Direct Labor: Definition & Cost Formula

Instructor: Tara Schofield

Tara has a PhD in Marketing & Management

Direct costs are explained through a real-life example that shows the importance of tracking and accounting for direct costs. The steps of calculating direct labor is included.

What is Direct Labor?

Direct labor is the amount of payroll expense related to specific projects or product manufacturing. Labor is one of the greatest costs that most companies incur in the course of doing business. When a company is managing or tracking the costs of a specific project, the labor costs must be added because they are a significant influence in the expenses of a project.

When a company is looking at manufacturing costs of a product, the labor incurred to create that product must be tracked and posted towards the expenses related to that project. Let's look at a scenario to help explain direct costs in manufacturing.

You manage a candy shop and have decided to add a new line of sea salt caramels. You believe the new type of candy will be a success because consumers keep requesting more sea salt items. However, because the product is new, you want to watch expenses and sales closely to ensure the sea salt caramels are profitable. One of the largest expenses of the new candy is labor because the candy must be dipped in chocolate by hand and the sea salt added to the top of the delicious caramels individually. Because there is direct labor, payroll costs that are specifically tied to the creation of the sea salt caramels, the expense to have employees finish the chocolates is included in the production cost as direct labor. This amount can be broken down further as explained in the calculation section below.

How Do You Calculate Direct Costs?

In your candy shop, you have many employees that work on different types of treats. As we discussed previously, because payroll is one of the largest expenses of a company, the direct labor costs will have a substantial impact on the expenses of creating the caramels. For this reason, it is vital that direct costs are calculated and added to the COGS (cost of goods sold).

The most effective way for a small business to analyze direct labor costs is to have employees track their time and activities. Employees are required to log when they start and stop an activity.

One of your employees, Nancy, works in the candy production area and is part of the caramel team. Because several types of caramels are created during the day, Nancy keeps track of her work time based on what type of candy she is creating. At 10:00 she starts working on sea salt caramels. She works on them exclusively until 1:00 when she takes a lunch break. When she returns from lunch at 1:30, she resumes work on the sea salt caramels and finishes up at 3:30 in the afternoon. Her timesheet entry looks something like this:

8:00 - 9:45 Caramel Popcorn

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