Labor Costing

Direct and Indirect Labor

• Direct labor 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 organization’s products.
• Indirect labor 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 Labor Costs
• 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
If employees are entitled to extra pay when hours in excess of
contracted hours are worked then they will be paid for
overtime. When employees work overtime, they receive an
overtime payment which includes a basic pay element and an
overtime premium.
Overtime and Overtime Premiums
It is important that the overtime payment is analyzed correctly
into direct and indirect labor costs
• Basic pay (whether it relates to overtime or normal working
hours) is always classified as a direct labor cost for direct labor
workers.
• Overtime premiums are usually classified as an indirect labor
cost but if the extra hours are at the specific request of a
customer because they want a job to be finished as soon as
possible they can be classified as direct labor.
• Employees who work night shifts, or other antisocial 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
labor cost.
Overtime and Overtime Premiums
 Accounting for Labor Costs
Labor costs are recorded in an organization’s income statement.
Accounting transactions relating to labor are recorded in the labor
account.
• The labor account is debited with the labor costs incurred by an
organization. The total labor costs are then analyzed into direct and
indirect labor costs.
• Direct labor costs are credited from the labor account and debited
in the work-in-progress (WIP) account. Remember, direct labor costs
are directly involved in production and are therefore transferred to
WIP before being transferred to finished goods and then cost of
sales.
• Indirect labor costs are also credited ‘out of’ the labor account but
debited to the production overheads account. It is important that
total labor costs are analyzed into their direct and indirect elements.
Remuneration Methods
Labor remuneration methods have an effect on:
• The cost of finished products and services.
• The morale and efficiency of employees.
 
There are two basic methods:
• Time-based systems
• Piecework systems
Time-based Systems
• Employees are paid a basic rate per hour, day, week or month.
• Overtime is paid if any extra hours are worked.
• 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)

• Basic time-based systems do not provide an incentive for

employees to improve productivity / efficiency. Therefore,
close supervision is necessary.
Output Related 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

• A guaranteed minimum wage is often required due to

minimum wage requirements.
• Piecework is often combined with a time-based system to
provide an added incentive to employees.
Output Related Systems
There are two main piecework systems
1. Straight piecework systems and Piece Rate with guaranteed
day rate 
Today, it is normal for pieceworkers to be offered a guaranteed
minimum wage, so that they do not suffer loss of earnings when
production is low through no fault of their own.

2. Differential piecework systems 

These systems involve different piece rates for different levels of
production.  
They offer an incentive to employees to increase their output by
paying higher rates for increased levels of production. 
Output Related Systems

For example:
up to 80 units per week, rate of pay per unit = $1.00
80 to 90 units per week, rate of pay per unit = $1.20
above 90 units per week, rate of pay per unit = $1.30
Incentive (bonus) schemes
The characteristics of such schemes are as follows:

1. Employees are paid more for their efficiency.

2. The profits arising from productivity improvements are
shared between employer and employee.
3. Morale of employees is likely to improve since they are seen
to receive extra reward for extra effort.
Incentive (bonus) schemes
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 as premium bonus plans. Examples of
such schemes are Halsey and Rowan.

Halsey – the employee receives 50% of the time saved.

Time allowed – Time taken
Bonus = ––––––––––––––––––––– × Time rate
2
Rowan – the proportion paid to the employee is based on the ratio
of time taken to time allowed.
Time taken
Bonus = ––––––––––– × Time rate × Time saved
Time allowed
Incentive (bonus) schemes
Incentive (bonus) schemes
Individual vs. group bonus schemes
• An individual bonus scheme is a remuneration scheme
whereby individual employees qualify for a bonus on top of
their basic wage, with each person’s bonus being calculated
separately.  
• Hence, the bonus is unique to the individual and it gets higher
if efficiency is improved.
• A group bonus scheme is related to the output performance of
an entire group of workers, a department or even the whole
factory.  It increases co-operation between team members
and is easier to administer.
Profit Sharing Schemes

A profit sharing scheme is a scheme in which employees receive

a certain proportion of their company’s year-end profits (the size
of their bonus being related to their position in the company
and the length of their employment to date).
Value added incentive schemes
• These incentive schemes exclude any bought-in costs and are
affected only by costs incurred internally such as labor. 

• Value added = sales – cost of bought-in materials and services.

• For example, valued added should be treble the payroll costs

and one third of any excess earned would be paid as a bonus.

• Payroll costs                         $50,000

Value added target (x3) $150,000
Value added achieved       $180,000
Excess value added             $30,000
Employee’s share                $10,000
Labor Turnover
• is the rate at which employees leave a company relative to the
average number of people employed. 
• This rate should be kept as low as possible.

Labor turnover Ratio

Labor Turnover
A Co. had 80 direct production workers at the beginning of last
year and 60 direct production workers at the end of last
year. During the year, a total of 45 employees has left the
company. What is the labor turnover ratio?
Solution:
Employees at the start -Those left + Those Replaced = Number
of employees at the end
80 at the start  - 45 (left)  + Replacement = 60 at the end

Replacement = 25
Average no of employees = (80 + 60) / 2 = 70
Labor turnover = (25 / 70) x 100% = 35.7%
Labor efficiency, capacity and production
volume ratios
Labor Efficiency Ratio measures the performance of the workforce by comparing
the actual time taken to do a job with the expected time.
                                              Standard hours  
Labor Efficiency Ratio =  ------------------   x 100%
                                              Actual hours
A Co. budgeted to work 8,000 hours manufacturing 20,000 units.
They actually produced 25,000 units and it actually took them 11,000 hours to
produce them.
Solution 
Step 1: Calculate the Standard hours
Budgeted hours to produce 1 unit = 8,000 hours / 20,000 units = 0.4 hours per unit
Standard hours to produce the Actual units =  0.4hr per unit  x 25,000 units =
10,000 hours
Step 2: Calculate the Labor Efficiency ratio
Labor Efficiency ratio = Standard hours / Actual hours  x 100%
= 10,000 / 11,000  x 100 = 90.9%
Labor efficiency, capacity and production volume ratios

Labor Capacity Ratio

measures the number of hours spent actively working as a
percentage of the total hours available for work.
                                           Actual hours  
Labor Capacity Ratio =  --------------------   x 100%
                                           Budgeted hours
Illustration
A Co. budgeted to work 8,000 hours manufacturing 20,000 units.
They actually produced 25,000 units and actually took 11,000 hours.
What is the capacity ratio?
Solution
Labor Capacity Ratio =  Actual hours  / Budgeted hours   x 100%
                      
Labor Capacity Ratio = 11,000 / 8,000 x 100% = 137.5%
Labor efficiency, capacity and production volume ratios

Labor Production Volume Ratio

Compares the number of hours expected to be worked to produce
actual output ( Standard hours) with the total hours available for
work (Budgeted hours).
                                                            Standard hours  
Labor Production Volume Ratio =  --------------------   x 100%
                                                             Budgeted hours
Illustration
A Co. budgeted on producing 20,000 units with 8,000 budgeted labor
hours.
They actually produced 25,000 units and actually took 11,000 hours.
Labor efficiency, capacity and production volume ratios

Solution

Calculate the Labor Production Volume Ratio

Labor Production Volume Ratio = Standard hours / Budgeted hours x

100%
Labor Production Volume Ratio = 10,000 / 8,000 x 100% = 125%
Question 01

Aslam Bottlers pay their labors under Piece Rate System.

Standard daily wage of workers is Rs 500/- standard daily output
is 500 pieces per worker. Output of workers during a day is as
follow
Mr. A 450 pieces
Mr. B 500 pieces
Mr. C 550 pieces
Required: Calculate wages earned by the workers under
a. Straight piece rate
b. Piece rate with guaranteed day rate
Question 02
For an operation standard production time is calculated as 45 seconds
per unit. Workers performing this operation are classified in pay scale of
Rs. 864 per day. Differential are to be applied as under:
80% of standard piece rate for below standard output
120% of standard piece rate for at or above standard output
During the day output of workers performing this operation is as under:
A 700 units
B 680 units
C 640 units
D 620 units
E 600 units
Required: Remuneration of each worker under:
a. Straight piece rate system
b. Differential piece rate system