Labor Costs Are Increasing - What to Do?There are 1001 chances that direct labor costs are increasing. Generally, although not every cost-increased means a problem, any increases on any costs, either it is a small or an excessive increase is always become a major concern of any financial manager or controllers in the real business world. An excessive increase on the direct labor cost is one of financial sickness symptom. A prudent manager [or controller or CFO] will conduct a sudden spot-check to diagnose the problems. While others may need a longer time to find discover and short it out.


Here is how to diagnose why labor costs are increasing and what to do next:


Review the Product Mix

It may be no fault of the production managers if the direct labor cost increases, because the mix of products produced may have shifted to ones that require much more labor. To see if this is the case, create a report that lists the quantities of all products made during the reporting period, multiplied by the standard labor cost per unit produced. When tracked over time, this will clearly show any changes in the total cost of standard direct labor per month.

If so, what to do next? 

If the mix of products has changed to ones that require a large amount of direct labor, be sure to run a margin analysis on each of these products to ensure that the price is sufficient to cover the added direct labor cost. If not, see if the price can be increased to improve margins. If not, consider eliminating the product if the manufacturing facility can more profitably create other products with a lower labor cost. Also, have an industrial engineer review the production process to see if the labor content of those products with high labor costs can be reduced.


Verify Differences between the Actual and Standard Labor Cost

Labor costs may be increasing in terms of the cost per hour, even though the number of hours worked may be steady or even declining. This problem is most common in a tight labor market, where workers have better-paying alternatives, which forces employers to offer higher wages. Also, if it is necessary to hire a more senior and experienced workforce, perhaps due to the complexity of the production process, wages will also increase. To see if this is a problem, summarize all direct labor hours for the most recent reporting period and divide this into the total direct labor payroll for the same period, which yields the average wage per hour. Compare this information to the same calculation for previous periods to see if there is a trend of increasing wages.

If so, what to do next?

One option is to move the production facility to another location where wage rates are lower, though this is a good option only when the labor cost component of a product is so high that major cost reductions can be achieved by making the move. Another alternative is to use industrial engineering reviews to make the production process simpler and in need of fewer workers, which has the byproduct benefit of requiring less trained and therefore less expensive workers. It may also be possible to invest in various kinds of automation to completely eliminate direct labor costs, though this option has the downside of requiring greater overhead costs, such as depreciation and machine maintenance.


Compare Total Hours Worked To Standard

The per-hour cost of labor may be in line with expectations, but the number of hours may have increased. To see if this possibility is true, summarize the number of direct labor hours worked in the last reporting period and compare this to the number of hours at standard, which is collected by multiplying the standard hours listed on the bill of materials by the total number of products produced. If the number of actual hours exceeds the standard, then management should work on making the labor force more efficient.

If so, what to do next?

Besides the recommendations noted under the last item, management can also focus on the scheduling of direct labor personnel. If employees are coming in and waiting around with no work to do, then there is a disconnect caused either by the absence of materials with which to make products (which requires better control over the purchasing function or the scheduling of products that require purchases), or by the absence of scheduling for machine downtime that stops the production process. To solve either issue requires close and continual coordination between the production scheduling staff and the maintenance and purchasing departments.


Check On Overtime Costs

An increase in labor costs may be brought about by additional employee overtime, which increases labor costs by a minimum of 50 percent for each overtime hour worked. To see if this is the problem, summarize all overtime dollars paid in the most recent reporting period, and compare this to the same calculation for previous periods to see if there is a change in the amount of dollars paid. Another measure is to divide the total dollars (or hours) of overtime by the grand total cost (or hours) for all labor in the period, which yields the overtime percentage for the period. This measure can also be compared to prior periods.

If so, what to do next?

Examine the reasons for overtime, and eliminate them. One may be that customers require shipments by a specified date, which cannot be met unless the staff works overtime. If so, can the extra cost be charged to the customer? Alternatively, could the production scheduling staff have done a better job of completing the work in an earlier period when more production capacity might have been available?


Investigate Shift Premiums

Direct labor costs will go up if there are multiple shifts, with the second and third shifts being paid a premium. To determine the extent of this cost, summarize the shift premium expense for the second and third shifts in the reporting period. The analysis can be further refined by dividing this cost by the total direct labor cost to see if the proportion of shift premium cost is changing over time.

If so, what to do next?

If there is a third shift, see if it is possible to cut back on or eliminate this shift, thereby eliminating the largest of the shift premiums. The same analysis can be applied to the second shift. These two shifts should be used only when there are firm customer orders in hand, or very reliable sales forecasts that call for more product than the day shift can create on its own.


By doing those diagnoses, you should be able to discover why the labor cost is increasing and fix the problems.