Human resources are said to be the biggest capital asset for any entity. In fact, the more labor intensive a business, the more essential are its people. Labor is employed at every stage of a business; for example, it is employed in the manufacturing processes, for office and administrative works, for securities, for maintenance and so on. Businesses invest significant amounts in their labor, from wages and salary to social security contributions to fringe benefits and perquisites. These labor costs comprise a significant part of a manufacturing entity’s total cost. It, thus, must be appropriately measured, recorded and allocated across product lines to determine product costing and pricing correctly.
This article looks at meaning of and differences between two types of labor relevant cost – direct and indirect labor cost.
Definitions and meanings
Direct labor cost:
Direct labor is the labor that is directly employed in the manufacturing process. This means that all personnel whose efforts contribute directly to and can be directly traced to the manufacturing of any product(s) are considered as direct labor.
In a manufacturing company, for example, it includes factory workers directly engaged in the assembly line – be it product assemblers, employees undertaking packaging, machine operators or quality check etc. Product managers and supervisors who are directly involved in overseeing the assembly line activities of a specific product may also be included in direct labor.
Total cost of direct labor includes all expenses incurred on employment of direct labor including their wages, social security costs and other monetary benefits given to direct labor employees/workers. The direct labor cost is generally allocated to the products manufactured by applying the following formula:
Cost of direct labor allocated = (Total direct labor cost/Total man hours employed) × Man hours on specific product
In case any specific employee works exclusively in the assembly line of a specific product, his cost will be directly allocated to the cost of that specific product.
ABC Inc. manufactures 3 different types of cars – Hatchback, Sedan and Luxury Sedan. The man hours and costs involved in assembling of each of these cars for the month of January 2021 is as follows:
Additionally, the Luxury Sedan department is a premium segment and thus employs an exclusive QC manager who is dedicated to high precision quality checks of the luxury sedan cars. His salary including benefits is $15,000 per month.
The total direct labor costs allocated to each type of car would be:
*Important note: We have considered that the hours dedicated by these personnel can be directly traced to the specific product line. In circumstances where personnel such as production or QC managers have overall factory supervision responsibility and their contribution to a specific product line cannot be traced, they would qualify as indirect labor.
Indirect labor cost:
Indirect labor constitutes those employees that are not directly engaged in the core manufacturing process. These personnel work in other processes or functions which contribute to the overall functioning of the entity. The work of indirect labor cannot be directly traced to the manufacturing of any specific product(s).
Security personnel, cleaning staff, office and administrative staff, sales staff etc. all constitute indirect labor. Even if any of these labor personnel work in the factory, they will qualify as indirect labor as their efforts cannot be directly related to the main production activity.
The cost of indirect labor qualifies as part of overheads cost and is allocated to the products manufactured on the basis of an appropriate allocation basis such as machine hours, direct labor hours and direct materials cost etc.
The formula for this allocation would be:
Cost of indirect labor allocated = (Total indirect labor cost/Total of basis i.e., machine or labor hours etc.) × Basis utilized for specific product
Difference between direct and indirect labor cost
The eight key points of difference between direct and indirect labor have been listed below:
- Direct labor are those personnel that are directly engaged in the manufacturing process of an entity.
- Indirect labor are all other personnel of an entity who work across departments but are not directly engaged in the manufacturing process.
2. Contribution and traceability to manufacturing of product
- The work of direct labor can be directly seen in and traced to a specific manufacturing process or specific product. For example, effort of employees in the packing department is clearly reflected in a packaged product.
- The work of indirect labor cannot be seen in nor traced to a specific process or product. For example, effort of ancillary workers in the factory such as cleaners and security cannot be directly seen in the manufactured product.
3. Work performed
- Direct labor generally performs all functions that are associated exclusively with the manufacturing process.
- Indirect labor performs a large gamut of functions that can range from administration to accounts and finance to sales and marketing and everything in between.
4. Place of work
- Direct labor works in the factory or shop floor.
- Indirect labor can be engaged in any part of the entity’s location, be it the factory, office or on-field.
- The cost of direct labor is generally variable in nature i.e., it changes in direct proportion to a change in the level of output.
- The cost of indirect labor, on the other hand, can be either variable, semi-variable or fixed in nature. For example, the salary of security guard could remain the same irrespective of whether there is an increase or decrease in the level of output.
6. Cost allocation
- The cost of direct labor is directly allocated to manufactured units on the basis of labor hours or on a direct one-to-one allocation.
- The cost of indirect labor is accumulated as overheads and then allocated to products on a reasonable allocation basis.
7. Grouping and cost sheet presentation
- Direct labor cost is categorized as prime cost and is allocated first in a cost sheet.
- Indirect labor cost is categorized under overheads cost and is allocated after all direct costs are allocated in the cost sheet.
- Direct labor includes machine operators, packers, assembly line workers etc.
- Indirect labor includes housekeeping and maintenance staff, security, accounts staff etc.
Conclusion – direct vs indirect labor cost:
Both direct and indirect labor are essential for the proper functioning of the entity. While direct labor is key to the manufacturing processes of the entity, indirect labor is entrusted with several other functions to ensure the entity functions smoothly. The cost of labor forming a large portion of the costs of any business entity, calls for focused attention of the management towards cost measurement, control and management. Classification of labor costs into direct and indirect labor is the first and most critical step required to achieve this.