Direct Labor Cost Method

Businesses large and small incur costs for materials and labor for all goods or services produced. Adequately controlling labor costs is essential to achieving profitability goals. Effective management of direct labor costs starts with accurately tracking direct labor costs and using the information to identify and address problems that cause excessive expenditures or loss of efficiency.


  1. Direct labor cost is defined as work expenses attributable to the actual manufacture of a good. For service industry businesses, direct labor cost refers to the cost of labor required to provide the service. In general, direct labor does not include employees uninvolved in production, such as administrative and office staff. Only include “shop floor” personnel responsible for maintaining or setting up equipment.


  1. To accurately measure direct labor cost, you must include all expenditures, not just wages. Thus, you would include employer-paid Social Security, Medicare and unemployment taxes as well as workmen’s compensation insurance. Expenditures for health insurance and contributions to pension plans are other examples of items you must include in the total labor cost. You may also need to include an allowance for training and worker recruitment.


  1. To effectively analyze direct labor cost, you need to establish a model or standard rate. The standard rate is an estimate of what you expect the direct cost of labor will be under normal conditions. There are two primary components of this model: the projected cost of one hour of direct labor and the number of labor hours required to produce one unit. Suppose your total cost for one hour of direct labor is $15 and you expect to use 0.5 hours per unit of production. If your shop produces 1,000 units weekly, your standard labor cost is $7,500.


  1. In the real world, it’s rare for actual outcomes to conform exactly to standardized models. The value of direct labor cost analysis is that it helps identify significant departures from expected results. There are two main things to look for: rate variance and efficiency variance. Rate variance occurs when the actual labor costs is above or below the expected level. For instance, you might find you actually spent $16 per labor hour instead of an expected $15 — an unfavorable variance. Efficiency variance is a departure from the amount of labor required to produce one unit. Thus, if you used an average of 0.4 hours to produce one unit instead of an expected 0.5 hours, you would have a favorable variance. Identifying the reasons for either type of variance allows you to maintain and improve profitability.