Jul 14

Comments Off on Direct vs Indirect Labor: What’s the Difference?

Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications. Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others. Someone on our team will connect you with a financial professional in our network holding the correct designation and expertise.

The variance between the two indicates whether the current direct labor cost is favorable for business.
The entity must decide a particular rate beneficial for the entity and the employees.
Usually, direct labor rate variance does not occur due to change in labor rates because they are normally pretty easy to predict.
According to the GAAP rules, companies can use direct labor as cost drivers to allocate the overhead expenditures to the production process.

Direct labor cost and indirect labor cost is one such quintessential fields for a small business to optimize their manufacturing process. For similar cost and management accounting knowledge, visit Akounto Blog and keep yourself updated. Direct labor costs can be traced to the specific production process, products, or services. Direct labor costs are a cost center and normally account for its productivity in terms of working hours, production per hour or day basis, etc. Their wage is not decided based on the job they undertook but on the number of products produced in the given period.

Subcategories of indirect labor cost

Rohan has also worked at Evercore, where he also spent time in private equity advisory. The most common causes of labor variances are changes in employee skills, supervision, production methods capabilities and tools. An overview of these two types of labor efficiency variance is given below. Later in Part 6 we will discuss what to do with the balances in the direct labor variance accounts under the heading What To Do With Variance Amounts. This team of experts helps Finance Strategists maintain the highest level of accuracy and professionalism possible. The Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters.

Sunshine Florals employs six florists for floral arrangements, two traveling floral consultants for events, and two delivery drivers.
Small businesses should collect appropriate direct and indirect labor data to properly analyze the total labor costs across departments.
For example, suppose a steel-producing firm requires 100 hours to produce 5 tons of steel.
Direct labor is considered to be a direct cost, which means that it varies directly with revenue or some other measure of activity.

Like direct labor, a significant part of total indirect labor cost consists of fringe benefits, employer’s contributions and payroll taxes etc. The direct labor cost includes the wages and fringe benefits of the direct labor employees and the cost of the temporary staff that are working directly on the manufacturer’s products. Just like direct labor costs, it’s important to track indirect labor costs. With indirect labor, though, the expense is tracked as overhead, not as cost of goods sold. Indirect labor costs can be fixed costs or variable costs, depending on the situation. In a manufacturing setting, administrative staff, maintenance staff, accounting staff, and supervisors would all be considered indirect labor.

They are considered relevant when making specific business decisions as they cannot be avoided. Direct labor costs are also classified as production costs, while indirect labor costs are classified as non-production costs. Suppose an accountant computes the ratio of the overhead costs to direct labor costs as $19 per hour. Hence the company will allocate $19 of the overhead costs per hour of direct labor to the production output. Since labor is one of the biggest expenses on a manufacturer’s income statement, cost accountants naturally want to track and control these costs by separating them from indirect costs. Management tracks direct labor costs and assigns them to the products they help produce.

Create a Free Account and Ask Any Financial Question

This bifurcation is done based on their traceability to the units produced. The company also contributes 8% of employees’ annual income toward their retirement savings plan. Direct labor is considered to be a direct cost, which means that it varies directly with revenue or some other measure of activity.

Direct Labor

Direct labor is production or services labor that is assigned to a specific product, cost center, or work order. When a business manufactures products, direct labor is considered to be the labor of the production crew that produces goods, such the issuance of common stock as machine operators, assembly line operators, painters, and so forth. When a business provides services, direct labor is considered to be the labor of those people who provide services directly to customers, such as consultants and lawyers.

Nonprofit Accounting: Essential Guide, Concept, and Examples

Direct labor rate variance is equal to the difference between actual hourly rate and standard hourly rate multiplied by the actual hours worked during the period. The variance would be favorable if the actual direct labor cost is less than the standard direct labor cost allowed for actual hours worked by direct labor workers during the period concerned. Conversely, it would be unfavorable if the actual direct labor cost is more than the standard direct labor cost allowed for actual hours worked.

Company

It includes any effort, skill, and time employees put toward producing goods and services. Usually, direct labor rate variance does not occur due to change in labor rates because they are normally pretty easy to predict. A common reason of unfavorable labor rate variance is an inappropriate/inefficient use of direct labor workers by production supervisors. In this example, the Hitech company has an unfavorable labor rate variance of $90 because it has paid a higher hourly rate ($7.95) than the standard hourly rate ($7.80). Small businesses should collect appropriate direct and indirect labor data to properly analyze the total labor costs across departments. Now we can calculate direct labor costs for the quarter by adding all these expenses.

Causes of direct labor rate variance

This is not necessarily the case in a production environment, where the manufacturing area typically requires a certain amount of staffing, irrespective of the number of units produced. The direct cost concept is more applicable in a professional billings environment, where the cost of direct labor usually varies with changes in revenue. The company will likely spend more than anticipated to generate one unit of output if the actual direct cost of labor per unit of production exceeds the standard direct cost of labor per unit of production. The amount incurred by the business as direct labor cost is significantly influenced by the effectiveness of the workers participating in the production process. These overhead costs are then allocated to the final products using cost drivers. We can divide the total overhead costs by the direct labor cost to get the value of the cost driver.

Companies can identify and trace direct costs to a specific product or service. However, tracking indirect costs and associating them with one item requires complex processes. Indirect labor performs in the back end, supporting the production process. Although they are necessary for the company, their role is not crucial for the direct development of a particular product.