Labor Cost: Definition,Applicability, Components , Total Labor Cost, Classification Of Total Labor Cost
1.1 Definition
There are various ways of defining the term labor cost. The following definitions are appropriate.
Definition 1: Labor cost is the monetary value of labor used in producing a unit of a product. The labor cost incurred may be through hiring of laborers who may be either;
Skilled
Semi-skilled or
Unskilled
Definition 2: Labor cost is the economic resources forgone by the organization to compensate for work directly or indirectly done or performed by the employees of the organization.
Definition 3: Labor cost is the payment given to all categories of workers or employees of a firm in the form of wages and salaries which are inclusive of allowances, payroll taxes, and any other work-related benefits such as payroll taxes, overtime, bonuses, medical health allowances, sick days allowances, vacation days, insurance cover benefits, meals, supplies, cost of employee training and travelling allowances etc.
1.2 Applicability of Direct Labor Cost
At what point can we say direct labor cost fits well? In other words, under what circumstances can we say that the aspect of direct cost is appropriate in a business set up? The following are some of the circumstances where direct labor cost is fitting
- Where direct labor represents the highest percentage of the total inputs of the total production cost such as 80% to 90% or so.
- Existence of product uniformity such that the output at the end of the production process is characterized by identical products.
- Existence of employee skill uniformity such as similar medical skills, similar construction skills, and training similar skills.
- Cases where mode or method of wage payment is the same. if there are any variations, it is not material.
Labor Cost Classification
As much as there are various activities in an organization other than production of goods or provision of services, similarly, there are also other categories of labor force who have a different classification of labor expenses or cost paid or incurred. In addition, there are also other terms and conditions that the employer engages the employees hence translating to another classification of labor cost.
2.1 Labor Cost Classification Criteria
Generally, labor cost is majorly classified into different viewpoints; namely;
- The degree or level of labor activity contributed by the employee in production of the product (i.e., good or service provision).
- Mode of payment agreement between the employee/worker and the employer.
2.1 Classification Criteria-Degree of Labor Activity Contributed by the Employee in Production of the Product
Under this classification, there are two categories of labor cos;
-Direct Labor cost.
-Indirect Labor cost.
2.1.1 Direct Labor Cost
Definition: Direct labor cost is the economic resources forgone by the organization to compensate the workers who are directly associated with production or provision of a certain good or service.
One condition for labor cost to be termed as direct labor cost is that the compensation being done to the employee or worker should be directly tied to the product being produced. Otherwise, such a cost will be an indirect cost.
Examples of Direct Labor Cost
Case One: Cost incurred or paid to constructors/builders of a House
-Wages of Builders-who carry out the work of actual laying of the bricks or building blocks, fixing the roof etc.
The following freely downloaded images depicts the nature of direct service provided and the corresponding direct labor cost.
Image source:https://www.dreamstime.com/photos-images/man-laying-concreate-block-wall.html
Case Two: Cost incurred or paid to medics/doctors for Medical Services
-Wages for doctors-who carry out the examination of patients in the hospital.
-Wages for nurses-who directly assist the doctors to treat patients in or out of the wards.
-Consultation fee for medical specialists-doctors who specialize on treatment of a particular sickness or major or minor operations.
The following freely downloaded images depicts the nature of direct service provided and the corresponding direct labor cost.
Image source:https://www.dreamstime.com/photos-images/doctor-gives-injection-to-patient.html
Usefulness of Direct Labor Cost
Direct labor cost classification is key in business. It helps in the following perspectives, such as;
- Used as cost driver when allocating overhead costs or indirect costs. This basis helps in eliminating the confusion of the amount of indirect cost to be allocated to other employees who are not directly associated with production activity.
- Controllability advantage. Direct labor cost is characterized by being flexible such that it is possible to adjust output as per the discretion of the producer. In this way the total cost of production can be regulated.
- Availability of labor cost data. Data related to direct labor cost is readily available and this helps in accurate estimation of the total direct labor cost associated with a particular product.
- Traceability advantage. The fact that direct labor cost is physically identifiable on the product produced, it helps in ensuring that no cases of overpricing or underpricing of the good or services sold to the end users.
2.1.2 Indirect Labor Cost
Definition: Indirect labor cost is the economic resources forgone by the organization to compensate the workers who are indirectly associated with production or provision of a certain good or service.
One condition for labor cost to be termed as indirect labor cost is that the compensation being done to the employee or worker should not be directly tied to the product being produced. Otherwise, such a cost will be direct cost. In other words, the labor cost incurred or paid is an auxiliary related cost to production of the product.
Examples of Indirect Labor Cost
Note that in this case, we are re-visiting the same previous cases of construction and medical care. But the examples used is what differentiates the two categories.
Here we go…..
Case One: Indirect cost incurred or paid to other employees linked to House Construction
-Consultancy fee for engineers-who ensure adherence to quantity and structural engineering requirements are met.
-Wages of a Foreman-Who supervise the ground work done to prepare a solid foundation for the construction to take place. They also supervise the actual construction of the building.
-Wages of construction supervisors-who do general supervision to ensure no breaking of the environmental or government rules and regulations.
-Wages of contractors-who are assigned specific roles to play in the construction. For example, supervising of laying of support metallic pillars to hold the building together.
-Wages of a Day and Night watchman-who ensure that no internal or external destructions take place or theft of construction materials
-Wages of cooks who provide food stuffs such as breakfast, lunch and supper to the people at the construction site.
The following freely downloaded images depicts the nature of indirect service provided and the corresponding indirect labor cost.
Image sources:https://www.dreamstime.com/photos-images/construction-foreman.html and https://www.istockphoto.com/photo/view-of-security-man-from-behind-gm96309375-3309633
Case Two: Indirect cost incurred or paid to other employees linked to Medical Services
- Wages of a Day and Night watchman-who ensure that no internal or external intruders take place or theft of patient belongings.
-Wages for hospital ward cleaners and repair and maintenance of the hospital buildings.
-Wages for ward attendants who clean and maintain the immediate environment.
-Wages for hospital reception attendants-who guide patients where to get the services they need.
The following freely downloaded images depicts the nature of indirect service provided and the corresponding indirect labor cost.
Usefulness of Indirect Labor Cost
Indirect labor cost classification is key in business. It has several importance such as;
- Adds up to total cost associated to production of a particular product. Indirect labor cost is part of total labor cost and cannot be ignored for it is paramount for pricing.
- Arise as a result of auxiliary support added to direct production. This type of labor cost arises to ensure production of a product or service provision is complete.
- Avoids over and under costing of goods or services. The factoring in of the indirect cost is a mile stone as far as avoiding of over pricing is concerned which can adversely affect marketing of the product. Also, it avoids underpricing which can result to cutthroat elimination of a firm from the market due to failing to meet the average cost of production.
2.2 Classification Criteria-Based on the Mode of Payment
The mode of making payment for the work done guides one to classify labor cost as
-Fixed Labor cost
-Variable labor cost
-Semi-variable labor cost.
2.2.1 Fixed Labor Cost
Definition: Fixed labor cost is the economic resources forgone by the company so as to compensate the workers or employees some constant amount of payment whether production took place or not.
To test whether labor cost is of fixed nature, ask yourself this question. Will there be any labor cost incurred or paid if the business closes down for a day or so? If labor cost will be incurred or paid, then this implies that this is a case of fixed labor cost.
Fixed labor cost occurs where there is an arrangement to make payment pegged on a constant or fixed factor such as a constant rate already set, or a set period, or even set lumpsum amount. You should note that unlike the case of direct and indirect labor cost, the case of fixed labor cost is mostly salaries for workers or employees. Whether paid due to direct production or otherwise. The common type of labor cost which works in this manner is monthly salary for workers. Therefore, the fixed cost may or may not necessarily be directly associated with production of a product.
Examples of Fixed Labor Cost
Case 1: Labor cost for those who work in a Law Firm
Salary for court attendant clerks-who prepare files ready for case hearing. Where there is work load of preparing the files or no single file is available to be prepared ready for court presentation, the employee has to be paid salary at the end of the month.
Salary for law firm office cleaners-who ensure that the office is clean and all files are well sorted and cleanly kept in cabins. These cleaners are always doing cleaning and have to be paid. Even when they break for vacation, their pay is guaranteed.
Salary for law firm receptionist-who coordinate the law firm activities and clients on when to attend court cases.
Case 2: University Lecturing Services
Salary for lecturers-who teach in two semesters or trimester and when they go for recess-long vacation, they are still paid by the University.
Salary of departmental and school office administrators- who ensure that learning continues by providing the necessary information to the students and the respective lecturers.
Case 3: Health care services-by Non-Profit Making Organizations (NGOs)
Salaries for NGO administration employees-who coordinate and manage the operational activities
Salary for office operations clerk-who ensure the office matters are well attended to and guiding of the NGO participating groups.
NB: You see, all these salaries has to be paid whether there is work done or not. Even when the offices are closed for a vacation, the salaries are to be paid. This are then constant/fixed labor cost.
2.2.2 Variable Labor Cost
Definition: Variable labor cost is the economic resources forgone by the company so as to compensate the workers or employees some amount of payment which is directly anchored on the level of production.
To test whether labor cost is of variable nature, ask yourself this question. Will there be any labor cost incurred or paid if the business closes down for a day or so? If labor cost will not be paid, then this implies that this is a case of variable labor cost.
Variable labor cost occurs where there is an arrangement to make payment pegged on the level of production such that if the production level is zero then no labor cost is paid or incurred. You should note that unlike the case of fixed labor cost which is mostly salaries for workers or employees, variable labor cost is flexible against output levels. The common type of labor cost which works in this manner is weekly or fortnight wage for workers.
Examples of Variable Labor Cost
Case 1: Labor cost paid by Law Firm to be provided with services
Seminar fee or charges for court attendant clerks-who are trained on how to deal with court matters. For instance, the case of online case presentation when there was Covid-19 pandemic. If the case of Covid-19 subsides, then no more cost for seminar trainers.
Salary for part-time lawyers-If the number of cases are more, the more the variable labor cost is paid to the part time lawyers. If the cases of such nature reduce, the less the payment.
Case 2: University Lecturing Services
Salary for part time lecturers-who teach to assist the full time employed lecturers-incase the number of classes to be taught reduce, the part-timers are also reduced and their salary reduce accordingly.
Wages for examination marking assistants-when the volumes of examination papers increase, the more salary is paid to those who are engaged. If the number reduce, then the salary reduces also in the same way.
Case 3: Banking Services
Commission for bank employees-who dispense loans to clients. Such that if one distributes more loans, the more the commission. Otherwise, if no loans are distributed up to the required sales threshold, then no commission except the basic salary.
Overtime for bank cashiers-who serve customers at the counter. Such that when the number of customers are more after the close of business, the extra hours worked are paid for. Other wise if no overtime work no extra pay and this is a case of variable labor cost.
NB: You see, all these salaries/wages are only paid if the volume of the output increases. If it decreases, less or no salary will be paid for the payments are pegged on the volume of output.
2.2.2 Semi-Variable Labor Cost
Definition: Semi-Variable labor cost is the economic resources forgone by the company so as to compensate the workers or employees some amount of payment which is dominated by both variable and fixed labor cost. In other words, this is mixed labor cost.
To test whether labor cost is of both variable and fixed nature (i.e., mixed), ask yourself this question. Will there be any labor cost incurred or paid if the business closes down for a day or so? If some labor cost will be paid and at the same time other labor cost paid before is now not paid, then this implies that this is a case of semi-variable labor cost.
Examples of Semi-Variable Labor Cost
Case 1: University Lecturing
Full time lecturers’ salary-who teach both classes for normal work load and part time classes for part time payment-in this case, the lecturer is paid the normal salary plus additional part time payment.
Permanent salary is fixed labor cost and the part-time salary is variable labor cost.
Case 2: Sales and Marketing Department
Salesman basic salary plus sales commission-these are the workers who have already set basic pay whether one makes sales or not and then additional pay for motivation incase he or she sells over and above a certain sales threshold.
Basic salary is fixed labor cost and sales commission is variable labor cost.
Components Of Labor Cost
From the discussion aforementioned, it is clear that the elements or characteristics making up labor cost are diverse. The following are then the general components of labor cost regardless of the classification used thereof.
- Public transportation stipends
Total Labor Cost
Definition: As general rule of the thumb, total labor cost is the forgone economic resources by the firm to pay for all labor services already provided by workers across all activities/departments. But more precisely, total labor cost can still be divided in to two categories depending on the focus the business is looking at. For instance, total labor cost may be as far as production is concerned. Or based on the financial reporting objective of the organization, then in this case the focus will be for the whole organization.
Classification Of Total Labor Cost Based On Production
Total labor cost is the forgone economic resources by the firm to compensate all workers or employees who directly or indirectly contributed toward production of a product. Therefore, the formula for total labor cost is expressed as follows;
TOTAL LABOR COST=DIRECT LABOR COST + INDIRECT LABOR COST
Classification Of Total Labor Cost Based On All Activities Of The Organization
Total labor cost is the forgone economic resources by the firm to compensate all workers or employees who have been engaged by the organization whether they contributed toward production of a product or were engaged on other non-production activities. Therefore, the formula for total labor cost is expressed as follows;
Total Labor Cost= Production Labor Cost + Labor Cost for other Services
