by Direct labor cost is wages that are incurred in order to produce goods or provide services to customers. The total amount of direct labor cost is much more than wages paid. It also includes the payroll taxes associated with those wages, plus the cost of company-paid medical insurance, life insurance, workers’ compensation insurance, any company-matched pension contributions, and other company benefits.
Direct labor costs are most commonly associated with products in a job costing environment, where the production staff is expected to record the time they spend working on various jobs. This can be a substantial chore if employees work on a multitude of different products. In the services industries, such as auditing, tax preparation, and consulting, employees are expected to track their hours by job, so their employer can bill customers based on direct labor hours worked. These are also considered to be direct labor costs. In a process costing environment, where the same product is created in very large quantities, direct labor cost is included in a general pool of conversion costs, which are then allocated equally to all of the products manufactured.
A strong case can be made in some production environments that direct labor does not really exist, and should be categorized as indirect labor, because production employees will not be sent home (and therefore not be paid) if one less unit of product is manufactured – instead, direct labor hours tend to be incurred at the same steady rate, irrespective of production volume levels, and so should be considered part of the general overhead costs associated with running a production operation.
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:
- 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.
- 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.
- Calculate the labor cost per unitThe 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).
- 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.
