CHAPTER
5
Measurement of the labor cost component (wages).
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Cost of labor
Definition: Cost of labor is the amount paid by an employer to cover an
employee’s wages and benefits, plus related payroll taxes and benefits.
Labor cost is an important value that finance and accounting professionals
calculate to determine the direct and indirect price that a company pays for labor.
The direct labor cost includes the cost of wages and benefits for employees who
are directly involved in producing the product or service commodity.
The indirect cost of labor refers to amounts paid for employees that support the
commodity but aren't directly involved in making it.
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Understanding the cost of labor helps companies price their products, and without
an understanding of direct and indirect costs, a company may find it challenging
to arrive at the right cost for its products. As a result, a deep understanding of
labor cost and how to use it is beneficial for the economy.
Cost of labor can be further broken down into fixed and variable costs:
• Fixed: Fixed costs are usually contracted costs but sometimes include essential
costs that are predictable.
• Variable: Variable costs will increase and decrease with variables like
production demand and economic conditions.
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Labor cost in manufacturing
In short, labor cost in manufacturing industry is the total amount spent on
employees by your company.
The total amount includes the salaries for hourly and salaried workers, plus
employee taxes, bonuses, and company-specific extras such as employee
compensation schemes.
Overtime, sick pay, maternity pay, and training costs all contribute, so your total
labor cost will be much more than just employees’ basic salaries.
In small-medium businesses especially, labor costs can make up a large
percentage of your overall costs.
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What’s the difference between direct and indirect costs?
There’s a significant difference between direct and indirect labor costs, and you
should consider both when measuring labor costs’ impact on your business.
Direct costs
Direct expenses are the costs associated with a specific object, such as raw
material, software, or tool used the create your company’s product or service.
If an employee uses raw materials or tools to develop your business’s product or
service, their salary is a direct labor cost example.
In manufacturing, the salaries of your engineers, production supervisors, truck
drivers, and assembly line workers are considered direct labor costs.
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Direct labor costs refer to costs that are derived directly from supply chain
employees involved in the production. This group could include assemblers,
manufacturers, heavy machinery users, fabricators, craftsmen and artisans,
delivery drivers and other logistical employees essential for getting goods into
consumers’ hands. Examples of direct labor costs include:
• The hourly salary of a quality assurance inspector is adjusted to include health
care benefits and short-term disability.
• The annual salary of a welder who works on the production line of a steel
parts manufacturing company.
• The payment made to a logistics company responsible for delivering goods
across the country.
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In each of these cases, the employee whose salary and benefits are being
accounted for plays an essential role in producing a product and distributing it
through the supply chain.
Indirect costs
Indirect labor costs include costs that are not linkable to a specific product or
service that your business offers consumers. Administrative expenses are a
common example.
The salaries of payroll staff, sales team members, administrative assistants, and
office managers are labor costs that are considered indirect.
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Indirect labor contributes to your company’s overhead, but these costs aren’t
attributed to a particular product or service because the roles relate to the entire
business. Indirect costs also include rent, insurance, depreciation, and quality
control.
While these indirect costs don’t directly contribute to the development of your
product or service, they’re necessary expenses for the successful running of
your business.
Indirect costs also include opportunity costs, which indicate the money lost
because a particular aspect of your business isn’t running as it should be.
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Let’s take a look:
Calculate the direct hourly labor rate
To calculate the direct labor hourly rate, add up all wages, taxes, and other benefit
costs for a given period. Then, divide that total by the number of hours worked in
the pay period.
To calculate your company’s direct labor hourly rate, use the following formula:
Wages + taxes + other benefits divided by number of hours worked during
the pay period
Calculate the direct labor hours
This calculation measures the number of direct labor hours it takes to produce one
unit of the product you manufacture.
To work out your direct labor hours, divide the number of units produced by the
hours it takes to create them using the following formula:
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Fixed vs. variable costs of labor
Here's a comparison of how fixed and variable labor costs are different:
Fixed labor costs
Fixed labor costs are costs that are unlikely to change for a known period. For
example, a fixed labor cost for a company would be the annual salary of an
essential production worker in a given year. While this employee could get a
pay increase, employers have a good idea of the term of the salary relative to
when increases are likely to occur.
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Variable labor costs
Variable labor costs are costs that increase and decrease with production. One
good example of a common variable labor cost is the rate of an hourly employee.
Several industries rely on variable labor, especially around the shopping
holidays. These include manufacturing companies, restaurants and retailers. To
fill the production needs in peak season, businesses will direct-hire hourly
employees or work with agencies to find temp workers.
Another example of a variable labor cost might be the cost associated
with contract workers who respond to things like equipment malfunctions and/or
emergency repairs that are critical for business functioning. These things occur
on a case-by-case basis which makes them more difficult to predict.
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Related: How To Calculate Variable Cost
Simple cost of labor formula
The following is a basic calculation that assumes the cost of benefits and
payroll taxes are rolled into the average hourly rate, or that the company
doesn't have additional benefits or payroll tax costs.
Cost of Labor = (Total sales x Percentage of labor) / Hourly average of
worker salaries
Example: If the company's total sales were $1,500,000, the percentage of the
labor equaled 12%, and the average hourly rate of labor was $12.90, we
would arrive at labor costs this way:
($1,500,000 x .12) / $12.90 = (180,000) / $12.90 = $13,953.49
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For example, assume that employees work 40 hours per week, earning $13 per hour. They
also get $100 in fringe benefits and $50 in payroll taxes. Get the sum of the benefits and
taxes (100+50) and divide the figure by 40 to get 3.75. The $3.75 is added to $13 to get an
hourly rate of $16.75.
2. Calculate the direct labor hours
The direct labor hours are the number of direct labor hours needed to produce one unit of a
product. The figure is obtained by dividing the total number of finished products by the
total number of direct labor hours needed to produce them. For example, if it takes 100
hours to produce 1,000 items, 1 hour is needed to produce 10 products and 0.1 hours to
produce 1 unit.
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3. Calculate the labor cost per unit
The labor cost per unit is obtained by multiplying the direct labor hourly rate by
the time required to complete one unit of a product. For example, if the hourly
rate is $16.75, and it takes 0.1 hours to manufacture one unit of a product, the
direct labor cost per unit equals $1.68 ($16.75 x 0.1).
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