Direct labor cost is one of the key components of fundamental business benchmarks such as efficiency and profitability. It’s no wonder, then, that understanding and calculating this financial variable is a big part of whether or not your business runs smoothly.
In this article, our experts at Sling discuss the ins and outs of this expense, show you how to calculate it, and give you tips for controlling it within your business.
What Is Direct Labor Cost?
The dictionary definition of direct labor cost is:
Wages incurred in order to produce goods or provide services to customers.
The reality of the concept, though, goes well beyond just the hourly rate you pay your employees.
It includes everything that goes into compensating an employee for manufacturing a specific product or providing a specific service, including:
- Payroll taxes
- Company-paid medical insurance
- Life insurance
- Workers’ compensation
- Company-matched pension contributions
- Standard benefits
- Fringe benefits
Direct labor cost even includes monies paid to individuals for ancillary tasks not related to the “hands-on” manufacture of a product or the “face-to-face” provision of a service.
For example, in a steel manufacturing business, the direct labor cost for a specific product includes the annual salaries (and benefits mentioned above) for a welder working on the assembly line, a quality assurance inspector examining the final product, and outlays made to the logistics company responsible for delivering the goods to market.
Stated again for clarity, this expense refers to salaries, wages, and benefits paid to workers directly involved in performing a service or manufacturing a product.
How To Calculate Direct Labor Cost
For this section, we’ll set up a hypothetical employee making a hypothetical widget and examine how the numbers apply to direct labor cost.
Here are the employee’s details:
This example only deals with one employee, but you can scale it up to accommodate as many employees as you have participating in manufacturing products or providing services.
1) Establish Gross Pay Rate
When an employee works full time, they will potentially work 2,080 hours in one year (40 hours x 52 weeks). So you’ll start with this equation:
Gross Pay = Pay Rate x Gross Hours
Gross Pay = $20/hour x 2,080 hours
Gross Pay = $41,600
2) Add In Other Annual Labor Costs
Remember, direct labor cost includes expenses other than just wages. Insurance, bonuses, taxes — all of these items play a part in what you ultimately pay your employees.
Here’s how we’ll break it down for this example:
- Insurance $500
- Taxes $500
- Overtime $1,000
- Benefits $1,500
- Supplies $500
Add those numbers together and you get $4,000 in additional expenses associated with the hypothetical employee’s labor. Add that number to the employee’s gross pay to determine annual payroll labor cost.
Annual Payroll Labor Cost = Gross Pay + Other Annual Costs
Annual Payroll Labor Cost = $41,600 + $4,000
Annual Payroll Labor Cost = $45,600
In essence, then, this number is your annual direct labor cost — it’s how much you’re actually paying out for your employee to produce widgets every year.
Looking at numbers that large (both the annual direct labor cost and the number of total widgets produced in one year) can get confusing very quickly.
That’s why we’re going to reduce the annual cost down to an hourly cost. Doing so will make it easier to work with, control, and, ultimately, reduce.
3) Calculate Hourly Direct Labor Cost
You know your employee’s base pay rate ($20 per hour in this example), and you know your annual cost, but it’s essential to calculate their hourly cost using this formula:
Hourly Direct Labor Cost = Annual Payroll Labor Cost / Net Hours Worked
It’s also important to determine the net hours your employee works in one year. You can find this by averaging together all the absences and illnesses of individuals who work in similar positions to the hypothetical employee in question.
For this example, we’ve calculated that our employee works 2,000 out of the total 2,080 hours annually. We’ll use that in the equation below.
Hourly Direct Labor Cost = Annual Payroll Labor Cost / Net Hours Worked
Hourly Direct Labor Cost = $45,600 / 2,000
Hourly Direct Labor Cost = $22.80 per hour
That number tells you that when you’ve factored in all the other employee expenses, you’re paying your employee $22.80 per hour to produce widgets.
4) Apply Direct Labor Cost Numbers
To get a real sense of the cost involved in the manufacture of your widgets, we need to see how the number we calculated in the previous step impacts your business.
We established at the beginning of this section that it takes this employee 0.5 hours to make one widget. That means your business is paying said employee $11.40 to make a single unit ($22.80 / 0.5).
Is that number high or low compared to the final price of your widget? Only your business will be able to determine that.
What can you do to lower that cost and give your business more profits? We’ll discuss that question in the next section.
Tips For Lowering Direct Labor Cost
1) Minimize Absenteeism
Everyone has emergencies that lead to absenteeism at one time or another.
But when an employee doesn’t show up for work, that often means someone else has to work overtime to cover their shift, which leads to an increase in direct labor cost.
You can minimize absenteeism — and keep overtime in check — by instituting strategies that promote good attendance.
Here are some suggestions:
- Offer a bonus for a spotless work record over a certain period of time
- Enforce the absenteeism policy put forth in your employee handbook
- Be realistic about when to permit absences
- Deal with no call, no show absences immediately (and strictly)
2) Enforce Time Clock Regulations
Another way to keep the cost in question low is to establish and enforce clock-in rules and regulations.
One such regulation should state that an employee’s shift will begin at the scheduled time (e.g., 9 a.m.) rather than when they clock in (e.g., 8:45 a.m.). Fifteen minutes may not seem like much, but, over a two-week period, it can add up to significant overtime hours.
Of course, employees are allowed to clock in early for work — and get paid for that time — but only if they have your permission first.
3) Adjust Business Operating Procedures
Once you’ve identified your cost and how it applies to your rate of production, you can tweak any number of variables and procedures within your business to achieve the result you’re after.
Here are some of the best ways to do that:
- Control attrition
- Cross-train your team
- Invest in hiring
- Assemble a diverse team
- Adjust your pricing
- Improve efficiency
- Track time and attendance
- Keep your team organized
- Motivate your employees
The Best Way To Manage Direct Labor Cost
And the built-in artificial intelligence automatically reminds you of requested time off, double bookings, and overtime hours so there’s less back-and-forth once you’ve completed the schedule.
And with Sling’s powerful geofencing, you can prevent early clock-ins and missed clock-outs with the touch of a button.
Sling even lets you optimize labor costs by setting wages per employee or position so you can see how much each shift will cost you in real time.
This unique component of the Sling software allows you to keep track of your labor budget and receive alerts when you’re about to exceed those numbers. This will help you reduce direct labor cost, save money, and increase profits overall.
Sling really is the turnkey solution for all your scheduling and direct-labor-cost-management needs.
For more free resources to help you manage your business better, organize and schedule your team, and track and calculate labor costs, visit GetSling.com today.