Labour costs

Labour costs

As part of a costing exercise a firm may need to determine the labour cost of a product or unit. This page looks at how labour costs are calculated in practice.

Direct and indirect labour

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.
  • Calculating labour in products and services

    Determining time spent doing jobs

    Methods can include:

    • time sheets
    • time cards
    • job sheets.

    Time records

    It is essential that organisations employ relevant methods in both manufacturing and service industries to relate the labour costs incurred to the work done. One of the ways in which this can be done is to make records 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 clock cards) 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 the use of activity time records. Activity time records may be either period related or time related.

    • Period-related time sheets 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 time sheets 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 time sheet 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.

    Accounting for labour costs

    Labour costs are an expense and are recorded in an organisation's income statement. Accounting transactions relating to labour are recorded 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.

Remuneration methods

There are two basic approaches to remuneration, time-related or output-related. The two basic methods are time-based and piecework systems.

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.

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.

Further detail and related topics

Further detail on labour ratios can be found here.

Created at 6/28/2012 10:14 AM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
Last modified at 11/14/2012 11:43 AM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London

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