Direct Labor Cost | 4 mins read

Lifting the Veil on Direct Labor Costs

lifting the veil on direct labor costs
Lauren Christiansen

By Lauren Christiansen

Budgeting is one of the most difficult and meticulous tasks for a small business owner. While it's important to have enough money to maintain and streamline operations, it's also imperative not to overspend.

Many businesses have made inaccurate and unrealistic assumptions about how operations will run, which caused their budgets to collapse once implemented. Recognizing all of the various factors that can impact a budget is an essential requirement of running a company.

Because labor costs make up such a large percentage of revenue, it's critical to know how to plan for these expenses in advance. It requires understanding all of the direct and indirect costs associated with labor, along with various formulas used to calculate cost per unit or hour.

  • 61% of small companies don't create a budget
  • Out of this group, 74% of companies with only 1-10 employees didn't create a budget
  • Experts say that 30% of business income should be spent on expenses
  • It's essential to consider all variable and fixed costs when budgeting

What is Direct Labor Cost?

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The direct cost of labor includes the total cost of salaries and/or hourly wages paid to employees who are involved in the production process.

All direct labor costs include payments to employees who work on a certain project or business activity that has to do with producing a product. For service-oriented companies, direct costs include any employee work that offers service to clients.

When performing calculations to monitor the costs of business activity, it's essential to include direct labor expenses because they constitute a large part of the activity.

To calculate direct labor expenses, business owners should list regular hours worked and any overtime hours for each employee. They should also write down the total amount of payroll taxes, health insurance payments, worker's compensation, and any other taxes or fees.

If a business has a pension plan, it should list its contribution for each worker involved in direct labor. Onboarding costs are sometimes included in direct labor expenses, depending on the type of organization.

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Types of Formulas

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There are various formulas used to calculate direct labor hours and expenses. Performing these calculations can assist in the accuracy of budgeting, pricing sales items, and managing cash flow. The most common formulas include -

1. Direct Hourly Rate- The total wages or hourly pay plus benefits and taxes divided by hours worked in a particular pay period. This shows an organization exactly how much each worker costs per hour.

Direct Hourly Rate = Wages + Benefits + Taxes / Hours Worked

2. Direct Labor Hours- This formula demonstrates how many hours are required to manufacture one product or service.

Direct Labor Hours = Total Number of Finished Goods / Total Direct Labor Hours

3. Labor Cost Per Unit- This formula shows how much it costs in labor to produce each unit of an item.

Labor CostPer Unit = Direct Labor Hourly Rate x Time to Finish One Unit

4. Standard vs. Actual Labor Cost- This formula determines whether there is too much money spent on manufacturing one unit of an item.

Variance = Actual Direct Labor Cost/Unit Direct Labor Standard Cost Per Unit

  • Unit labor cost refers to the amount of employee expenses required to produce one single product or service. Knowing the unit labor cost can assist in analyzing how sales levels impact profits, which may alter the way a manufacturer operates the production process.
  • Unit labor cost is also a term used in economics to compare productivity levels and the economy.
  • Unit labor cost is calculated by a specific time frame, such as a week, month, or payroll period.

Indirect vs. Direct Labor Costs

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It can be confusing to know exactly what constitutes a direct labor expense. For example, raw materials are included in production costs even though these materials are used by direct laborers to produce a product/service.

Overhead expenses like training costs are sometimes included in direct expenses, but other companies keep them separate. Understanding how direct and indirect expenses differ can assist in accurately performing calculations and managing budgets.

Direct labor expenses will always relate to an employee that helps to produce a product or service. Indirect labor costs are critical to producing items but are not directly related to manufacturing. Examples of indirect workers include those in the accounting department, quality control, customer service, or security. Direct workers include assembly line employees, painters, machinists, and welders.

It's also important to note that an employee may be considered direct labor in one company and indirect labor in another. For example, an accountant at a manufacturing plant is indirect labor because he/she isn't producing goods, but an accountant at a law firm offering consultations to customers is a form of direct labor. The title of the job isn't the determining factor of whether an employee is part of indirect or direct labor, the type of business is.

It is imperative to track both indirect and direct labor costs to know exactly how much the company is spending. Understanding these expenses will optimize the budgeting process and improve financial decision-making so owners can increase the bottom line and widen profit margins.

Key Takeaways

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In conclusion, here are the key takeaways to remember about direct labor costs

  • The direct cost of labor includes all of the wages, payroll taxes, and benefits paid to workers who are directly related to producing a product or service.
  • Formulas that help to drill down into total labor costs include the direct hourly rate formula, direct labor hour formula, labor cost per unit formula, and the standard vs. actual labor cost formula.
  • Understanding and calculating direct labor costs will optimize budgeting, cash flow management, and sales item pricing.
  • Indirect labor costs are anything unrelated to producing a product or service. Examples include accountants, security personnel, and quality control workers. Direct labor expenses must be directly related to producing an item in manufacturing or offering a service to customers (in non-manufacturing companies).

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