Chapter 7: Accounting for labour

Chapter learning objectives

Upon completion of this chapter you will be able to:

  • calculate direct and indirect costs of labour
  • explain the methods used to relate input labour costs to work done
  • prepare the journal and ledger entries to record labour costs inputs and outputs, and interpret entries in the labour account
  • describe different remuneration methods: time-based systems; piecework systems; individual incentive schemes; group incentive schemes
  • calculate the level, and analyse the costs and causes of labour turnover
  • explain and calculate labour efficiency, capacity and production volume ratios.

1 Direct and indirect labour

Direct and indirect labour costs

Labour is often one of the major expenses of a business. One of the most important distinctions of labour is between direct and indirect costs.

  • Direct labour costs make up part of the prime cost of a product and include the basic pay of direct workers.
  • Direct workers are those employees who are directly involved in making an organisation's products.
  • Indirect labour costs make up part of the overheads (indirect costs) and include the basic pay of indirect workers.
  • Indirect workers are those employees who are not directly involved in making products, (for example, maintenance staff, factory supervisors and canteen staff.
  • Indirect labour costs also include the following.
    • Bonus payments.
    • Benefit contributions.
    • Idle time (when workers are paid but are not making any products, for example when a machine breaks down).
    • Sick pay.
    • Time spent by direct workers doing 'indirect jobs' for example, cleaning or repairing machines.

Overtime and overtime premiums

When employees work overtime, they receive a basic pay element and an overtime premium.

  • For example, if Fred is paid $8 per hour and overtime is paid at time and a half, when Fred works overtime, he will receive $12 per hour ($8 + $4 (50% x $8)). It is important that his pay is analysed into direct and indirect labour costs.
  • Overtime premiums are treated as direct labour costs, if at the specific request of a customer because they want a job to be finished as soon as possible.
  • Employees who work night shifts, or other anti-social hours may be entitled to a shift allowance or shift premium. Shift premiums are similar to overtime premiums where the extra amount paid above the basic rate is treated as an indirect labour cost.

 Illustration 1 – Direct and indirect labour

Vienna is a direct labour employee who works a standard 35 hoursper week and is paid a basic rate of $12 per hour. Overtime is paid attime and a third. In week 8 she worked 42 hours and received a $50bonus. Complete the following table.



(1) Basic pay for standard hours = 35 hours × $12 per hour = $420

Basic pay for standard hours is a direct labour cost because the work involved is directly attributable to production.

(2) Basic pay for overtime hours = 7 hours × $12 = $84

This is also a direct labour cost because the basic rate for overtime is part of the direct labour cost. It is the overtime premium which is usually part of the indirect labour cost.

(3) Overtime premium = 1/3 of $12 = $4

Total overtime premium = 7 hours × $4 = $28

Unless overtime is worked at the specific request of a customer, overtime premium is part of the indirect labour costs of an organisation.

 Test your understanding 1

A company operates a factory which employed 40 direct workersthroughout the four-week period just ended. Direct employees were paidat a basic rate of $4.00 per hour for a 38-hour week. Total hours of thedirect workers in the four-week period were 6,528. Overtime, which ispaid at a premium of 35%, is worked in order to meet general productionrequirements. Employee deductions total 30% of gross wages. 188 hours ofdirect workers' time were registered as idle.

Calculate the following for the four-week period just ended.

2 Calculating labour in products and services

Determining time spent doing jobs

Methods can include:

  • time sheets
  • time cards
  • job sheets.

Time records

Time records

It is essential that organisations employ relevant methods in bothmanufacturing and service industries to relate the labour costs incurredto the work done. One of the ways in which this can be done is to makerecords of the time spent by employees doing jobs.

  • Time recording is required both for payment purposes and also for determining the costs to be charged to specific jobs.
  • In manufacturing industries both direct and indirect workers will be supplied with an attendance record on which to record their time of arrival and departure from the factory. Such records are known as time cards (gate or clockcards) and are used to calculate wages and rates of pay.
  • The most sophisticated time recorders use plastic 'swipe' cards which are directly linked to a central computer.

Activity time records

Another method of relating work done to costs incurred is by theuse of activity time records. Activity time records may be either periodrelated or time related.

  • Period-related timesheets are commonly used in service industries, for example in accountancy firms where time spent working for different clients is analysed, often to the nearest 15 minutes.
  • Period-related timesheets are records that may cover days, weeks or sometimes longer periods.
  • Task-related activity time records are known as job sheets, operations charts or piecework tickets. They are generally more accurate and reliable than time-related activity time records, and are essential when incentive schemes are in use.

An example of a daily timesheet is illustrated below.

Payroll department

The payroll department is involved in carrying out functions that relate input labour costs to the work done.

  • Preparation of the payroll involves calculating gross wages from time and activity records.
  • The payroll department also calculates net wages after deductions from payroll.
  • The payroll department also carries out an analysis of direct wages, indirect wages, and cash required for payment.

3 Accounting for labour costs

Labour costs are an expense and are recorded in an organisation'sincome statement. Accounting transactions relating to labour arerecorded in the labour account.

  • The labour account is debited with the labour costs incurred by an organisation. The total labour costs are then analysed into direct and indirect labour costs.
  • Direct labour costs are credited from the labour account and debited in the work-in-progress (WIP) account. Remember, direct labour costs are directly involved in production and are therefore transferred to WIP before being transferred to finished goods and then cost of sales.
  • Indirect labour costs are also credited 'out of' the labour account and debited to the production overheads account. It is important that total labour costs are analysed into their direct and indirect elements.

 Illustration 2 – Accounting for labour costs

(1) Labour costs incurred are paid out of the bank before they are analysed further in the labour account.

(2) The majority of the labour costsincurred by a manufacturing organisation are in respect of direct labourcosts. Direct labour costs are directly involved in production and aretransferred out of the labour account via a credit entry to the WIPaccount as shown above.

(3) Indirect labour costs includeindirect labour (costs of indirect labour workers), overtime premium(unless overtime is worked at the specific request of a customer), shiftpremium, sick pay and idle time. All of these indirect labour costs arecollected in the production overheads account. They are transferredthere via a credit entry out of the labour account and then debited inthe production overheads account.

 Test your understanding 2

The following information is taken from the payroll records of a company.


Using the information given, complete the labour account shown below.

4 Remuneration methods

There are two basic approaches to remuneration, time-related oroutput-related. The two basic methods are time-based and pieceworksystems.

Time-based systems

We looked at time-based systems, the most common remuneration method, at the beginning of this chapter.

  • Employees are paid a basic rate per hour, day, week or month.
  • Basic time-based systems do not provide any incentive for employees to improve productivity and close supervision is often necessary.
  • The basic formula for a time-based system is as follows.
Total wages = (hours worked x basic rate of pay per hour) + (overtime hours worked x overtime premium per hour)

Piecework systems

A piecework system pays a fixed amount per unit produced. The basic formula for a piecework system is as follows.

Total wages = (units produced x rate of pay per unit)

Types of piecework system

There are two main piecework systems that you need to know about:

  • Straight piecework systems – these systems are almost extinct today as employees are more likely to be paid a guaranteed minimum wage within a straight piecework system. A variation on the straight piecework system is the differential piecework system.
  • Differential piecework systems – these systems are the most widely used piecework systems and involve different piece rates for different levels of production.

 Illustration 3 – Piecework schemes

A company operates a piecework system of remuneration, but alsoguarantees its employees 75% of a time-based rate of pay which is basedon $19 per hour for an eight hour working day. Three minutes is thestandard time allowed per unit of output. Piecework is paid at the rateof $18 per standard hour.

If an employee produces 200 units in eight hours on a particular day, what is the employee gross pay for that day?

A $114

B $152

C $180

D $190



200 units x standard time of 3 minutes per unit = 600 minutes, or 10 hours.

Employee gross pay = 10 hours x $18 = $180

Guaranteed ($19 x 8 hours) x 75% = $152 x 75% = $114

As gross pay exceeds the guaranteed amount, the answer is $180.

 Test your understanding 3

The following graph shows the wages earned by an employee during a single day.

Which one of the following remuneration systems does the graph represent?

A Differential piecework

B A flat rate per hour with a premium for overtime working

C Straight piecework

D Piecework with a guaranteed minimum daily wage

Incentive schemes

Incentive schemes can be aimed at individuals and/or groups.

  • Many different systems exist in practice for calculating bonus schemes. General rules are as follows:
    • They should be closely related to the effort expended by employees.
    • They should be agreed by employers/employees before being implemented.
    • They should be easy to understand and simple to operate.
    • They must be beneficial to all of those employees taking part in the scheme.
  • Most bonus schemes pay a basic time rate, plus a portion of the time saved as compared to some agreed allowed time. These bonus schemes are known premium bonus plans. Examples of such schemes are Halsey and Rowan.
  • Halsey – the employee receives 50% of the time saved.

  • Rowan – the proportion paid to the employee is based on the ratio of time taken to time allowed.

  • Measured day work – the concept of this approach is to pay a high time rate, but this rate is based on an analysis of past performance. Initially, work measurement is used to calculate the allowed time per unit. This allowed time is compared to the time actually taken in the past by the employee, and if this is better than the allowed time an incentive is agreed, e.g. suppose the allowed time is 1 hour per unit and that the average time taken by an employee over the last three months is 50 minutes. If the normal rate is $12/hour, then an agreed incentive rate of (say) $14/hour could be used.
  • Share of production – share of production plans are based on acceptance by both management and labour representatives of a constant share of value added for payroll. Thus, any gains in value added – whether by improved production performance or cost savings – are shared by employees in this ratio.

 Illustration 4 – Remuneration methods

The following data relate to Job A.

The employee is paid the basic rate for the allowed time for the job and then the bonus based on any time saved.



Additional test your understanding

Ten employees work as a group. When production of the group exceedsthe standard – 200 pieces per hour – each employee in the group ispaid a bonus for the excess production in addition to wages at hourlyrates.

The bonus is computed thus: the percentage of production in excessof the standard quantity is found, and one half of the percentage isregarded as the employees' share. Each employee in the group is paid as abonus this percentage of a wage rate of $5.20 per hour. There is norelationship between the individual worker's hourly rate and the bonusrate.

The following is one week's record:

During this week, Jones worked 42 hours and was paid $3 per hour basic.

Complete the following.



5 Labour turnover

In an examination you will be given clear instructions on any bonusscheme in operation. You should follow the instructions given carefullyin order to calculate the bonus payable from the data supplied.

Labour turnover is a measure of the proportion of people leaving relative to the average number of people employed.

  • Management might wish to monitor labour turnover, so that control measures might be considered if the rate of turnover seems too high, and the business is losing experienced and valuable staff at too fast a rate.
  • Labour turnover is calculated for any given period of time using the following formula:

 Illustration 5 – Labour turnover

At 1 January a company employed 3,641 employees and at 31 Decemberemployee numbers were 3,735. During the year 624 employees chose toleave the company. What was the labour turnover rate for the year?


Labour turnover rate =

Average number of employees in the year = (3,641 + 3,735) ÷ 2 = 3,688.

 Test your understanding 4

A company had 4,000 staff at the beginning of 20X8. During theyear, there was a major restructuring of the company and 1,500 staffwere made redundant and 400 staff left the company to work for one ofthe company's main competitors. 400 new staff joined the company in theyear to replace those who went to work for the competitor.


Calculate the labour turnover rate for 20X8.

Causes and costs of labour turnover


It is important to try to identify why people leave an organisationand to distinguish between avoidable and unavoidable causes of labourturnover.

  • Causes of labour turnover – avoidable:
    • poor remuneration
    • poor working conditions
    • lack of training opportunities
    • lack of promotion prospects
    • bullying in the workplace.
  • Causes of labour turnover – unavoidable:
    • retirement
    • illness/death
    • family reasons (e.g. pregnancy)
    • relocation.
  • Efficient managers will investigate high levels of labour turnover and aim to keep that turnover rate at a minimum.


Every time an employee leaves, an organisation will incur coststhat are associated with replacing the employee. These costs are knownas replacement costs.

  • Replacement costs include the following:
    • advertising costs
    • cost of selection (time spent interviewing etc.)
    • training new employees
    • reduced efficiency until the new employee reaches the required skill.
  • A high labour turnover rate tends to lower the performance of employees who remain in the organisation. Such employees may become restless and resentful of the extra burden of training new members and of additional temporary duties imposed upon them.
  • In order to keep the labour turnover rate to a minimum, organisations should aim to prevent employees from leaving. Such preventive measures come with their own costs, known as preventive costs.
  • Preventive costs include the costs associated with escaping the avoidable causes of labour turnover:
    • pay competitive wages and salaries if remuneration is poor
    • improve poor working conditions
    • offer good training opportunities
    • make sure promotion prospects arise as necessary.
    • stamp out bullying in the workplace
    • investigate high labour turnover rates objectively.

6 Labour efficiency, capacity and production volume ratios

Labour efficiency ratio

Labour is a significant cost in many organisations and it isimportant to continually measure the efficiency of labour againstpre-set targets.

  • The labour efficiency ratio measures the performance of the workforce by comparing the actual time taken to do a job with the expected time.
  • The labour efficiency ratio is calculated using the following formula:

Idle time ratio

Sometimes the workforce is 'idle' through no fault of its own, andcannot get on with productive work. This happens if machines break down,or need to be reset for a new production run. An idle time ratio can becalculated as follows:

Labour capacity ratio

The labour capacity ratio measures the number of hours spentactively working as a percentage of the total hours available for work(full capacity or budgeted hours). The labour capacity ratio iscalculated using the following formula:

Labour production volume ratio ('activity' ratio)

  • The labour production volume ratio compares the number of hours expected to be worked to produce actual output with the total hours available for work (full capacity or budgeted hours).
  • The labour production volume ratio is calculated using the following formula:


Labour efficiency, capacity and production volume ratios

Standard hours

A standard hour is the number of production units which should be achieved by an experienced worker within a period of one hour.

Expected hours to make actual output = 840 units x 0.5 hours per unit = 420 standard hours

Standard (std) hours are therefore the expected hours to make actual output.

Labour efficiency ratio:

Labour capacity ratio:

Production volume ratio:

 Test your understanding 5

A company budgets to make 40,000 units of Product DOY in 4,000 hours (each unit is budgeted to take 0.1 hours each) in a year.

Actual output during the year was 38,000 units which took 4,180 hours to make.


Calculate the labour efficiency, capacity and production volume ratios.

 Test your understanding 6

Which one of the following should be classified as direct labour?

A Supervisors' salaries in a factory

B Maintenance workers looking after equipment in a hospital

C Bricklayers in a house building company

D Wages of cleaning and housekeeping personnel

7 Chapter summary

Test your understanding answers

 Test your understanding 1


 Test your understanding 2

 Test your understanding 3

D The graph represents a pieceworksystem (as shown by the gentle upward-sloping line) with a guaranteedminimum daily wage (as shown by the horizontal line).

 Test your understanding 4

Number of staff at beginning of year = 4,000

Number of staff at end of year = 4,000 – 1,500 – 400 + 400 = 2,500

Labour turnover rate =

 Test your understanding 5

Expected hours to produce output = 38,000 x 0.1 hours = 3,800 standard hours.

Labour efficiency ratio:

Labour capacity ratio:

Production volume ratio:

[Expected hours to produce actual output (std hours) ÷ Total hours available (budgeted)] x 100%

 Test your understanding 6


Created at 5/24/2012 5:07 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
Last modified at 5/25/2012 12:53 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London

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