The Average Overhead Labor Rates
Manufacturing businesses have a choice between using actual or average labor rates in determining overhead. While direct labor isn’t considered part of manufacturing overhead, both direct labor and direct materials costs are components in the calculation. Accurate overhead calculations are essential for valuing work in process and finished goods inventory on the balance sheet and determining the cost of goods sold on the income statement.
Labor rates used in overhead calculations include only those of employees directly associated with product manufacturing. All other wages are treated as indirect costs and included in manufacturing overhead. While labor rates for production-line employees are considered direct labor, labor rates for the management team, quality assurance employees, materials handlers and maintenance are considered indirect costs. These costs, along with other fixed and variable expenses, must be calculated and absorbed into the cost of each item produced.
Average labor rates make allocating direct labor costs significantly easier than using actual labor rates. That's because in addition to an hourly wage, labor rates also include payroll expenses for which the business owner pays. This includes Social Security, unemployment tax, Medicare, workers' compensation insurance, the business owner’s portion of health insurance premiums and employer contributions to the company retirement plan. While not every employer includes this, an accurate labor rate should incorporate costs related to employee training and development.
The objective of using average labor rates is to facilitate cost calculations. The formula -- average hourly labor rate multiplied by standard labor hours per unit -- is used to arrive at a standard labor cost per unit, which then becomes the allocation base. For example, if the average labor rate is $15 per hour and the standard hours per unit for an item is 30 minutes, the direct labor cost allocated to each item is $7.50.
Average labor rates for each department are typically calculated annually and used throughout the coming year. In addition to simplifying costing calculations, average labor rates allow managers to better manage departmental efficiency. This is done by spot-checking using actual labor rates to determine the amount of any direct labor variance. For example, an unfavorable labor rate variance -- one in which the actual rate exceeds the average rate -- can indicate that skilled workers aren’t being used to their best advantage or that the department is incurring excess overtime.