Direct vs. Indirect Labor: What are the Difference?

In order to have an accurate picture of your labor cost, it’s

important to understand the difference between direct labor
and indirect labor. Learn how to calculate these two labor
costs.
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.

Direct labor includes the employees involved in producing a

product or providing a service. Source: CFI.

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.
 DIRECT OR
TYPE OF
JOB INDIRECT REASON
BUSINESS
LABOR
Not directly involved in p
Accountant Manufacturing Indirect
production
Directly provides services
Accountant Service Direct
customers
Directly involved in produ
Welder Manufacturing Direct
production
Directly involved in produ
Assembly worker Manufacturing Direct
production
Directly involved in produ
Machinist Manufacturing Direct
production
Quality control oversees
Quality control Manufacturing Indirect products so it cannot be ti
to one individual product
Administrative Not directly involved in p
Service Indirect
assistant services
Not directly involved in p
Security Service Indirect
services
Not directly involved in p
Security Manufacturing Indirect
services
Directly involved in produ
Painter Manufacturing Direct
production

The chart lists various jobs and whether they should be

considered direct or indirect labor.
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.

Direct labor

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.

Indirect labor

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.