Cost of Labor

Updated on April 16, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Cost of Labor?

Cost of labor can be defined as the remuneration paid in the form of wages and salaries that are paid to the employees including allowances, payroll taxes, and such other benefits and can be sub-divided broadly into two categories- direct labor involved in the manufacturing process and indirect labor pertaining to all other processes.

Cost of Labor

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It is an amount paid by employers towards the workers’ wages, benefits, and payroll taxes. It can be classified into direct costsDirect CostsDirect cost refers to the cost of operating core business activity—production costs, raw material cost, and wages paid to factory staff. Such costs can be determined by identifying the expenditure on cost objects.read more and indirect costsIndirect CostsIndirect cost is the cost that cannot be directly attributed to the production. These are the necessary expenditures and can be fixed or variable in nature like the office expenses, administration, sales promotion expense, etc.read more. Direct costs are such costs that can be directly allocated to the finished goods. In contrast, indirect costs are such costs that cannot be directly associated with the overall production costs of the finished goods.

Cost of Labor Explained

The cost of labor refers to the direct and indirect cost of employing the labor force within a business. It is an important element of any business operation in which considerable investment is required. The cost is typically calculated based on the salaries, wages or different facilities that the company has to provide to its human resources, and which results in cash outflow.

This cost can be direct or indirect as well as fixed and variable in nature. It is important to calculate it with accuracy so that various operations like pricing of goods and services, sales related expenses like advertising and marketing, the cost of inventory and raw materials can also be planned in proper way, with clarity. This is because if the labor cost is high, then the cost incurred on all the above elements will be affected.

It is obvious that a very high cost of labor will affect the profitability of the business. Therefore, it is necessary that it should be under control. Again, it is also true that highly skilled and experienced labor force will be costly. But in such a case the cost incurred will be compensated by the revenue earned using such skilled expertise.

Calculating this total or average cost of labor is an important responsibility of all accounting and finance professionals. There may be employees who are directly contributing towards the manufacturing of goods and services and some that are indirectly doing so. But both type should be considered while doing the calculation.

Formula

The cost of labor is broken into direct and indirect costs. So, the formula that can be used for calculation is as follows:

Cost of Labor = Total Direct Labor Cost + Total Indirect Labor Cost

Where,

  • Total direct cost is the total cost of the company paid to its employees for work that relates directly to the manufacturing of products or the provision of services. Such employees or laborers will include those who directly use and handle the machinery, craftsmen or artisans, people who make the delivery of goods, etc. Those who handle heavy machinery have lot of risk involved in their job process. The company has to bear the cost of insurance policy related expenses, and they are often given various healthcare benefits and short-term disability benefits as direct cost of labor. Their salary may also be higher than those who are not exposed to such risks. Thus, these are considered as direct costs of labor that the business has to bear.
  • Total indirect cost is the total cost of the company paid to its employees for work that does not relate directly to the manufacturing of product or provision of services. These costs can also be the amount paid to support labor etc. Such labors can be involved in administrative or supervisory roles which are equally important as direct labor. Examples include employees who work in the human resource of finance of administrative department and are not involved in directly making or manufacturing goods and services. However, they have an equally important role to play in terms of business operations and the business has to bear the cost of employing them.
Cost of Labor Formula

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Examples

Let us understand the concept of indirect or direct cost of labor with the help of suitable examples, as given below.

ABC Company manufactures dolls and sells them in the market. During a period, ABC Company paid wages of $100,000 to the assembly workers for making dolls in the factory and $15,000 to the security guards at the manufacturing plant. Calculate the cost of labor of the company using the information given.

Solution:

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Step 1: Calculate Direct Labor Expense

From the information given, the wages of $100,000 paid to the assembly workers for making dolls in the factory are related directly with the manufacturing of the product of the company, and it is the company’s direct labor cost.

So for the period total direct labor expense = $100,000

Step 2: Calculate Indirect Labor Expense

From the information given, the wages of $15,000 paid to the security guards at the manufacturing plant are related not directly with the manufacturing of the product of the company, and it is the company’s indirect labor cost.

So for the period total indirect labor expense = $15,000

Step 3: Calculate

Cost of Labor Example
  • = $100,000 + $15,000
  • = $115,000

Importance

Cost of labor is a highly important aspect for employers as it helps them in the following matters:

  • Management of Costs: It helps employers in managing costs. Employers can easily identify workers that are not performing as per the expectations and requirements. In this way, they can go for cost-cutting as and whenever required and got rid of undeserving and under-performing workers.
  • Outsourcing: For estimating the updated cost structureCost StructureCost Structure refers to those costs or expenses (fixed as well as variable costs) which businesses will incur or will have to incur to produce the desired objective of the business; such costs include the cost of purchasing the raw material to the cost of packaging the finished products.read more of a business, management must understand all its labor costs before outsourcing any sort of activities to a seller or a supplier.
  • Major element – It is a major and a very important element in a business. Any business cannot do without its labor force who should be skilled and efficient enough to handle the work. Therefore, total or average cost of labor is a cost that has to be borne by the business.
  • Changes with market policy – The cost of labor index will change with changes in the market rules and policies relate to labor management within a jurisdiction. Such changes will influence the labor force to act for their own benefit and influence management decisions for betterment of their status. So, the company management has to pay important and remain updated with all such changes to that they are in a position to negotiate with their company labors.
  • Leads to employee satisfaction – A good management will try to keep labors satisfied and at the same time reduce the cost on them through use of updated methods, technologies and training them to do better.
  • Overhead calculation– This cost is a major element in calculation of overheads that lead to evaluation of profits and income of the business. This helps in understanding the areas that needs cost cutting for better profitability.

Advantages

Some of the benefits of total cost of labor are given below:

  • It helps the management of an organization in managing the labor costs of an organization as it allows the same in the identification of such employees that are under-performing. The management during lay off can get rid of the identified under-performing employees instead of the ones that are performing and delivering as per the expectations.
  • It allows the management to compare the costs of labor to his output or performance.
  • It allows the management to get rid of underperforming employees.
  • Helps the management in avoiding mistakes and creating a labor budget for the company.

Disadvantages

Some of the disadvantages of total cost of labor are given below:

Cost Of Labor Vs Cost Of Living

Both differ from each other on different parameters. The differences are given below:

  1. Meaning: Cost of living can be defined as the costs that are necessarily borne by a customer to maintain a standard of living in a particular geographical area. On the other hand, the cost of labor index of any country can be defined as the costs that are borne by an employer in the form of salaries or wages, payroll taxesPayroll TaxesPayroll taxes are statutory deductions made by the employer from an employee’s regular salary and wages, and usually, such withholdings mostly have both employer and employee equal contributions. These taxes are collected by tax authorities from respective employers and paid for human welfare schemes, infrastructure development.read more, and other benefits paid to a worker.
  2. A consumer bears the cost of living, and he or she can be a worker, employer, businessman, unemployed individual, etc. On the other hand, the cost of labor is borne by an employer.

The cost of labor is merely an amount that is paid by an employer to his workers. These costs include salaries, wages, payroll taxes, and benefits paid by an employer. It helps the management of an organization in the management of costs, outsourcing, union negotiations, etc.

This has been a guide to what is Cost Of Labor. We explain it with formula, differences with cost of living, example, importance, advantages & disadvantages. You may learn more about financing from the following articles –

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