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Cost Accounting

Labor Cost [An overview]



Labor CostLabor cost is second biggest portion of a manufacturing cost of any manufacturer after the raw materials. A rise up on labor cost will directly drag profit down significantly and a right approach on the labor cost management contributes directly to the value added company can generate. Therefore, labor cost is second major concern of the management. A cost accountant of a manufacturing company devotes her/his energy time and focuses in watching at the labor cost after the raw material consumption.

This post is by no mean complete in discussing the labor cost, but it is a starter for anyone who are interested and plans to involve in the cost accounting. If you are a cost accountant, some parts of this post maybe missing pieces you are looking for, so read on…



Direct and Indirect Labor Costs

Labor is the physical or mental effort expended in manufacturing a product. Labor cost is the price paid for using human resources. The compensation paid to employees who engage in production-related activities represents factory labor cost.

Direct laborers are those who work on a product directly, either manually or by using machines. Direct labor is all labor that is directly involved in the production of a finished product, that can be easily traced to the product, and that represents a major labor cost of producing that product. Examples are assembly-line workers in an automobile factory or knitting machine operators in a sweater factory. Direct labor is considered both a prime cost and a conversion cost.

Indirect labor is factory labor not directly traceable to a product; also, it is not considered worthwhile to try to relate the cost of the indirect labor to production. Laborers whose services are indirectly related to production include product designers, job supervisors, and product inspectors. Indirect labor is considered part of factory overhead cost.


Costs Included in Labor

The principal labor cost is wages paid to production workers. Wages are payments made on an hourly, daily, or piecework basis. Salaries are fixed payments made regularly for managerial or clerical services. However, in practice, the terms “wages” and “salaries” are often incorrectly used interchangeably.

Total labor costs have been increasing rapidly in recent years, particularly in areas such as vacation and holiday pay, pensions, hospitalization, life insurance, and other fringe benefit costs. In some cases these supplementary costs represent nearly 30% of regular earnings.


Accounting for Labor

Accounting for labor by a manufacturer usually involves three activities: (1) timekeeping; (2) computation of total payroll; and (3) allocation of payroll costs. These activities must be performed before the payroll is recorded in the accounting records.

I am going to discuss these activities on the next paragraph. Read on…



Most large-scale manufacturers have a separate timekeeping section within a personnel department whose function is to collect the hours worked by employees. Two source documents commonly used in timekeeping are the “time card” and the “labor job ticket“:

  • A  time  card  (clock  card)  is  inserted  in  a  time  clock by  the  employee several  times each day: upon arrival, going  to  lunch,  taking a break, and when leaving for the day. By mechanically keeping a record of total hours worked each day by employees, this procedure provides a reliable source for computing and recording total payroll costs.
  • Labor job tickets are prepared daily by employees for each job worked on. Labor job tickets indicate the number of hours worked, a description of the work performed, and the employee’s wage rate (inserted by the payroll department). The  sum  of  the  labor  cost  and  hours  for  different  jobs  (as shown on labor job tickets) should be equal to the total labor cost and labor hours for the period (as shown on time cards).


Computation of Total Payroll

The payroll department’s primary function is to compute the total payroll, including gross amount earned and  the net amount payable  to employees after  deductions  (for  federal  and  state withholding  taxes,  Social  Security taxes, and so on). The payroll department distributes the payroll and maintains records of employees’ earnings, wage rate, and job classiication.


Allocation of Payroll Costs

Using time cards and labor job tickets as a guide, the cost accounting department must allocate the total payroll costs (including the employer’s portion of taxes and fringe costs) to individual jobs, departments, or products.

Some  companies have  the payroll department prepare  the  allocation  and send  it  to  the  cost  accounting department where  the  appropriate  journal entries are prepared. The total payroll cost for any one period must equal the sum of the labor costs allocated to the individual jobs, departments, or products. Below figure depicts the cycle for labor costs:

The Labor Costs Cycle


Special Problems Relating to the Accounting for Labor Cost

The accounting for labor involves special problems that are not encountered in the accounting for raw materials and other areas. In this section, I am going to discuss the following problem areas in greater detail: employee taxes, employer taxes and fringe benefit costs, shift premiums, overtime, idle time, and minimum guaranteed wage and incentive plans. Follow on…


Employee Taxes

Employers are required by law to withhold, from their employees’ earnings, federal, state, and local income taxes (hereafter referred to as collectively as income taxes) and Social Security taxes as per the Federal Insurance Contributions Act (FICA).  FICA taxes are designed to offer employees some measure of income upon retirement. Employers remit to the government, on a quarterly basis or more frequently, the employees’ income taxes and FICA taxes withheld as well as the employers’ share of payroll taxes.


Employer Taxes and Fringe Benefit Costs

Total payroll costs generally exceed the cost of gross wages or salaries by over 30%. Employers are required at present to match the employee’s contribution to Social Security (FICA) and also to pay federal unemployment taxes [according to the Federal Unemployment Tax Act (FUTA)] and state unemployment insurance, herein referred to as SUI. The FUTA/SUI tax s levied only on employers that up to a maximum limit on total gross earnings of employees subject—to—tax. The purpose of FUTA/SUI is to provide funds that can be used to pay unemployment benefits to employees in the event of terminated employment.

Most  states  also  require  that  employers  bear  the  cost  of worker’s  compensation insurance (to provide funds to employees who are injured on the job). The preceding payroll taxes must be paid  by  the  employer.  Two optional fringe benefits are contributions to health, life, or other insurance, and contributions to a guaranteed annual wage fund. Today, because of the skyrocketing costs of medical insurance, it is common to have the cost of health care paid jointly by the employer and employee.

Factory  employees  are  generally  entitled  to  paid  vacations  after  an initial  period  of  employment. The amount of vacation time is usually based on length of employment. For example, an employee who has worked between 1 and 5 years may get two week vacation, while an employee who has worked more than 5 years may be entitled to 3 weeks.

Practical Insight: Vacation  pay  should  not  be  charged  to  work-in-process  when  an employee  is  on  vacation.  An employee is contributing to production only while on the job. Therefore, only payroll costs for the weeks actually worked should be included in work-in-process inventory, and vacation pay should be accrued over that same period of productive labor and charged to factory overhead control. For holiday pay, the amount of  the accrual depends  on  provisions  of  the  labor  contract  or  on  company  personnel policies, with the number of paid holidays usually ranging from 8 to 11 during a year. Accounting  for holiday pay  is handled much the same as vacation  pay;  in  fact, many  companies  combine  the  two  costs  into  one account, Vacation and Holiday Pay, making one entry instead of two.


In real businesses, these accruals are generally based on estimated annual totals. Thus, the estimated total vacation pay could be based on last year’s amount adjusted for any expected changes. Since most vacations are taken during July and August, any corrections in the accrual could be spread out over the last 5 or 6 months of the year so that no costs would be unduly distorted. This same accrual procedure can be used for other paid absences, such as jury duty or sick leave. For a salaried employee, the vacation pay, holiday pay, or other paid leave is charged to the period in which the absence occurs. It is assumed that the work will be done by another person during the absence or that the absent employee will take care of it upon returning. If a temporary worker is hired to handle the duties, the additional labor cost is charged to factory overhead control (to avoid double counting).

Payroll fringe benefit costs have increased appreciably. A growing number of companies have chosen to treat fringe benefit costs as direct labor costs. However, most companies still include the cost of fringe benefits in factory overhead accounts.


Shift Premiums

It is an accepted practice to pay shift premiums, or higher hourly rates, for the less desirable evening shift (3 P.M. to 11 P.M.) or night shift (11 PM to 7 AM). This shift premium, or shift differential, should be charged to factory overhead control rather than work-in-process, and spread over all units produced.

Note: Charging factory overhead control for shift premiums (instead of work-in-process)  is especially  important when a  job order cost system  is used because the unit cost of individual jobs produced when shift premiums are paid will not be distorted. Shift premiums are not caused by speciic jobs and therefore should be spread over all the jobs produced during the period.


Overtime Premium

Regular earnings represent the total hours worked, including overtime hours, multiplied by the regular pay rate. Overtime premium represents the overtime hours multiplied by the premium rate. The premium rate for overtime is usually some fraction of the regular rate. Overtime is commonly referred to as time-and-a-half because most overtime hours worked are paid at the regular rate plus a premium of one-half the regular rate.

Three accounting treatments that are commonly used are based on  the underlying cause of overtime:

  • Treatment 1: Most overtime results from the random scheduling of jobs and should be treated like a shift premium and charged to factory overhead control.
  • Treatment 2: When overtime results from the requirements of a specific job and not from random scheduling, the overtime premium should be charged to the specific job that caused the overtime.
  • Treatment 3: If overtime resulted  from negligence or poor workmanship  on  the  part  of  a worker,  then  the  overtime  premium  should  be charged as a loss.


The type of accounting treatment accorded overtime is important in that it determines what actions, if any, should be taken by management in the planning and control of labor costs. For example, the recording of a loss might call for closer supervision or better on-the-job training.


Idle Time

Idle time results when employees have no work to perform but are still paid for their time. For example, when a new job is being set up for production, some workers may temporarily have nothing to do. If their idleness is normal for the production process and cannot be avoided, the cost of idle time should be charged to factory overhead control. If the cost of idle time was due to negligence or inefficiency, it should be charged to a loss account.


Guaranteed Wage and Incentive Plans

When payments to an employee are based solely on the number of units produced, the employee is said to be paid at a piecework rate. Many employers pay employees a minimum wage but employees can earn more if they produce more. This labor payment system benefits new employees because it guarantees them a minimum salary while they are learning their new job (during which time they usually do not produce enough units to trigger the piecework rate).

Experienced employees also benefit from this system because they are provided an opportunity to earn more money as they become more efficient. If the output multiplied by the piece rate results in an amount less than the guaranteed wage, the difference is charged to factory overhead control. If the output multiplied by the piece rate results in an amount greater than the guaranteed wage, it should theoretically be charged to work-in-process [WIP] inventory. Under this type of compensation system, an average employee working on a job is expected to earn not only the minimum wage but a bonus as well. Had another type of compensation system been used, the employer would probably have paid workers an amount equivalent to the minimum wage plus the average bonus.

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