The Meaning of
Direct Labor, Indirect Labor, and Manufacturing Overhead
Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Revised 2013-12-17.
Direct labor is so named because it is associated directly with the production of specific units of finished goods. An assembly line worker's labor installing windows on automobiles, for instance, is direct labor applied to specific vehicles.
Indirect labor, on the other hand, usually refers to production support labor costs not so easily associated with specific units. The mechanic repairing assembly line machinery, for instance, is viewed as indirect labor and classified as a manufacturing overhead cost.
Understanding the contributions of these two labor cost categories is crucial, obviously, in budgeting and planning exercises. However, these can also be important cost categories in financial accounting reports, (especially the Income Statement) and business case analysis (including cost/benefit, financial justification, total cost of ownership, cost/benefit, and return on investment analysis).
Explaining direct vs indirect labor in financial reporting
In financial reporting, both labor categories contribute to cost of goods sold as shown on the simple income statement, below. Cost of goods sold is subtracted from net `sales revenues to produce the reported gross profit. (Gross margin is the gross profit expressed as a percentage of net sales.) Direct and indirect labor, of course, also impact operating income and net income (profit), as shown.
The income statement shows reported gross profit for the company, but management usually has a high interest in knowing gross profits for individual product lines and individual products, as well. Such information is crucial for effective product management and product strategy decisions, for instance. For product gross profits, actual sales and actual direct labor costs can be estimated rather directly. When indirect labor supports multiple products or product lines, however, these labor costs for specific products may have to be determined by an arbitrarily set allocation percentage.
In recent years, many companies have
attempted to implement activity based costing, as a means of turning
cost items that traditional costing treats as indirect costs into direct
costs. See the encyclopedia entry on activity based costing for an introduction to this approach with example calculations.
Labor costs in the business case
Direct and Indirect Labor may be important cost categories in business case analysis, whether the case is a general cost benefit analysis, financial justification, total cost of ownership (TCO), or return on investment (ROI) analysis.
Decisions having to do with asset acquisition or asset life cycle management, for instance, may rely on business case analysis to predict total financial costs and financial gains under different possible actions. Some kinds of production-related assets bring large direct labor costs and indirect labor costs for operation and maintenance over a long life cycle (e.g., factory machines, vehicles, aircraft, and buildings). Expected direct and indirect labor costs may in fact be the deciding factor in choosing one asset action over another.
Direct labor costs and indirect production labor costs also belong in business case analysis when the case looks forward to different product sales under different scenarios. Higher sales revenues normally require higher direct and indirect labor costs to produce the additional product units sold. Direct and Indirect labor costs should be projected for each business case scenario, in accord with the scenario's projected sales.