Labor is the cost of paying your employees. This cost includes all employee-related expenses, such as payroll taxes, sick time and vacation time, and any other benefits they may receive. Regardless of the type of business you own, if you have employees, you have labor costs.
However, calculating labor costs isn’t enough. In order to get a clearer picture of your business health, you should be calculating both direct and indirect labor. There are numerous reasons these two labor costs need to be calculated accurately:
- Ability to measure worker productivity: Tracking direct labor costs will help you to determine how efficiently your employees are working and how quickly they are able to produce a product.
- More accurate product pricing: Both direct and indirect labor costs should play a starring role in determining accurate product pricing. That’s why it’s vital that both direct and indirect costs are factored into any final pricing decisions.
- Product profitability levels: If you only manufacture a single product, you can easily tell whether that product is profitable. However, for businesses that manufacture more than one product, both direct and indirect labor costs can play a significant role in determining individual product profitability.
- Financial statement accuracy: Financial statements are essential in order to understand your current fiscal status. But running a balance sheet or income statement doesn’t yield any new insights if the information contained in the statements is inaccurate.
Tracking both direct and indirect labor costs is important for all business owners, particularly those that manufacture products. The good news for you or your bookkeeper is that if you’re using accounting software, much of the heavy lifting is done for you.
What is direct labor?
Direct labor refers to any employee that is directly involved in the manufacturing of a product. If your business manufactures bicycles, the employees producing the bicycles are considered direct labor.
Assemblers, welders, painters, and machinists would all be considered direct labor. Direct labor costs are always variable costs, as they will rise and fall with production costs.
Direct labor costs are the expenses incurred by paying the wages of your direct labor employees. For example, if you work for an automobile manufacturer and your job is to paint the cars as they are completed, your salary would be considered a direct labor cost.
It’s important to keep direct labor costs separate from other labor costs, since you’ll need to have access to these costs in order to accurately calculate total production costs.
Service businesses aren’t off the hook for calculating direct and indirect labor, though.
If you have a service business, your direct labor costs are the wages of staff members that provide services directly to your customers, which would include retail salespeople, wait staff, beauty salon stylists, and even accountants and attorneys.
What is indirect labor?
Indirect labor is labor that is not directly related to the production of a product. For example, once a product has been completed, the salespeople you employ would be responsible for selling the product, but because they were not involved in making the product, they would be considered indirect labor.
Indirect labor costs can be fixed costs or variable costs, depending on the situation. In a manufacturing setting, administrative staff, maintenance staff, accounting staff, and supervisors would all be considered indirect labor.
Just like direct labor costs, it’s important to track indirect labor costs. With indirect labor, though, the expense is tracked as overhead, not as cost of goods sold.
For example, let’s say you’re a practicing attorney that employs a receptionist and a research assistant. Although both of your employees play a vital supporting role in keeping your practice running, both are considered indirect labor, as neither provides services directly to the customer.
Direct vs. indirect labor: What's the difference?
Direct labor always involves production. Anyone directly involved in the manufacturing of products or delivery of services is considered direct labor.
Indirect labor can be a bit trickier to identify, though, because while many employees are essential to production, they are not necessarily involved in the actual manufacturing process. The chart below lists some common jobs and whether the role should be considered direct or indirect labor.
|Job||Type of Business||Direct or Indirect Labor||Reason|
|Accountant||Manufacturing||Indirect||Not directly involved in product production|
|Accountant||Service||Direct||Directly provides services to customers|
|Welder||Manufacturing||Direct||Directly involved in product production|
|Assembly worker||Manufacturing||Direct||Directly involved in product production|
|Machinist||Manufacturing||Direct||Directly involved in product production|
|Quality control||Manufacturing||Indirect||Quality control oversees all products so it cannot be tied back to one individual product|
|Administrative assistant||Service||Indirect||Not directly involved in providing services|
|Security||Service||Indirect||Not directly involved in providing services|
|Security||Manufacturing||Indirect||Not directly involved in providing services|
|Painter||Manufacturing||Direct||Directly involved in product production|
Looking at the chart above, you’ll see that an accountant at a manufacturing company would be considered indirect labor, as they have no direct role in producing a product.
However, an accountant that provides services to clients would be considered direct labor because they are directly involved in providing the services that the business offers.
When in doubt, an easy way to determine whether an employee’s labor costs should be considered direct or indirect labor is whether you can directly tie them back to a specific product or service.
How to calculate labor costs
In order to have an accurate estimate of labor costs, you’ll need to track both direct and indirect labor costs.
To calculate direct cost, you’ll need to first calculate the hourly rate for your employee. The hourly rate needs to include any fringe benefits as well as employee payroll taxes. For example, your welder earns $20/hour and typically works a 40-hour week. Fringe benefits and payroll taxes for the week total $90. Your first step is to calculate the total hourly wage for your employee:
$90 ÷ 40 = $2.25
You’ll then add the $2.25 to the hourly wage of $20:
$2.25 + $20.00 = $22.50
That is your actual labor cost per hour. If your employee worked 180 hours in June, his total direct labor cost would be $4,050.
While they’re not directly involved in production, indirect labor plays a supporting role in the manufacturing process. To calculate indirect labor, you’ll need to add up the hours that any indirect employees worked and calculate their salary accordingly.
For example, you had two indirect employees work in the month of June. Sam worked 80 hours with a salary of $10/hour and fringe benefits of $100, while Debra worked 120 hours with a salary of $15/hour and fringe benefits totaling $125.
Sam’s indirect labor for the month would be calculated as follows:
80 x $10 + $100 = $900
Deborah’s indirect labor for the month will be calculated as:
120 x $15 + $125 = $1,925
Added together, the total indirect labor cost for the month would be $2,825. To calculate your total labor costs, you’ll just add the two totals:
$4,050 + $2,825 = $6,875
Indirect labor can be a fixed or variable cost, depending on the employee, while direct labor costs will always fluctuate with production totals.
Tracking direct and indirect labor costs is important for any business
While it’s standard practice for larger businesses, even smaller businesses can gain from tracking both direct and indirect labor costs. Some of the benefits include:
- Accurate financial reporting
- Better budgeting
- More accurate pricing
Remember, even service businesses can benefit from keeping track of direct and indirect labor costs. While it may seem like a lot of extra work, particularly for a small business, you’ll have a much clearer picture of the financial health of your business by managing these costs properly.