What is direct vs. indirect labor?

When calculating labor costs, you typically categorize each employee as indirect or direct labor depending on their role in the overall process. Understanding the difference between indirect vs. direct labor is essential for accounting accuracy. For example, it can help you measure labor productivity and efficiency, determine profitable product or service pricing and ensure accurate financial statements.

Before we explore the differences between direct vs. indirect labor, let’s first examine why factoring in labor costs can be an important part of your accounting process:

Accounting and labor costs

Your company’s operating expenses are necessary for delivering services or goods to your customers. When measured against revenue, the operating expenses help determine values such as profit and cost of goods sold. Typical expenses may include:

• Manufacturing costs
• Materials
• Utilities and maintenance
• Rent or mortgage
• Labor and payroll costs

Labor and payroll costs, which include all the costs of paying your employees, typically represent a large portion of a business’s overall expenses. Labor costs include not only salary but also payroll taxes, paid time off (PTO) and additional benefits you offer. 

Because these expenses make up a significant portion of your total expenses, it’s essential to consider them when accounting for the cost, price and profit of goods and services produced and sold.

Defining direct vs. indirect labor

With the above in mind, let’s now address how to define direct vs. indirect labor, including how to calculate different costs for each:

Direct labor

Direct labor refers to employees, roles or tasks that are directly involved with producing goods and services. These employees physically create the products you sell or directly provide the services you offer your customers. 

You can trace their labor costs to a specific product or service your company offers. Because of the nature of the work, the costs vary based on production output.

Examples of direct labor

Understanding direct labor vs. indirect labor is often easier with concrete examples. Several roles fall under the direct labor category and these positions can vary depending on the industry. The following roles represent direct employees in various industries:

• Plumbers
• Electricians
• Hair stylists
• Restaurant servers
• Assembly line workers
• Machinists
• Accountants who work directly with clients.

Calculating the cost of direct labor

When calculating direct labor costs, you determine the total amount you pay your direct employees. This includes their wages, payroll taxes, benefits and any other payroll costs. The cost of direct labor is typically split into the following categories:

• Regular hours: This is typically classed as a 40-hour work week. However, for part-time workers, this could be less.
• Overtime hours: Also factor in the hours worked over the employee’s typical work week. Typically, this is any additional work over the 40-hour work week.
• Shift differentials: If employees are paid a premium for later shifts, then you may need to factor this into the cost of direct labor as well.
• Payroll taxes: These are any taxes you pay on behalf of your employee and deduct from the wage you are paying your employee.

For example, start by calculating the total hourly costs for an employee. Say an employee earns $22 per hour. Their benefits and other payroll costs average $3 per hour, making the labor costs for this employee $25 per hour.

From there, you can calculate the total labor cost over longer periods. If the employee works 180 hours a month at $25 per hour, the total monthly cost can be calculated by multiplying these numbers, resulting in $4,500.

You can also add the direct labor costs for multiple employees to evaluate how much you’re spending on a specific project. 

If you have three direct employees working at the same rate at a monthly cost of $4,500 each, then the total direct labor cost for that project is $13,500. You can then apply those costs to the revenue generated to calculate the direct labor cost per product or service.

Indirect labor

Indirect labor refers to employees who support direct labor and the overall enterprise. They don’t directly manufacture goods or deliver services, but they still play an essential role in keeping the business running and producing products.

They perform background functions

These employees perform background or overhead functions rather than directly contributing to production and work performed by indirect employees can’t be directly applied to the revenue of a service or product.

The work that indirect employees perform typically counts toward the business’s overhead costs. For example, a human resources manager can’t be directly linked to a company’s revenue or profit but contributes to other functions that improve the business’s general productivity. Indirect positions often relate to supervision or management, administrative support, quality control, maintenance and technical support.  

Fixed expenses

Indirect labor costs are usually fixed expenses. This means that they remain steady even if your company’s production output fluctuates. However, some indirect labor costs can vary depending on production. 

Examples of indirect labor

Some examples of indirect employees include:

• Administrative staff
• CEOs
• Maintenance and repair workers
• Marketing associates
• Teachers or instructors
• Customer support agents
• Accountants
• Quality control
• Security staff
• Janitorial staff

While most roles fall into one category, some positions could be direct or indirect, depending on the situation. For example, an accountant who works in the corporate office of a manufacturing company is an indirect employee. They handle financial data that supports the company’s production. 

However, an accountant who works directly with clients at an accounting firm would be a direct employee. They’re working directly with the clients and performing the company’s primary service. 

Calculating the cost of indirect labor

To calculate indirect costs, total the hours an employee works and subtract any time off for sick days, vacations and attending seminars and training. If an employee works about 2,000 hours per year at $25 per hour, their cost is $50,000. Total all indirect employee costs and add this figure to the overall direct employee cost.

While indirect labor costs can’t be attributed to a specific product, they are still an important factor in managing labor costs. 

Comparing direct vs. indirect labor

When comparing direct vs. indirect labor, there are several key differences. Not only are their duties different, but the way you determine the costs of each type of employee also varies. Understanding the following differences can help clarify the distinctions between indirect labor vs. direct labor:

• Relationship to goods or services: The main distinction between direct vs. indirect labor is how the cost relates to a company’s production of goods or services. While indirect employee costs can’t be traced back and applied to units of production, direct labor costs can be applied to unit costs.
• Business expense categories: The two labor costs are also added to different categories of business expenses. Direct labor costs are included in the overall costs of goods or services, while indirect labor costs are factored into overhead business expenses.
• Cost management: You also manage the two costs in different ways. For example, direct labor costs may be managed by identifying efficiency solutions so that a given product or service requires less overall labor. If that’s not possible, businesses might raise the price of a product or service to improve cost efficiency. Indirect costs are managed through business expense budgeting, often during quarterly or annual financial reviews.
• Changes in labor amounts: With indirect labor, you can’t easily decrease the hours worked if your sales change. Your HR team members, customer support team and other indirect employees still have a similar workload to do whether or not sales are high. Direct labor hours can increase once your business’s forecasted sales demand increases, meaning that you may need to hire more staff in these roles to compensate.

Different labor types and the general hiring landscape

When budgeting for direct vs. indirect labor, it can be useful to consider the contemporary hiring landscape. 

Hiring for direct vs. indirect labor roles

When searching for employees to fill these different employment categories, it is useful to keep in mind a skills-first hiring approach. Direct labor roles may require skills focused on transferable practical technical skills, problem-solving and teamwork. While indirect labor roles may benefit from these as well, also look for project planning, time management, organizational and inventory management skills. 

You might find, for example, that skills gaps are more common for some indirect labor roles, particularly those that use information technology (IT) for management and administration. A lack of digital skills and literacy can impact how easy it is to hire employees in indirect roles relating to administration and IT support. 

That’s because digital transformation and automation are changing IT-related role requirements and responsibilities. This increases the need for AI experience and skills.

However, some direct labor roles require specialist experience, which means that professionals with these qualifications are more difficult to hire for and are therefore in higher demand. For example, this could include registered and licensed electricians, plumbers or lawyers.

Automation may be affecting the demand for direct labor

Automation may be affecting the demand for certain types of direct labor. In some areas, such as software coding, specific tasks are becoming more automated. While technology may take on repeatable or rules-based work, many organizations continue to rely on human involvement for oversight and decision-making. Remote direct labor may be more difficult to trace.

It may also be harder to trace direct labor costs in your pipeline if you hire remote employees. For example, it could be more challenging to monitor how many hours are spent on a particular task or different rates of pay per project. Make sure that direct laborers are on the same payroll as everyone else within your business to ensure traceability.

Differentiating direct labor and contract work that provides goods and services

Furthermore, in a gig economy, it is important to distinguish between direct labor employees who provide a good or service and contractors. In comparison to contractors who may provide a good or service on a project basis, direct laborers provide these on a waged basis. 

There may be times when it is more appropriate for you to hire a contractor rather than an employee who performs direct labor and vice versa. Hiring direct employees can save on overall costs if you need someone to work regular shifts on a long-term project. 

However, contractors may be more cost-effective if you need someone to work on short-term projects. An example could be hiring a contractor for a specific event rather than employing someone full-time. 

Another benefit of hiring a direct employee is that the time and cost of their labor are more traceable since they are on your payroll. Conversely, contractors may be paid different rates per project, making it harder to track their hours spent.

Being able to differentiate between direct and indirect labor employees can be useful since the cost of hiring each differs. By understanding how to calculate costs for each role type, you can better manage your business budget and overhead. Finally, the number of direct labor employees you hire may depend on the demand for your goods and services.