Flow of Costs

Labor Costs

Description of Labor Costs

In most companies, labor can be directly allocated to a job.

Labor costs need to be collected and allocated to the appropriate job in all types of businesses. Manufacturers, retailers, wholesalers, and service industries need to identify the labor that relates to the product or service that they sell. Labor that can be directly allocated to a job is direct labor. Most direct labor is easy to identify because it involves those hours when an employee devotes time to the product or service.

Not all labor that is needed to manufacture a product is direct labor. A product manager, a production supervisor, and a security guard all provide indirect labor. This is work that supports the creation of a product or service without actively changing materials into finished products. Companies allocate indirect labor costs to the job as part of the overhead allocation.

Direct labor costs in manufacturing usually come from employees who receive an hourly wage. While businesses use the hours an employee works on a product to help calculate labor costs, the hourly rate they use is typically not the individual employee's hourly rate. Instead, labor costs are often based on a standard rate for the process. Businesses can use actual wages to apply labor costs to the product, but other employee costs need to be included in applying labor costs to products. Any labor rate used will need to include all costs associated with the employee, such as benefits and taxes. Costing systems let production employees record the hours worked on a product or a process. Then the accountant multiplies the hours recorded by the standard labor rate to add the direct labor cost to the product.

Keeping Track of Hours Worked by Process

Adams Brick Manufacturing Corp. Time Sheet
Employee Name: Jason Clark
Employee Number: 29
Department: 2
Supervisor: Danielle Garcia
Date Project Code Start Time End Time Regular Hours Overtime Hours Total Hours
Jan. 14 787 Operation of dry clay machine 8:00 1:00 5.0 0 5.0
Jan. 14 798 Maintenance of dry clay machine 2:00 2:45 0.75 0 0.75

Employers can assign codes based on products employees work on or processes they complete. Either system allows accountants to track direct labor costs.

A company develops the standard labor rate before the accounting period in which it is used. The accounting period is the time span covered by financial reporting, such as monthly, quarterly, semiannual, or annual financial statements. Depending on the business, the accounting period could be a month, three months, six months, or a year. The standard labor rate is the best estimate of anticipated labor costs for each production activity. This rate becomes part of the analysis of determining product pricing and calculating product costs. Companies perform a process called variance analysis to find out how accurate their standard labor rate is. This analysis provides quantitative information regarding the difference between actual and planned performance. If the standard labor rate does not closely reflect the labor costs for the current period, then the business needs to make changes to their standard rate.

From the financial perspective, labor costs are initially recorded as expenses. When companies use labor to produce a product, this moves the labor cost in the general ledger from direct labor expense to the WIP inventory. This can be done perpetually, through an integrated computerized costing system, or monthly, as part of the financial statement creation. As the costs flow into the WIP inventory in the costing system, the accountant also needs to correct them in the financial accounting information.

Direct Labor Flow of Costs

It is important to record the flow of direct labor to keep the financial information in the general ledger and the costing information correct. As products in a manufacturing company are completed, the accountant moves the direct labor costs into the WIP inventory.
Direct labor hours also apply to service businesses, such as law firms and real estate agencies. Many service businesses involve billing for professional services, such as accounting or legal services. While there may be some process differences between manufacturing and the service industry when it comes to labor costs, the basic concept is the same.

Allocation of Labor Costs

There are multiple applications for labor costs.

Businesses allocate direct labor costs to products similarly to how they allocate direct materials costs. In job order costing, the direct labor cost is allocated to a specific product, while in process costing, it is allocated to a production batch. Allocating labor costs helps management in both environments to correctly value inventory, estimate appropriate pricing, and analyze how the business operates.

In manufacturing firms, accountants classify direct labor costs as being both direct costs and conversion costs. Labor is an expense necessary to transform (or convert) raw material into the finished product, thus labor is a conversion cost and is part of the cost of the product. WIP inventory will contain both direct material and direct labor costs as part of the inventory value.

Labor Cost Ticket

Company Name: XYZ Energy Co.
Employee: Bethany Jones
Employee Number: 475
Date: 8/5/19
Start Time Stop Time Total Hours Job # or Overhead Are Task Rate Direct Labor Costs Manufacturing Overhead
6:30 11:30 5.0 A40 Cutting $8 $40
11:30 1:30 2.0 S35 Painting $8 $16
1:30 2:30 1.0 Repair $8 $8
Total 8.0 $56 $8

Companies require employees to define where they are spending their time. Businesses monitor time for both direct labor and administrative hours.

While service industries do not have material to track, most of them use a costing system to manage labor. One of the key elements of direct labor is the ability to trace the labor to a specific product or job. In some companies, employees in service industries charge their labor to a specific job by using a time sheet. An example of this is an accounting firm whose employees charge the hours they are working on a specific client's project.

Some service industries exist in an environment similar to process costing, where cost can be tracked to a process but not a specific job or client. An example of this would be a bank. While banks can track the costs of tellers at a specific branch, the costs are not traceable to a specific client or job.

The ability to track the cost of labor has changed the way service industries operate. For instance, online banking has replaced many teller functions. Being able to deposit checks from a smart device or to use an app to transfer money from one person's account to another reduces the need for tellers. As processes change, organizations need to evaluate the cost and the effects on profits. In the case of the bank, its leaders will continually evaluate the activity performed at a branch in relationship to the teller cost. Also, banks and other organizations need to evaluate the costs of technology and how those costs affect profits.