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Direct and Indirect Labor Overhead Costs Explained
Definition, Meaning, and Examples

© Business Encyclopedia, ISBN 978-1-929500-10-9. Updated 2016-05-02.

Accountants assign direct and indirect labor costs to products and services, using either traditional costing or activity based costing. The chosen approach impacts profitability and estimated true cost of products and services.

What are direct and indirect labor costs?

Direct and indirect labor are costing terms used in budgeting, planning, and financial reporting.

Direct labor costs are so named because they are 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 (or overhead), 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 counted as indirect labor and classified as a manufacturing overhead cost. 

Understanding the cost contributions of direct labor and indirect labor is crucial, obviously, in budgeting and planning exercises. However, these can also be important cost concepts in setting prices, evaluating 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).

Contents

How are direct and indirect labor costs reported on the financial accounting income statement?

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.

For more on the reporting of manufacturing overhead and administrative overhead, see the encyclopedia article Overhead.

What is the role of direct and indirect 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.

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