All companies that hire employees to manufacture products or provide services for customers incur direct labor charges. In the factory, direct labor employees convert the materials into finished products; in service companies, they perform the service. For example, in a landscaping business, the employees who plant the grass seed represent direct labor, which represents both an asset and an expense for the business. As an asset, direct labor appears on the balance sheet; as an expense, it appears on the income statement.
The income statement reports the money earned from business activities, which include selling finished products or performing services. The revenues earned from these activities appear first on the income statement, and the company’s expenses, which refer to the costs incurred to operate the business, appear next. The income statement reports the activities for a specified period. The revenue minus the expenses equals the net income for the period.
Companies need to categorize their employees as direct or indirect labor. Direct labor employees work directly on the operational activities for the business whereas indirect labor employees support the operation of the business, which include accounting staff, forklift drivers or administrative assistants. Indirect labor wages always appear on the income statement as an expense while direct labor wages appear on the income statement or the balance sheet.
The company records direct labor wages as a part of the cost of the finished product or the service job. If the company sells finished products, it transfers the direct labor cost to the finished goods inventory account. The finished goods inventory appears on the balance sheet as an asset. If the company sells a service, it transfers the direct labor cost to the Service Work in Process account, an asset.
When the company sells the finished product to a customer or completes the service job for the client, it transfers the cost to an expense account, transferring finished goods to the Cost of Goods Sold account. The company transfers Service Work in Process to the Cost of Services Performed account. The Cost of Goods Sold account and the Cost of Services Performed account include the direct labor wages. These accounts appear just below the total revenues.