A portion of the costs incurred by business organizations is designated as direc

Question

A portion of the costs incurred by business organizations is designated as direct labor cost. As used in practice, the term direct labor cost has a wide variety of meanings. Unless the meaning intended in a given context is clear, misunderstanding and confusion are likely to ensue. If a user does not understand the elements included in direct labor cost, erroneous interpretations of the numbers may occur and can result in poor management decisions. In addition to understanding the conceptual definition of direct labor cost, management accountants must understand how direct labor cost should be measured. Discuss the following issues:

A). Distinguish between direct labor and indirect labor.

B). Discuss why some nonproductive labor time (such as coffee breaks and personal time) can be and often is treated as direct labor whereas other nonproductive time (such as downtime and training) is treated as indirect labor.

C). Following are labor cost elements that a company has classified as direct labor, manufacturing overhead, or either category depending on the situation.

- Direct labor: Included in the company’s direct labor are production efficiency bonuses and certain benefits for direct labor workers such as FICA (employer’s portion), group life insurance, vacation pay, and workers’ compensation insurance.

- Manufacturing overhead: Included in the company’s overhead are costs for wage continuation plans in the event of illness, the company- sponsored cafeteria, the personnel department, and recreational facilities.

- Direct labor or manufacturing overhead: Included in this category are maintenance expenses, overtime premiums, and shift premiums. Explain the rationale used by the company in classifying the cost elements in each of the three categories.

D). The two aspects of measuring direct labor costs are (1) the quantity of labor effort that is to be included, and (2) the unit price by which the labor quantity is multi-plied to arrive at labor cost. Why are these considered separate and distinct aspects of measuring labor cost?

Explanation / Answer

(A) Direct labor is the amount of labor hours given to direct activities associated with production of a good (or rendering a service), while indirect labor is the number of labor hours allocated to activities that are supporting activities for producing the good (or service).

(B) Workplace recreation time is treated as direct labor because the coffee breaks etc cannot be exactly measured as idle time in terms of hours, and these durations are included within the time during which an employee engaged with direct production remains in office or factory. But downtime or training are support activities because it can not be established how much of the training time has exactly contributed to making of the good or service. In absence of such direct identification, these are considered as indirect labor.

(C)

(i) Direct labor

These cost elements are treated as direct labor because they increase the employee satisfaction, therefore enhancing productivity, therefore has a directly identifiable relationship with production of the good or service.

(ii) Manufacturing overhead

The costs in this category are incurred in running the production of multiple goods or services, and usage by employees cannot be directly attributed to a specific good or service since these are resources jointly shared by every employee.

(iii) Direct labor or manufacturing overhead

Costs included in this category can fall into either of the two categories with equal likelihood. For example, maintenance expense is an aggregative factory level expense, but at the same time it contributes to effective functioning of the production process. An exact point of separation is unclear.

(D) Quantity of labor corresponds to the actual labor hours worked. Actual hours is an indicator of labor efficiency, since if actual hours for production is higher than budgeted hours for producing same number of units, it indicates inefficiency (higher than budgeted time taken).

Similarly, labor price (labor rate) is a necessary input in measuring labor cost, because the higher the labor rate, the higher the cost of labor. If actual labor rate paid is higher than budgeted labor rate, there exists a labor rate inefficiency.

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