moving from hourly pay to piece-rate pay).

Example: Now, suppose you switch from hourly pay to a piece-rate system, where each worker is
paid $1.80 per unit they produce. The revised cost per unit is directly the payment per unit:

Revised cost per unit = 1.80

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So, the revised cost per unit is $1.80.

3. Determine the difference:

In this step, you compare the current cost per unit with the revised cost per unit to see if the cost
has increased or decreased.

Difference} = Current cost per unit - Revised cost per unit

If the difference is positive, the cost per unit has decreased (saving money).

If the difference is negative, the cost per unit has increased (costing more).

Example:

Difference = 2.00 - 1.80 = 0.20

In this case, the cost per unit has decreased by $0.20, meaning the new payment system is
cheaper.

Further Considerations:

If productivity increases: For instance, if switching to a piece-rate system motivates workers to

produce more units per hour, the cost savings could be even greater.

Example: If workers now produce 12 units per hour instead of 10, the cost per unit under the new
system would remain the same ($1.80 per unit), but the company would benefit from higher output.

If productivity decreases: However, if the new system results in lower productivity (e.g., fewer units
produced because workers feel demotivated by the new system), this could lead to higher costs.

Labor Payroll
Gross to Net Pay (Employee's Pay)
This is how we calculate the amount of money an employee takes home after deductions.

1. Basic Pay: This is the employee's fixed salary or wage.

2. Overtime Pay: This is any extra payment for working beyond normal hours.

3. Bonus: Additional compensation, typically performance-related or incentive-based.

4. Gross Pay: This is the total of Basic Pay, Overtime Pay, and Bonus before any deductions.

Gross Pay = Basic Pay + Overtime Pay + Bonus

Next, we subtract the deductions to arrive at the Net Pay.

5. Deductions: These include taxes, contributions, and other subtractions:

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PAYE (Income Tax): Income tax deducted from the employee's gross pay.

Employee’s Benefit Contribution: Payments for benefits (like health insurance) that employees
contribute towards.

Employee’s Pension Contribution: Employee’s contribution to a pension plan.

Charitable Donation: Voluntary contributions to charity (if applicable).

Employee’s National Insurance Contributions (NICs): Contributions to social security.

6. Net Pay: The final amount paid to the employee after all deductions are subtracted from the gross
pay (the amount the employee takes home).

Net Pay = Gross Pay - Total Deductions

Cost to Employers (Total Labor Cost)

This section outlines what it costs the employer in total to employ someone. It includes the gross pay
and any additional contributions made by the employer.

1. Gross Pay: This is the same as in the first section, the total amount before deductions.

2. Employer Benefit Contribution: The amount the employer contributes to employee benefits, such
as health insurance.

3. Employer Pension Contribution: The amount the employer contributes to the employee’s pension
plan.

4. Employer's National Insurance Contributions (NICs): The amount the employer must contribute
to social security or similar programs.

5. Employer’s Labor Cost: This is the total cost to the employer for having the employee, including
all their contributions.

Employer’s Labor Cost = Gross Pay + Employer's Contributions

Labor Documentation
Attendance Sheet: It records In and Out.

Time Sheet: It records how an employee spend his time at work.

Clock Card: When workers are paid at hourly rate.

Job Card: It records employee’s time on a particular job.

Piecework Ticket: When workers are paid at number of units basis.

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Labor Costs Bookeeping
DR CR
Opening Balance XXX

*(Direct Labors)
Work in progress/Finish
goods/Production account XXX

*(Indirect Labor)
Overheads XXX

Wages Payable/Cash XXX

*(Direct Labor + Indirect Labor)

Closing Balance XXX