Overhead Vs. Direct Labor Costs

Accounting numbers help you tunderstand the workings of your business so you can make necessary adjustments and become more profitable. The expenditures on your income statement are organized to distinguish between the costs that funnel directly into revenue, and those that contribute to the background and infrastructure that keep your business running and set the stage for you to earn this revenue. Direct labor costs such as payment for production hours are directly tied to income, while labor overhead goes into bookkeeping, facility maintenance and any other work that doesn't translate directly into production and revenue.

Direct Labor Costs

Direct labor costs are classified as variable costs because they differ more or less directly relative to your revenue. It takes more work to manufacture 100 shoes than it does to make 50. Although you'll be able to leverage some economies of scale as you produce more units, it's safe to assume that producing a greater number of units requires an increased amount of labor. Calculating direct labor costs allows you to better understand these economies of scale. If it take $200 worth of labor to manufacture 100 pair of shoes and it takes $150 worth of labor to manufacture 50 pair of shoes, then your direct labor cost is $2 per pair when you manufacture 100 pair, and $3 per pair when you manufacture 50 pair.

Direct vs. Indirect Labor

In addition to the labor that goes directly into producing the products you sell, your business must maintain the physical and information systems that allow you to do your production work and deliver the end results to your customers. Handling inventory, shipping orders, compiling invoices, making sales calls and writing employee paychecks all generate indirect labor costs that are tracked as part of overhead costs rather than cost of goods sold, or indirect costs. These costs don't increase appreciably relative to the volume of business you transact. You still have to have your oven cleaned whether you've baked one batch of bread or 10. There will likely be more buildup after 10 batches, but it certainly won't take 10 times as long to clean it.

Why Track Business Overhead?

It's fairly obvious why you should track direct costs: If you know how much it costs you to produce an item, you're well on your way to figuring out how much to charge for it. But your prices should also be high enough to cover your indirect costs, or overhead, because you have to pay these amounts even if you don't sell a single item. Understanding your overhead costs can help you calculate your break-even point, or the amount you have to sell before your business becomes profitable. To calculate the number of units you need to sell to break even, subtract your variable cost per unit from your revenue per unit. Divide fixed costs, including labor overhead, by the amount left over.

Gray Areas

Distinguishing between direct versus indirect labor helps you to better understand the costs your business incurs, but, in actuality, this distinction is sometimes hard to make. If you own a restaurant, you need to keep a skeleton staff in the kitchen – whether or not a single customer walks in the door and orders a meal. Kitchen labor is a direct cost, but paying kitchen staff when there are no customers is an indirect cost. Management labor is an indirect cost, but your manager may jump in and do some production labor if you're shorthanded, and it's unlikely that you'll track these management hours separately and include them in your direct labor costs. It's important to distinguish in broad strokes between direct labor costs and labor overhead, but when you're immersed in the day-to-day, you're unlikely to monitor and categorize every task your staff performs.