Labor Cost Vs. Material Cost

A business manager who understands the details of what it costs to manufacture a product has a greater potential for increasing profit margins. Knowing how to correctly separate labor from material costs allows her to quickly discern which areas of the business need improvement and which are operating as they should.

Direct labor is the time it takes to actually make a product. Sometimes referred to as touch labor, this includes the production, testing and inspection of an item for sale. It does not include the hours paid to production workers for vacation, holiday or sick leave, nor does it include wages for supervisors or other administrative functions. Hours that don’t go into making the product are considered indirect labor and are classified as overhead expense, otherwise known as labor overhead.

When a business manager separates direct and indirect labor, he can track trends in production that might signal the need for better machinery or a correction in a labor process. With corrective action comes greater efficiency; this, in turn, produces increased profit.

In addition to paid absence and supervisory and administrative labor, labor overhead includes all other costs required to sustain the production and support staff. This includes company-paid payroll taxes and benefits. It also consists of the building costs, utilities, machinery and incident supplies used to run the production area. Separating overhead from direct labor costs allows management to analyze what type of expenses may be affecting profit, even when they’re not directly related to the touch labor of a product.

Segregating the direct material costs of a product allows managers to analyze the cost of a sale right down to the individual parts required to make a given product. Similar to tracking and trending direct labor, fluctuations in direct material costs motivate managers to investigate individual purchase prices and look for ways to renegotiate or decrease the cost of the material delivered in the end product. This detailed knowledge is key to protecting profit margins.

Material overhead includes the cost of procuring parts -- including the wages and benefits of buyers, material expeditors and planners or stockroom personnel. Just like labor overhead, it includes the building costs, utilities and equipment used to store or move materials during production. As with all other cost details, material overhead is separately monitored and managed to produce the lowest possible expense and the highest possible profit.