The time your employees spend working to deliver a specific product or service is known in business-speak as direct labor hours. The production line workers who make your widgets are putting direct labor into the product; your accounting and HR departments are putting in indirect labor. Knowing the direct labor cost helps you decide whether you need to raise prices or cut costs.
To calculate direct labor rates, first figure out how much the relevant employees make per hour, including all fringe benefits. Next, calculate the number of hours it takes to make each product. Multiply the hourly labor rate by the number of hours to get the direct labor rate per individual product.
The direct labor rate for work on a product or service is more than just employee wages or salary. It's employee pay, plus employee payroll taxes, plus benefits: medical, worker's comp, pension contributions and whatever else you offer. That makes it more work to calculate, but it reflects the true costs to the company better.
You can't calculate the direct labor rate unless your employees work direct labor hours. This is time that can be tracked and tied to a specific job or work on a specific product or service, such as:
- An automobile production line, where the labor force works assembling the same cars day after day
- Accountants and lawyers who are expected to track their work hours and bill them to specific services provided to specific clients
- Software designers who work on a new program and count their hours as direct labor on their creation
- Government service contractors working for federal agencies who assign their work hours to specific projects
Costs that cannot be linked to a specific worker or a specific product are indirect. Along with many administrative positions, production-related positions such as purchasing supervisor or quality control manager count as indirect labor.
You can calculate what indirect labor costs you by adding up the hourly expense, but you can't tie it to a specific product or service.
It's simple to calculate direct labor costs, whether your team is working on a production line or in a computer lab. It can, however, take a lot of number crunching. For example, assume your employees are making $20 per hour assembling widgets and working a 40-hour week.
- Figure the payroll taxes and benefits for each employee per 40-hour week. In this example, they're $120.
- Divide $120 by 40, giving $3 per hour. Add that to the $20 hourly pay, and you have $23 per hour in direct labor costs.
- Calculate the cost per widget. If it takes one person 2 hours of work to make a single widget, then the labor cost is $46 per widget.
Now you have a metric you can use. Having precise labor costs to add to materials, shipping and other expenses shows the total cost. That information enables you to set the total price you need to turn a satisfactory profit.
Along with setting prices, you can use the direct labor rate in planning. If you anticipate your new, improved factory equipment will cut labor costs to $23 per widget, you can build your budget around the anticipated savings.
Sometimes your labor-rate predictions don't come true, which is when you need to calculate a labor spending variance. For example, it turns out that even with new equipment, your workers need 1.5 hours to assemble a widget, resulting in labor costs of $34.50 per widget. You need to revise your planning based on the variance from your projections.
Some accounting experts question whether the variance is worth worrying about. Labor costs are often small potatoes compared to the other costs of manufacturing. It's also easy to get projected direct labor rates wrong, for example, by setting tough standards nobody can live up to.