Career Development

What Is Labor Cost? Definition, Direct vs. Indirect Costs and Examples

March 5, 2021

Labor cost is a financial term that's used interchangeably with "cost of labor" on financial reports. This value is arrived at by calculating the cost of all employee pay and benefits. If you're in human resources, finance, accounting or executive leadership, you may need to understand labor cost and how it impacts you. In this article, we define labor costs and give examples of how to use it and how it's calculated.

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What is the cost of labor?

Labor cost is an important value that finance and accounting professionals calculate to determine the direct and indirect price that a company pays for labor.

The direct cost of labor includes the cost of wages and benefits for employees who are directly involved in producing the product or service commodity. The indirect cost of labor refers to amounts paid for employees that support the commodity but aren't directly involved in making it.

Understanding the cost of labor helps companies price products, and without an understanding of direct and indirect costs companies may find it challenging to arrive at the right cost of products. As a result, a deep understanding of labor cost and how to use it is beneficial for the economy.

Cost of labor can be further broken down into fixed and variable costs:

  • Fixed: Fixed costs are usually contracted costs but sometimes includes essential costs that are predictable.
  • Variable: Variable costs increase and decrease with variables like production demand and economic conditions.

Related: Learn About Being an Estimator

Example of labor cost

Here are four examples of labor cost:

Direct labor cost example

Direct labor costs refer to costs that are derived directly from supply chain employees involved in the production. This could be assemblers, manufacturers, heavy machinery users, fabricators, craftsmen and artisans, delivery drivers and other logistical employees essential for getting goods into consumer's hands.

One example of a direct labor cost is the hourly salary of a quality assurance inspector adjusted to include healthcare benefits and short-term disability. Another example could be the annual salary of a welder who works on the production line of a steel parts manufacturing company. Yet another option for direct labor costs is the payment made to a logistics company responsible for delivering goods across the country.

In each case, the employee whose salary and benefits are being accounted for plays an essential role in producing a product and distributing it through the supply chain.

Indirect labor cost example

Indirect labor refers to any employee whose role is not essential to the direct production of a product. These employees still play important roles like administration, supervisory roles and finance but they aren't involved in the supply chain. An example of indirect labor costs is the salaries of employees in the human resources department.

Another example of indirect labor costs would be the salary, benefits and bonuses of a chief financial officer of a Fortune 500 company that manufactures auto parts. Since this employee is not directly involved in the production of auto parts, their salary represents an indirect cost.

Related: How To Create a Cost Leadership Strategy

Fixed labor cost example

Fixed labor costs are costs that are unlikely to change for a period.

For example, the annual salary of an essential production worker in a given year might be a fixed labor cost. While the employee could get a pay increase, employers have a good idea of the term of the salary relative to when increases are likely to occur.

Variable labor cost example

Variable labor costs increase and decrease with production. A good example of a common variable labor cost is the rate of an hourly employee. Several industries rely on variable labor, especially around shopping holidays. These include retailers, restaurants, manufacturing companies and more. Businesses direct-hire hourly employees or work with agencies to find temporary workers to fill production needs in peak season.

Another variable labor cost might be the cost associated with contract workers who respond to things like equipment malfunctions and other emergency repair services that are critical for business functioning. These things occur on a case-by-case basis which makes them more difficult to predict.

How to calculate labor cost

There are several ways to calculate the various labor costs associated with employees.

Simple formula for cost of labor

The following is is a basic calculation that assumes the cost of benefits and payroll taxes are rolled into the average hourly rate, or that the company doesn't have additional benefits or payroll tax costs.

Cost of Labor = (total sales x percentage of labor) / hourly average of worker salaries

Example: If the company's total sales were $1,500,000, the percentage of the labor equaled 12%, and the average hourly rate of labor was $12.90, we would arrive at labor costs this way:

($1,500,000 x .12) / $12.90 = (180,000) / $12.90 = $13,953.49.

Formula for the average hourly cost of an employee

To calculate the average hourly cost of an employee, including absenteeism and other expenses, you would follow the following steps:

1. First, calculate gross pay

Gross pay = hourly rate of pay x projected hours worked annually

Example: If an employee makes $10 per hour and works 40 hours a week, then we would use:

10 x 2010 = $20,800

2. Include absenteeism in your calculation

Employees receive holidays and sick days, so use industry or company averages to determine how much sick time and how many holidays should be included.

In the original example above, we can predict 5 days of absenteeism and 5 holiday days for a total of 80 hours. You would then subtract this from total hours worked annually as follows:

New annual hours worked calculation: 2080 - 80 = 2000

3. Add other expenses in your calculation

Refer to additional financial data to find any other employee expenses, such as costs of providing benefits. For instance, you could find an additional $5,000 in expenses per employee.

In the original example above, you would then increase the individual employee cost by $5,000 per employee, bringing the annual payroll labor cost = $25,800.

4. Calculate actual hourly labor cost

After following the three steps above, we are ready to apply the formula for our final calculation:

Actual hourly labor cost = annual payroll labor cost / new annual hours worked

Using the above example, our calculation would look like this:

$25,800 / 2000 = $12.90 actual hourly rate

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