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, 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.

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 products or service pricing and ensure accurate financial statements.

Direct labor

The first type is direct labor. Learn more about what constitutes direct labor.

What is direct labor?

Direct labor refers to employees, roles or tasks that are expressly involved with the production of goods and services. Direct employees physically make the products you sell or provide the services you offer directly to 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. You can measure labor costs over various time periods, from hourly to monthly or longer. 

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

Other employees on your company payroll fall under the indirect labor category. 

What is 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. 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.  

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 for 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. 

Distinctions between 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: The two costs are also managed in different ways. For example, direct labor costs may be managed through 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 employees might see fluctuations in their hours if productivity levels increase or decrease. For instance, they might need to work overtime if you have a larger order. 

FAQs about direct vs. indirect labor

Which is more important: direct vs. indirect labor?

Both types of labor are necessary to keep your company running effectively. You need indirect employees to perform the support duties that make it possible for direct employees to assemble products or perform services. How you calculate and look at the cost might vary, but both types of labor are essential. 

Why is it important to calculate direct labor vs. indirect labor?

Evaluating labor costs is essential to improving overall operations and ensuring cost-effectiveness. Analyzing the rates can help you make decisions on controlling costs when necessary. This process also helps ensure accurate financial reporting and effective budgeting for future expenses. Direct labor costs, in particular, help you price your products and services correctly. 

How do you determine if an employee is direct vs. indirect labor?

Does the person have hands-on experience in making the products you sell? Do they perform a service directly for customers or clients? Look at the primary duties of the role and whether it’s more administrative or directly involved in production.