The more you understand what is going on in your business, the better you position yourself to earn a profit and build an enterprise that will help you meet your personal and financial goals. Knowing the difference between your direct and indirect labor costs is critical to grasping the ways your different types of business expenses fit together. This helps you to develop a solid foundation that is fit to scale up into a profitable company.
TL;DR (Too Long; Didn't Read)
Direct labor is dedicated to producing the items you sell. Indirect labor goes toward running other aspects of your business, such as accounting, management and cleaning.
What Is Direct Labor?
Direct labor is manufacturing or production labor. It is part of your cost of goods sold, which also includes the materials that are directly used in creating your products. In a shoe plant, direct labor is dedicated toward operating machinery and doing the hands-on work of creating the actual shoes. In a food business, direct labor is time that is spent cooking or preparing the food that your customers eat.
Direct labor is characterized as a variable cost, or one that fluctuates directly relative to output. It takes more time to produce six pairs of shoes than it does to produce two pairs, and the relationship between the time spent and the items manufactured is relatively direct, although you do achieve some economies of scale as your production volume increases.
The fact that you can correlate direct labor costs with output volume allows you to make informed forecasts about spending relative to earning.
What Is Indirect Labor?
Indirect labor includes all of the other employee hours that figure into your payroll but are not directly associated with production. These may include wages, salaries and bonuses paid to sales staff, management expenses and human resources expenditures.
Unlike direct labor, which varies in proportion to the amount of goods your company produces, indirect labor is a fixed cost, or one that stays relatively steady regardless of the amount of business your company transacts.
The cost of paying your payroll department does not change significantly if the personnel write five checks or ten, and you have to keep sales staff on the floor even on days when no customers show. As a result, indirect labor cost per unit tends to drop as volume increases, and the fixed cost gets spread out over a greater number of units.
Direct vs. Indirect Labor
From an operations standpoint, it is important to develop systems that keep direct labor costs under control because these costs equally affect every unit you produce regardless of the volume you produce and transact.
If your direct labor cost formula shows that you are spending 50% of your incoming revenue on production labor, your business is unlikely to be profitable even if you double or triple your sales. A 50% direct labor cost is simply too high for most businesses to operate sustainably. However, if your direct labor cost is closer to 20%, your gross profit, or income after subtracting all of your direct costs, will increase dramatically as you scale up your operations.
In contrast, a problem with high indirect costs does not necessarily need to be addressed at a systems level because it can be solved as your business volume increases, and these expenditures are divided among a greater number of units. If your rent is $2,000 per month, and you make 20 sales per month, your indirect rent cost will be $100 for each sale.
However, if you make 2,000 sales per month, your rent cost per sale drops to a mere $1. You can increase your sales volume to see your per unit indirect costs decrease; you do not necessarily need to streamline your systems or focus on employee productivity.