How to Calculate Direct Labor Cost Per Unit

The task of managing a company requires the management of information, usually the analysis of costs and benefits as well as income, an assessment that allows you to establish the level of profitability of your company.

Marketing and sales promotion activities allow you to boost income levels to meet managerial expectations.

These results define the market share and growth potential of your organization. The site outlines a four-step plan to increase the profitability of your organization.

Knowing the costs associated with manufacturing a product is necessary to make decisions that directly affect the business. Variations in prices and market conditions are factors that affect the expected profit.

To start the cost analysis it is necessary that you know the cost structure of your manufacturing process. This cost structure describes the various cost accumulation concepts.

Generally, costs for materials, labor and manufacturing expenses are handled. These concepts are applicable in any production system.

Material cost refers to the raw material we use to create your product. This cost will depend on the amount of material used to make your product.

Regarding the cost of labor, it corresponds to the concepts that are paid to the personnel working in the organization. It is classified according to its level of participation in the production process in direct and indirect labor.

So, depending on the tasks they carry out, they have two groups of personnel. The first, direct labor, corresponds to the production personnel who intervene directly in the manufacturing process.

The second group corresponds to indirect labor. They are the people who perform a series of tasks necessary for management and administration.

Calculating a standard direct labor cost per unit allows you to establish a tolerance range for direct labor cost variance.

You can use this information to identify and investigate why their real costs are higher? or lower? than your unit direct labor costs.

What is direct labor cost?

Companies that produce, modify, or manufacture goods incur direct labor costs.

The cost of direct labor is the cost of employing people who work directly in a manufactured product.

The direct labor, direct materials and overhead costs of production comprise the total production costs.

The sum of these three costs equals the total inventory costs according to generally accepted accounting principles.

Knowing the cost of direct labor per unit allows you to manage and administer your prices and profit margins.

To calculate the total cost, it is necessary to consider all the elements related to the manufacturing process of the product.

What items are included in direct labor costs?

The direct labor may include full – time employees, part – time employees, temporary employees and contract workers. Provided they are directly involved in the manufacture or handling of the goods.

Personnel who work on the premises but are not directly involved with the product. Colloquially, those who “do not touch” the product or participate in the provision of the service are not part of the direct labor cost.

For example, an assistant who sweeps and mops the floor of a brewery but never works with beer is part of indirect labor costs, not direct labor costs.

Also employees who oversee operations but are not involved in the product, such as a plant manager, are part of the overall manufacturing costs rather than direct labor costs.

How to calculate direct labor cost?

The cost per unit is derived from the variable costs and fixed costs incurred by a production process, divided by the number of units produced.

The variable costs, such as direct materials, vary approximately in proportion to the number of units produced

This cost could decrease slightly as unit volumes increase and even more when volume discounts are achieved in purchases, there being a direct relationship between production and cost.

The fixed costs, such as rent or lease of facilities. They will remain unchanged, regardless of the number of units produced. Although it may increase as a result of the expansion in production capacity.

An increase in production occurs as a result of the acquisition of greater installed capacity or the commissioning of additional units. This new fixed cost level is maintained until it reaches full capacity.

Some examples of step costs that we can mention are:

  • Add a new production facility or production team
  • Incorporate mezzanines and lifting equipment into a warehouse
  • Automate operations or production processes
  • Expand the plant either in physical space or by installed capacity.
  • A new branch or physical plant
  • Add a second or third work shift.

When this cost of production leveling is incurred, the total fixed cost will now incorporate the new cost, which increases the total cost per unit affecting the net profit margin.

Depending on the increase in the cost of the step, a manager may decide to keep the production capacity the same, subcontracting or outsourcing the additional production, thus avoiding significant outlays with the consequent increase in the fixed cost.

To calculate direct labor costs, add up the corresponding total costs incurred during the year.

The direct labor costs include the following components: salary, payroll taxes, workers ‘ compensation, direct recruitment costs, health insurance, dental insurance and life insurance.

As well as any other fringe benefits paid to employees representing direct labor. That is, those who participate directly in the manufacture of the product.

To illustrate, if a business incurs $ 50,000 in wages, $ 10,000 in payroll expenses; USD 10,000 in workers’ compensation and USD 40,000 in benefits for direct employees. The total direct labor cost is USD 110,000.

This amount corresponds to the total expenditures to the personnel necessary to process the units produced.

The direct labor cost or direct labor cost is calculated based on the commitment to pay the workers. Regardless of whether they have actually already paid it.

For example, suppose a group of direct labor workers worked the last two weeks of March. But for some reason the payment is made in the month of April.

The wages and the corresponding expenses for those two weeks. They must be included in the labor costs for the month of March. Although they have not been paid on that date, the amount corresponds to the previous month.

How is the direct hourly labor rate calculated?

The direct labor hourly rate includes the normal hourly rate of pay; additionally the fraction of the cost of labor benefits and employee payroll taxes.

You can calculate the hourly value of labor benefits and employee taxes by dividing the cost of those benefits by the number of hours worked in the pay period.

For example, your employee earns $ 10 per hour, works a 40-hour week. It has payroll taxes of USD 60; Just divide $ 60 by 40 hours and you’ll get an hourly tax rate of $ 1.50.

Now you must add $ 1.50 in employee payroll taxes at the normal hourly rate. According to the example, the normal rate is US $ 10, adding together results in a total hourly rate for direct labor of $ 11.50.

Calculation of direct labor efficiency standard

The hours of direct labor, also known as the efficiency standard direct labor, corresponds to the number of hours of direct labor needed to produce a finished article.

If you produce items in batches, you must calculate per unit of direct labor hours. To find this number, divide the total number of parts produced by the number of hours it takes to produce it.

Thus, if it takes 10 hours to produce 10 articles. That means it takes an hour of direct labor to produce a finished product.

Calculation of unit labor cost

The standard direct labor rate is the direct labor cost per unit.

To calculate this, multiply the total rate per direct labor hour by the number of direct labor hours required to complete a unit.

As simple as if the total hourly rate for direct labor is $ 11.50. If it takes five hours to complete a unit. The direct labor allocable cost is $ 11.50 times five hours, or $ 57.50.

Given these conditions, we can summarize you by saying that the calculation of the cost per unit is:

(Total fixed costs + Total variable costs) ÷ Total units produced

The cost per unit decreases as the number of units produced increases. Mainly because the total fixed costs will be spread over a larger number of units.

The precious decrease will occur, provided there is no level change in fixed cost or fixed investment. As a consequence, the cost per unit is variable.

For example, Company XYZ recorded total variable costs of USD 50,000 and total fixed costs of USD 30,000 in the month of February, when it managed to produce 10,000 pieces of equipment.

The cost per unit is:

($ 30,000 + $ 50,000) ÷ 10,000 units = $ 8 per unit

For the following month, XYZ produces 5,000 pieces of equipment at a variable cost of USD 25,000. Keeping the same fixed cost of USD 30,000.

For the month of March the cost per unit is:

(US $ 30,000 + US $ 25,000) ÷ 5,000 units = US $ 11 / unit

You can see that the unit cost increased in the month of March, there was a lower production resulting in less efficient use of resources.

Direct labor cost variation

Direct labor cost variance allows you to identify when costs exceed the tolerance range. This allowed range is usually a standard that maintains the percentage of profit set in the price.

Calculate the actual unit direct labor cost, compare it to the standard direct labor rate. The difference is the direct labor cost variance.

If the actual unit direct labor cost. It is less than the standard rate of direct labor, you have a favorable variance. The cost of producing the items is lower than expected.

If the real cost of direct labor per unit is greater than the standard rate of direct labor, it has an unfavorable variance; it costs you to produce the articles more than the expectation.

Controlling direct labor costs is an important part of ensuring your business maintains its return on investment.