1

Accounting for Labor Cost

Direct and indirect labor costs

Labor is often one of the major expenses of a business. One of the most important distinctions of labor is
between direct and indirect costs.

• 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 also include the following.
1. Bonus payments.
2. Benefit contributions.
3. Idle time (when workers are paid but are not making any products, for example when a machine breaks
down).
4. Sick pay.
5. 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 analyzed into direct and indirect
labor costs.
• Overtime premiums are treated as direct labor 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 labor cost.

Time records

It is essential that organizations employ relevant methods in both manufacturing and service industries to relate the
labor 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.

1
https://kfknowledgebank.kaplan.co.uk/acca/chapter-accounting-for-labour
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 timesheets are commonly used in service industries, for example in accountancy firms where
time spent working for different clients is analyzed, often to the nearest 15 minutes.
• Period-related timesheets 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.

Payroll department

The payroll department is involved in carrying out functions that relate input labor 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 labor costs

Labor costs are an expense and 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 and debited to the production overheads
account. It is important that total labor costs are analyzed 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:
1. They should be closely related to the effort expended by employees.
2. They should be agreed by employers/employees before being implemented.
3. They should be easy to understand and simple to operate.
4. 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.

• 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 labor
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.

Labor turnovers

In an examination you will be given clear instructions on any bonus scheme in operation. You should follow the
instructions given carefully in order to calculate the bonus payable from the data supplied.

Labor turnover is a measure of the proportion of people leaving relative to the average number of people employed.
Management might wish to monitor labor turnover, so that control measures might be considered if the rate of

turnover seems too high, and the business is losing experienced and valuable staff at too fast a rate.

Causes and costs of labor turnover

Causes

It is important to try to identify why people leave an organization to distinguish between avoidable and unavoidable
causes of labor turnover.

Causes of labor turnover avoidable:

• poor remuneration
• poor working conditions
• lack of training opportunities
• lack of promotion prospects
• bullying in the workplace.

Causes of labor turnover unavoidable:

• retirement
• illness/death
• family reasons (e.g. pregnancy)
• relocation.

Efficient managers will investigate high levels of labor turnover and aim to keep that turnover rate at a minimum.

Costs

Every time an employee leaves, an organization will incur costs that are associated with replacing the employee.
These costs are known as replacement costs.

Replacement costs include the following:

• advertising costs
• cost of selection (time spent interviewing etc.)
• training new employees
• reduced efficiency until the new employee reaches the required skill.

A high labor turnover rate tends to lower the performance of employees who remain in the organization. Such
employees may become restless and resentful of the extra burden of training new members and of additional
temporary duties imposed upon them.

In order to keep the labor turnover rate to a minimum, organizations should aim to prevent employees from leaving.
Such preventive measures come with their own costs, known as preventive costs.

Preventive costs include the costs associated with escaping the avoidable causes of labor turnover:
• pay competitive wages and salaries if remuneration is poor
• improve poor working conditions
• offer good training opportunities
• make sure promotion prospects arise as necessary.
• stamp out bullying in the workplace
• investigate high labor turnover rates objectively.