In many industries, such as manufacturing, employees are directly involved in producing the goods that customers buy. However, employees can also perform countless other tasks, from writing payroll checks to tinkering with the plumbing. A useful and thoughtful bookkeeping system breaks down these separate labor functions so you can clearly see how your payroll dollars are being spent.
Direct labor on a financial statement appears as part of cost of goods sold.
Overhead and Profit
Your business incurs two broad categories of costs: direct costs, or cost of goods sold, and indirect costs, or overhead. Your gross profit is the amount left over after subtracting direct costs (the labor and materials that go directly into producing the items you sell) from your gross revenue (the total amount you receive from selling these items). Net profit is the amount left over after also subtracting overhead costs, which are the other expenses you incur to keep your business running.
Direct costs, including direct labor, vary more or less in direct correlation to your sales volume. It takes twice as much material to produce twice as many goods, and your labor costs will roughly double as well, although you'll probably reap the benefit of some economies of scale as your sales volume increases. In contrast, overall overhead costs stay roughly the same even if your production increases, so the more you produce, the less your overhead (and the greater your profit) for each item.
Direct and Indirect Labor
Your record keeping should distinguish between the hours your employees spend on direct labor, or manufacturing, and the time they spend working on other parts of your business that are recorded as overhead. Manufacturing direct labor includes operating machines, preparing materials for production and packaging finished products. Labor for manufacturing overhead includes maintaining and repairing machinery, cleaning the facility and writing payroll checks.
By distinguishing between direct and indirect labor and listing them separately on your financial statements, your business can develop a sophisticated understanding of how it is spending money and what it will take to become more profitable. If direct labor costs are high, you probably need to take a close look at your systems and processes. If indirect labor costs are high, you may simply need to increase sales and production volume so these indirect costs will add up to less relative to each unit produced.
Other Direct Costs
Your business includes plenty of direct costs besides labor, and they should all be tallied as part of the cost of goods sold on your income statement. Materials are direct costs because your direct labor transforms them into the physical products that your customers buy. Packaging is a direct cost as well, and if you pay for shipping for your materials and packaging, these transport expenses also go directly into producing the products you sell.
Other Indirect Costs
Producing the products you sell is only part of what it takes to keep your business running. Before your products are produced, you must pay rent and outfit your facility, and you also must obtain all required licenses and certifications. Once you've invested in all the direct costs necessary to create your offerings, you must also invest in selling them. Marketing and advertising are indirect costs as are the hours that you pay your staff to work on the sales floor.
Maximizing Net Profit
Your business can improve profitability by lowering both direct and indirect costs. However, controlling direct costs provides ongoing opportunities for increasing earnings. Rent and utilities are reasonably static expenditures, and unless you regularly move your shop or renegotiate your lease with your landlord, you're unlikely to save much money there. However, the costs of materials and the details of your systems are much more nuanced and fluid, allowing you ongoing leeway for improving operating margins.