Chapter 3: Labor Costs

Introdution

Labor cost includes all the salary and wages paid to those employees plus the benefits, taxes and etc. Therefore, expenditure on labor occupies a major place among total costs. Also, controlling labor cost is more important and difficult when compared to others for example materials due to the involvement of humans. Employee behavior and satisfaction of employees are also involved in the other phase of labor.

Elements of Labor Costs

Labor costs emerge because of two fundamental activities, which are manufacturing and nonmanufacturing. Labor costs have several components that are different from each other. At the core of labor costs, there is payment. That payment may be in the form of a wage or salary. Salaries are fixed payments to employees for their performance and productivity working on a monthly basis. However, wages are payments to employees working on an hourly or daily basis. It does not matter whether the pay type is salary or wage because they are both reflecting payments to employees.

Below the elements of labor cost are listed;

• Basic Pay
• Week and Holiday Pays
• Overtime Payment/Premium
• Night/Shift Payment/Premium
• Production and Efficiency Premium
• Holiday Pay
• Allowances (ie. traveling allowance)
• Education and Training Payments
• Social Welfare Contributions
• Health Payments
• Severance Payments
• Social Security Premiums
• Unemployment Insurance Premiums

Labor Costs Related to Actual Work

Basic pay, overtime pay and production and efficiency payment are directly related to the actual work of the employee. Basic pay is received in return for regular work. Overtime pay and premium are received for overtime work that is work exceeds forty-five hours in a week. Overtime pay is considered as labor cost related to actual work, where overtime premium is considered as labor cost related legal or/and contractual enforcement or discretionary reasons.

Labor Costs Related to Legal or/and Contractual Enforcement or Discretionary Reasons

Labor law enacts that employees shall be paid full day’s wages for the national and public holidays on which they have not worked; if they work instead of observing the holiday, they shall be paid an additional full day’s wages for each day worked

Classification of Labor Costs

Costs are classified as direct and indirect according to traceability to cost objects. Direct/indirect labor refers to employees; direct/indirect labor cost refers to cost.

Direct Labor Costs

Direct labor costs refer to wages or salaries paid to direct employees for the work performed. Direct labor costs are directly assigned to the cost of goods produced or services rendered. There are two main points for determining the labor cost as direct;

• payment must be done to employees to make a product or render a service, and
• those employees must be clearly involved that production or service process that are defined as direct labor.

The question is that “all payments made to direct employees are direct labor cost?”. The answer is “no”. Only basic payment, overtime payment, and production and efficiency payment of direct labor are considered direct labor costs. In other words, elements related to the actual work of direct labor are characterized as direct labor cost. However elements related to legal or/and contractual enforcement or discretionary reasons which are week and holiday pays, overtime premium, night/shift premium, social welfare contributions, health payments, holiday pay, allowances, education and training payments, severance payments, social security premiums and unemployment insurance premiums of direct employees are indirect labor cost. As those kinds of payments are made for direct employees, the nature of those costs is indirect this is why they are classified as indirect labor costs.

Indirect Labor Costs

Indirect labor refers to employees who are necessary for operations but who are not directly involved in the production or service process. Therefore, indirect labor cost covers all payments done for indirect labor. Basic pay, overtime pay, production and efficiency premium, week and holiday payments, overtime premium, night/shift premium, social welfare contributions, health payments, holiday pay, allowances, education and training payments, severance payments, social security premiums and unemployment insurance premiums of indirect labor are classified as indirect labor cost.

Determining Labor Costs

First of all some concepts related to labor should be clarified: Wage is a general term and refers to payments to employees by employers in exchange for work. Basic pay (wage) refers to payments made to employees only for working. Vested wage refers to payments made to employees for regular work plus other payments such as premiums, allowances, social welfare payments and etc. Gross wage refers to wage, which has not yet been object to any deduction due to legal enforcement.

Basic Wage

There are three main methods to determine basic pay. Those methods are the time-based system, piece based system (accord system) and premium-based system. These are also called remuneration systems.

Time-Based System

Under the time-based system, the important point is the time that employee spends at work. The measure of time can be the hour, day, week or month. Under this system, productivity is ignored, only time is considered.

Piece Based System

Under the piece-based system, the output is considered. This system focuses on the units that employees produce and ignores the time spent. This kind of system is only applicable to businesses where efficiency is measurable for employees. Basic pay increases in proportionate with produced units This system makes employees work harder in order to earn much more money. However, like other systems, this system also has disadvantages. For instance, in order to produce more units, employees may be too ambitious and thus more careless. This may result in occupational accidents or the production of defective products

Premium Based System

Finally, for determination of labor costs, there is another system, which is known as premium based. Criticisms about the disadvantages of time-based and piece based systems lead to apply for a new one, which is named the premium-based system. Under this very well-known system employee is paid a basic wage and premium for his/her efficient work. In any case, the employee is paid a basic wage but not premium even if he/she is not able to achieve the target efficiency.

Accounting for Labor Costs

There are two main types of labor costs; direct labor costs and indirect labor costs. Direct labor costs are regulated under the account group 72 in Turkish Uniform Chart of Accounts. Indirect labor costs are accumulated in manufacturing overhead; therefore, in Turkish Uniform Chart of Accounts the account groups 73 and 74 are used for indirect labor cost. Details of the accounts are as follows;

• 720 Direct Labor Expenses
• 721 Reflection Accounts for Direct Labor Expenses
• 722 Direct Labor Wage Differences
• 723 Direct Labor Time Differences
• 730 Manufacturing Overhead (General Manufacturing Expenses)
• 740 Cost of Production of Services

Accounting for Labor Costs in a Manufacturing

Company Direct labor costs incurred in a manufacturing company are tracked by 720 Direct Labor Expenses account and indirect labor costs incurred in a manufacturing company are tracked by 730Manufacturing Overhead account.

Accounting for Labor Costs in a Service Company

Direct labor costs incurred in a service company are tracked by 740 Cost of Production of Services account and indirect labor costs incurred in a service company are tracked again by 740 Cost of Production of Services account. However, it is indicated that cost is an indirect labor cost.

Payroll Related Issues

Payroll is not a salary or wage. Payroll or payroll register is a process. The process includes calculating wages, withholding taxes and other deductions. Nowadays automated payroll systems are used because as determined before payroll related costs constitute a major part of the total costs and tracking them accurately is important.

An employee receives net pay, which is less than gross pay. This is because there are two main deductions from the gross pay. One is required deductions by legal enforcement, the other one is optional deductions that depend on discretionary reasons. Required deductions are mainly social security premiums and unemployment insurance premiums according to social security and tax regulations. Optional deductions i.e. private pension plans are authorized by the employer for special reasons. This section aims to focus on social security premiums and unemployment premiums that are a real fact of Turkey.

Special Topics in Labor Costs

Tracking Labor Costs Among three types of manufacturing costs, which are direct materials, direct labor and overhead, direct labor cost occupied the largest portion for many years. However, recent developments in technology shifted this largest portion from direct labor cost to overhead costs. Because the use of technology in manufacturing resulted in a decrease in direct labor and an increase in overhead costs.

The most common way to track labor costs is keeping labor time cards for many years now. The firm assigns a card to each employee. Time card can be a physical piece of paper. In such a case as the employee enters or leaves the firm, he/she inserts the card in the clock and that clock prints the exact time for arriving and leaving. In addition, the timecard can be a virtual record updated as the employee checks in and out and enters the job number in a computerized information system. In recent years instead of those kinds of manual labor timecards, some other technological systems are used to keep track of labor. For instance, some firms use scanning devices to read employees’ barcoded identification, some use biometric fingerprint scanner and etc.

Idle Time

Idle time labor costs are regarded as indirect labor costs. In order to understand the logic behind this, it would be better to clarify the concept of idle time and the reasons for idle time.

Overtime Premium

Overtime work is defined in the Labor Act of Turkey Law no. 4857. Article 41 states that overtime work is work which exceeds forty-five hours a week. Important points of the law related to overtime premium are listed above;

“Wages for each hour of overtime shall be remunerated at one and a half times the normal hourly rate.”

“Overtime work may be performed for purposes such as the country’s interest, the nature of the operation or the need to increase output” (Labor Act of Turkey Law no. 4857, Article 41).

“All or some of the employees may be required to work overtime either in the case of a breakdown, whether actual or threatened, or in the case of urgent work to be performed on machinery, tools or equipment or in the case of force majeure, provided that it shall not exceed the time necessary to enable the normal operating of the establishment” (Labor Act of Turkey Law no. 4857, Article 42).