How to Do Labor Cost Allocation
Imagine your team has a big project ahead. You know you will have to pull a lot of resources to make it happen, and you know that there is a huge potential for profit. To start, you will need to allocate costs for not only the materials required, but also the overhead, administration, logistics, and work necessary to complete it. Naturally, most of the money will go directly to labor.
Paying the employees who work on the project is a foundational part of a profitable business. However, labor cost allocation involves much more than simply paying out hourly wages. Good accounting in this area requires both an estimated (standard) and adjusted (actual) cost analysis. Most full-time employees also get paid in benefits in addition to their regular wages.
This can become very complex, and it will look different for each industry. In this article, we will cover the basics of labor cost allocation and some other aspects you will have to consider to ensure you turn a profit.
Why is Labor Cost Allocation Important?
Since your project will be mostly produced by paid employees, it’s important to make sure those employees are paid properly. Often, you will need to allocate this cost toward a paycheck before you turn a profit. If not paid properly and on time, you will likely lose workers or face legal consequences.
However, even if you run payroll accurately, you still want to make a profit. You don’t want to complete a long project just to break even or lose more money for the company.
Labor cost allocation gives you an accurate picture of what the project will likely cost to complete. With this information, you can subtract that from what you charge the customer to better understand how much you profit from your product or service.
In the end, it is simply a good accounting practice. It is also an essential part of human resource management. Over time, it can help improve labor practices and other cost measures to increase profit and efficiency. To do this effectively, you will need to calculate labor cost both before and after the project.
This step is usually done before the project starts, so that you can plan out in rough form what the project will cost the company in labor hours. In other words, standard costing answers the question, “What should this project cost?” If the standard cost of labor is higher than what the customer would pay, it might not be worth the effort to complete.
Although based on real numbers, this step is partly theoretical. Human employees rarely operate as efficiently as possible, and a number of factors can cause delays or obstacles to completion. Because of this, calculating your standard cost beforehand may seem unnecessary in comparison to the real numbers.
Instead, think of standard costing like setting a target labor cost. Of course, these figures will change based on the actual cost to influence pricing and labor decisions later on.
To calculate standard cost, you will need to consider the following:
- The hourly wages of the workers who will be involved with the project
- The benefits those workers earn
- The taxes required for payroll with each worker
- How many hours each employee will work to complete the project
For example, imagine you have a team of factory workers who manufacture steel plates. While you will likely have a continuous production schedule, imagine your next contract is to make 1,000 steel plates for a client.
Based on previous figures, you estimate that it should take two employees 10 hours each to make that many steel plates for the client. You pay each laborer $15.00 per hour.
Labor cost for wages alone is calculated like this:
$15.00 per hour x 10 hours is $150.00
$150.00 x 2 employees = $300.00 for direct labor
While some taxes will come out of the employees wages, some other taxes will be your responsibility to pay as an employer. To keep it simple, let’s say you owe $10.00 per employee in other taxes that can’t be taken from the employee’s gross pay. That’s $20.00 for two employees.
After that, let’s say the employees both have a retirement pension and other benefits that amount to about $200.00 each every paycheck. This is typically a stable number, so even if the employee is owed overtime, this will be stable for a 40 hour workweek. Thinking of benefits in terms of hourly rate can help estimate your cost more accurately when looking at price per unit. In this case, it comes out to $5.00/hour in benefits. 10 hours x $5.00 in benefits is $50.00. For two employees, it’s $100.00.
There are also some overhead labor costs (also called indirect labor costs) that you can calculate beforehand. For instance, you might factor in the salary of a secretary who books an appointment, sets up shipping, and sends an invoice for that project. In this example, let’s say this comes out to about $20.00 per hour. If this roughly amounts to about 5 hours of indirect labor, that’s another $100.00 to consider.
With all this in mind, your standard costing would look like this:
$300.00 (wages) + $20.00 (taxes) + $100.00 (benefits) + $100.00 (overhead) = $520.00
You can take this one step further into estimating the labor cost per unit. That looks like this:
$520.00 / 20 hours of total work = $26.00 per hour
1000 units / 20 hours = 50 units per hour
1 hour / 50 units per hour = 0.02 hours to complete 1 unit
$26.00 x 0.02 = $0.52/unit
Remember, this is what the project for 1000 plates should cost. When setting the customer’s price for each unit, it’s important to estimate your cost first. However, you will need to re-calculate the actual cost of the project cost once complete.
Actual cost is calculated after the project is complete. While standard cost paints a picture of a project being completed at the ideal efficiency, a real project almost always has variables.
Because of this, you will want to recalculate costs of your project(s) on a regular basis. While many companies can calculate actual cost on a monthly basis, some industries like construction might require a weekly or even daily calculation.
Actual costing is important because it allows companies to understand the variances between what a project was estimated to cost and what it cost in reality. Over time, these variances will influence standard cost and labor practices when calculated regularly.
During this process, you can also take a look at the true overhead cost (which is also likely to change). Consider any extra cost for travelling, administrative work, extra billing, or other unexpected labor that was required to complete the project.
This is also where salaried employees can complicate the labor allocation process. Imagine a salaried employee makes $1000.00 per week for any number of hours worked. If that employee works 40 hours one week, the allocation is standard at $25.00 per hour. However, if that same employee works 32 hours to complete the same work, that’s technically a higher allocation ($31.25 per hour). Assuming it takes longer to produce the same product, you might also have to pay some hourly or salary employees overtime.
To continue the example, let’s calculate the actual cost of labor for the same employees at the steel plant.
Let’s say it took each worker 15 hours (instead of 10) to create the same 1000 steel plates. They still get paid the same hourly rate. 15 hours x $15.00 = $225.00. For two employees completing 30 total hours of work, that’s $450.00.
Except, let’s imagine instead that these employees worked 50 hours in a given workweek (on this project and others) and were paid overtime. To understand the true hourly wages, first calculate how much you have to pay in overtime. In this case, you will need to pay them 1.5 times the normal rate for the overtime hours. This means the employee makes their regular $15.00 x 50 hours ($750) + 10 hours of overtime pay ($7.50 x 10) which is $75.00. In total, the employee makes $825.00 for that week. Divide that by 50 hours and you get the average hourly wage at $20.63 / hour.
You can calculate the actual labor cost for 15 hours of work during an overtime week like this:
15 hours x $20.63 = $309.45
$309.45 x 2 employees = $618.90
That means that taxes also increase. To keep it simple, let’s say you owe another $5.00 per paycheck. Originally, it was $10.00 per employee. Now, we come to $30.00 total in taxes that you owe as an employer.
Benefits are still a stable cost, but you’ll want to recalculate that for the 50 hour week. First, take the same $200.00 per paycheck in benefits. At 50 hours, that becomes $4.00 per hour in benefits. Then, take $4.00 x 15 hours for the project. You are now looking at $60 per employee. That’s actually $120.00 in benefits for two employees.
Then let’s say you calculate some of that unexpected overhead cost and it comes out to about $25.00 more than anticipated. Looking at the previous $100.00, you now have $125.00 in indirect labor cost.
So the total actual cost for this project looks like this:
$618.90 (wages) + $30.00 (taxes) + $120.00 (benefits) + $125.00 (overhead) = $893.90
While that is certainly an undesirable increase, these are the real costs of the project which you will need to pay. From there, you can calculate the actual labor cost per unit like this:
$893.90 / 30 hours of total work = $29.79 per hour
1000 units / 30 hours = 33.33 units per hour
1 hour / 33.33 units per hour = 0.030003 hours to complete one unit
$29.79 x 0.030003 = $0.89 per unit
The main focus of labor cost allocation is calculating the variance between the standard and actual cost. While many industries will have labor situations like those illustrated above, there are some trades that have more complex wages and billing requirements. For instance, you may have to consider payment rules for certain unions, and you may not be able to bill the customer for all hours worked.
Billable and Non-Billable Hours
Some companies are able to bill customers for all hours spent working on a given project. This is often the case with many healthcare professions. These hours are called billable hours.
However, you may also choose to maintain a steady price to create a good customer experience. No one likes to be billed extra for unexpected labor behind the scenes.
Still, you might have a project that required extra labor to fix a mistake or repair a machine. If you don’t charge the customer more money for that extra labor, you will need to allocate funds for that labor in your actual cost calculations.
In situations like this, the extra labor hours are marked as non-billable hours. The company still eats the cost, but you can’t make up for it by charging the customer more money.
This can get more complicated depending on the type of contract you have with the customer and the type of job. In many cases, there are rules about what hours can and can’t be billed to the customer.
When it comes to labor allocation for union employees, you may also have to account for collective bargaining agreements. These are contractual rules with local unions that determine how an employee is paid for a certain job classification.
For instance, imagine you are paying an electrician $40.00 when working in Boston. You then allocate labor costs for that employee by the regular wage.
However, you might send that electrician out to a section in Milwaukee one week to do a new job. The local union rules in Milwaukee could require electricians of a certain class to be paid $45.00 per hour. Now you have to allocate labor for that job based on the new wages. If you have one employee working in different local sections during the same workweek, you have two different wages to account for on that paycheck.
In addition, you might also need to account for fringe benefits. These are additional perks for more specific types of employees. For instance, you might have an electrician that gets paid $1.00 more per hour for having a certain level of experience or training certificate.
You will also want to account for union dues as part of the labor cost. Because union dues are taken from the employee’s paycheck, this should be a portion of the regular wages for standard and actual costing. However it’s good practice to know this portion of labor cost ahead of time. While these are strictly an employee deduction, you will still be responsible for allocating those funds to the union during payroll.
While there are many other parts of accounting that will keep your company in profit, labor cost is an important piece to consider. Labor cost allocation involves setting a target cost and reevaluating that target based on actual numbers. Over time, this becomes the new standard and creates better practices. However, it can get complicated when considering union rules and billable hours.
By using Criterion’s HCM software, you can manage these factors automatically. For union workers, you can start by creating a rate table for different local sections. Any time an employee changes locations, you simply select that location and let the program calculate the correct rates for you.
Our custom HCM solutions can help you manage your labor cost, payroll, and more so that you can make informed, data-driven decisions that are relevant to your company’s needs. Let us show you how it works by booking a demo today.