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Direct Labor

The wages paid to workers who are directly involved in the manufacture of a specific product or in performing a service

What is Direct Labor?

Direct labor refers to the salaries and wages paid to workers who are directly involved in the manufacture of a specific product or in performing a service. The work performed must be related to the specific task. For a business that provides services to its customers, direct labor is the work performed by the workers who provide the service directly to the customers such as store workers, lawyers, and consultants.

 

Direct Labor

 

If the work performed cannot be connected to a specific employee, then the wages paid are considered indirect. When tracking the total cost incurred in a specific project, the direct labor cost must be added to the total cost since it constitutes a significant portion of a company’s expenses.

 

Quick Summary

  • Direct labor refers to the salaries and wages paid to workers that can be directly attributed to specific finished products.
  • It includes the cost of regular working hours, overtime hours worked, payroll taxes, unemployment tax, Medicare, employment insurance, etc.
  • Direct labor can be used to allocate overheads to the production process.

 

How to Measure Direct Labor

Direct labor comprises the cost of regular working hours, as well as the overtime hours worked. It also includes related payroll taxes and expenses such as social security, Medicare, unemployment tax, and worker’s employment insurance. Companies should also include pension plan contributions, as well as health insurance-related expenses. Some companies may include employee training and development costs that were incurred in the course of employment.

When measuring direct labor cost, the company must include every cost item that is incurred in keeping and hiring employees. Apart from what the company pays the employees, it must make consideration on the extent to which retaining an employee impacts its payroll tax contribution, insurance premiums, and benefits costs.

Most companies establish a standard rate that gives an estimate of what they expect to be the direct labor cost in normal conditions. For example, assume that the direct labor cost per hour for assembling baby car seats is $10, and the company expects to use 0.5 hours for the assembly of each car seat. If the company produces 1,000 units, the standard direct labor cost will be $5,000 ($10 x 0.5 x 1,000).

 

Using Direct Cost to Allocate Overheads

GAAP rules provide that companies may use direct labor as a cost driver to allocate overhead expenses to the production process. Overhead costs refer to indirect costs that cannot be connected to a specific final product. However, such costs are required in the production process of goods, and must, therefore, be added to the overall cost of the product. The costs are allocated to the final product using a cost driver.

The easiest way to calculate the cost driver is to divide the total overhead costs by the direct labor costs. Direct labor can be broken down further to the number of employees required to manufacture a specific product or the number of employee-hours utilized per unit of production. For example, if the ratio of overhead costs to direct labor hours is $35 per hour, the company would allocate $35 of overhead costs per direct labor hour to the production output.

 

How to Calculate Direct Labor Cost per Unit

The amount incurred as direct labor cost depends on how efficiently the workers produced finished items. Usually, companies calculate a standard direct labor cost against which to compare their actual direct labor costs. Here is how to calculate direct labor cost per unit of production:

 

1. Calculate the direct labor hourly rate

First, calculate the direct labor hourly rate that factors in the fringe benefits, hourly pay rate, and employee payroll taxes. The hourly rate is obtained by dividing the value of fringe benefits and payroll taxes by the number of hours worked in the specific payroll period.

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, it means that 1 hour is needed to produce 10 products, and 0.1 hours to produce 1 unit.

 

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).

 

4. Calculate the variance between the standard and actual labor cost

The variance is obtained by calculating the difference between the direct labor standard cost per unit and the actual direct labor cost per unit. If the actual direct labor cost per unit is higher than the standard direct labor cost per unit, it means that the company incurs more to produce one unit of a product than is expected, making the cost unfavorable to the business. If the actual direct labor cost is lower, it means that it costs lower to produce one unit of a product than the standard direct labor rate, and therefore, favorable.

 

Related Readings

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Cost of Goods Manufactured (COGM)
  • Fixed and Variable Costs
  • Labor Force KPIs
  • Project Finance – A Primer

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