Labour costs

Cost/Management Accounting notes

Labour costs refer to all the costs incurred in compensating the human resources employed to provide a useful service in the production process. Just like material costs, labour costs form a large percentage of the total cost of production. There is, therefore, need to exercise maximum care so that this cost is minimized. Correct determination of labour costs is important for various purposes including correct determination of gross and net pay for each individual employee, for financial accounting and managerial accounting purposes. Managerial accounting purposes include stock valuation decision making and labour cost control.
Labour costs can either be direct or indirect. They include;
 Basic salary or wages: this is the amount contracted for. A wage is the amount of money paid for some specified quantity of labour. When expressed with respect to time (usually per hour), it is typically called the wage rate, and is specified in pre-tax amounts. It is often the main monetary item upon which the worker and the employer focus when negotiating an employment contract.

 Overtime premium: compensation paid to employees in addition to normal wages for hours worked in excess of normal working hours. Normal hours refer to the time pre-specified in the employment contract to be the official working hours. In most organizations in Kenya, the normal working hours is between 8.00 am and 5.00 pm.

 Bonus payment: this is a payment in addition to the amount contracted for, in most
cases based on the level of performance or profitability.

 Allowances: allowances are payments in addition to an employee’s wage or salary, and are paid as compensation for a particular feature of work, inconvenience or discomfort incurred as part of your position. For instance, sitting allowance, traveling allowance and hardship allowance.

 Idle time: this is the non productive time paid for. For instance, workers are still paid
though no production is continuing due to power failure or machine breakdown

 Labour turnover: this includes the cost of recruiting new employees who come in to
replace the outgoing employees.
Elements of Labour Costs
Basic wages
Basic wages is the amount contracted for. There are various methods by which basic wages can be paid out. They include

(a) Fixed rate or fixed salary per month or per annum
Here, the employees earn a fixed amount despite the amount of work done. For instance, a production manager may be allowed a salary of Shs500,000 per month, whether the company production is at peak or off-peak.

b) Piece rate or piece work
Under this method, the earnings depend on the level of activity or output achieved and it is expressed as

Earnings = Output (units) x basic rate per unit
Under the piece rate system, there are three schemes of remuneration. These are straight piece rate, straight piece rate with a guaranteed minimum pay and a differential piece rate.
Straight piece rate
Here, the basic rate per unit remains constant irrespective of the number of units produced. For instance, if 200 units are produced at a basic rate of Shs1000 per units, then the earnings will be
= Shs.1,000 per unit x 200 units
= Shs.200,000

The graphs below illustrate the straight piecework remuneration method

Straight piece rate with a guaranteed minimum pay
Under this scheme, although the employee is paid on the number of units produced, one is guaranteed of some main wage since there are occasions when production does not take place due to power failures, machine breakdowns, etc. Therefore, a standard rate is agreed upon for the production of each unit based upon an expected time to produce one unit and the normal rate per hour.
The total wages graph for this scheme would appear as shown below

Differential piece rate
Here, employees’ basic rate of pay per unit changed as the level of activity changes. Under differential rate system, the workers time rate is fixed at a higher level than the usual rate of payment if the output exceeds the expected (usually set) level. The objective of this system is to provide an incentive to the workers while retaining the simplicity of the system. It is most appropriate for easily measurable output to which groups of workers contribute e.g. car assembly lines. The low piece rate is applicable where a worker is not able to achieve the standard (normal) output and the highest piece rate is for those above standard. It does not provide the security of a guaranteed minimum wage but has the enhanced incentive of increased rates for higher production. The graphical illustration of the scheme will be as follows;

If it does not guarantee minimum wages on time basis, this may lead to high wage differential in the company and consequently demotivation. For this reason, the differential price rate system as well as many variations of the piece rate system contain a minimum (guaranteed) pay.

(c) Time rate or time work

Under this method, employees earnings depend on the time spent on the job. Total
wages can be expressed as;

Total earnings = Basic rate per hour x total hours worked

Under this system there are various schemes that may be applied. They include
Flat time rate
Under flat time rate, each worker is paid for the time spent without considering the volume of production during that period. The basic rate per hour remains constant irrespective of the number of hours worked. For instance, assume that an employee worked for 200 hours on a specific assignment. Assume further that the basic rate per hour is Shs100. The total earnings under flat time rate will be
= Shs100 per hour x 200 hours
= Shs20,000
The graphical illustration of labour cost behavior under flat time rate is as shown;

Measured day rate
This is where although the employee is paid on the basis of the number of hours worked, before
such payment is made, one must have completed a given piece of assignment.
Graduated time rate
Under this scheme, the rate of pay is adjusted to reflect changes in the cost of living
Graphical illustrations of the two schemes above; measured day rate and graduated day rate are as follows;

Time Keeping
A labour cost control routine should ensure that payments are paid only to employees who have spent time at the work place and that payments are at agreed rates of pay including overtime premium and shift premium payments where relevant. Where an employee is paid a fixed sum for an agreed length of working week, it may be decided by a check by the supervisor that the employee is at work is all that is necessary.
Where the employee is being paid at the rate per hour for the time spent at work together with premium rates for overtime work, it is likely that a detailed record of time spent on the premises is required. This is done by having the employee to register his arrival and departure times.
Time analysis
This is usually achieved by having the employee complete a daily or weekly time sheet or by having job cards or piecework tickets. Where time sheets are issued, the employee records the time analysis stating how much time was spent on each job and recording idle time. This sheet will then be authorized by the supervisor. Job cards move with a job as it passes from one employee to another.

There may be time clocks at each work center where the time spent on the job is recorded. Where this routine is used, employees may also be required to clock idle time on an idle time card, which will be analyzed to determine the cause of idle time. Where payments are made in return for out put units, piecework tickets may be completed which are signed by the supervisor certifying the number of units claimed. The analysis of employee time will facilitate:

 Correct charge of direct labour cost to each job

 Correct charge of indirect labour cost to cost centers

 Control of labour costs by job and cost center

 Calculation of employee bonus

 Measurement of efficiency
Improvement in the differential piece rate system
An improvement of the high day rate system is the measured day work system. This system attempts to grade workers according to their efficiency and pay them a fixed amount based on which bracket they fall. For example, a company may have the following efficiency brackets paid at the respective rates.

Suppose a worker falls in the 96% to 100% bracket, the actual amount of wages to be paid to him is Shs.60,000. The challenge here is that some employees may be more or less efficient than graded. Does the company still pay them the same amount as indicated in the efficiency

table? This calls for a consistent review of the employees’ efficiency and remuneration scheme. Where, for instance, an employee has performed more efficiently, the company may pay an excess amount based on the evaluation. Assuming the employee in the same bracket as above achieves 104% efficiency, the company may decide to pay him/her the basic amount plus an extra amount based on evaluation.

The challenge comes in when the employee hits a lower class than the one he has been rated. Does the company pay him less?

Overtime premium
This is the compensation paid to employees in addition to normal wages for hours worked in excess of normal working hours. The overtime is that time paid for over and above the basic hours for the period. Overtime premium is the difference between the rate at which normal working hours are paid and the rate at which overtime hours are paid.
Overtime by direct workers might either be to make up for the lost time earlier in the production process or to produce more of the product than was originally anticipated. The premium is considered to be an indirect labour cost and is treated as a production overhead.
Note that if overtime is needed to produce extra units i.e. overtime hours are worked for general production, then it is unavoidable and it should be treated as part of production overheads (indirect labour costs). In addition, if overtime is worked at a specific request of a customer, to get his work or order completed, then the premium is charged to that order as part of direct labour costs.
Shift premium
This is the payment of labour over and above the standard rate when they work on shifts especially
during the nights or periods outside the normal working hours.
Bonus payments
Bonus payment is paid to employees to increase their efficiency. Various incentive bonus schemes have been introduced. The characteristics of such schemes include;

 Employees are paid more for their efficiency

 In spite of extra labour costs, unit cost of output is reduced and the profit earned per unit
of sale is increased

 The morale of the employees should be expected to improve since they are seen to
receive extra reward for extra effort.
Idle time
Idle time is non-predictive time paid for i.e. workers are paid but no goods have been produced
e.g. when there is machine breakdown, power failure or tea breaks. Idle time can either be avoidable or unavoidable. It could be due to production disruptions whereby there is machine breakdown, inefficient scheduling of jobs or shortage of raw materials or policy decisions i.e. changes in production specifications or retraining skills.
Labour costs for paying for hours of avoidable time are costs that simply should not have occurred. Therefore, they should be written off in the profit and loss account.
Unavoidable idle time is that which cannot be helped. It is uncontrollable or unnecessary cost to the business e.g. tea breaks, unexpected fall in demand for a product or a strike at the suppliers affecting vital supplies. Unavoidable idle time of direct workers may be included in the cost of products as a production overhead. All other idle time is treated as period costs.

Labour turnover
It is the number of employees leaving or being recruited in a period of time. It is expressed as a percentage of the total labour force. It is expressed as;

Causes of labour turnover; these causes outline the reasons why an employee may leave an
organization. They include

 Illness and accidents

 Retirement and death

 Rate of payment; the employee may find that the remuneration is not commensurate to
the amount of work done

 Poor working relationship between the management and the employee

 Lack of opportunity for career or lack of job satisfaction
Costs of labour turnover
Costs of labour turnover can be broadly categorized into replacement costs and preventive

Replacement costs are costs incurred as a result of hiring a new employee. They include cost of selection and placement (advertising and interviewing), inefficiencies in new labour, lower productivity, cost of training, loss of output due to delay in new labour becoming available, increased wastage and spoilage due to lack of expertise among the new staff, possibility of more frequent accidents, cost of tools and machine breakages.
Preventive costs are costs incurred in order to prevent employees from leaving an organization. They include cost of personnel administration in maintaining good relationships and cost of welfare, services and pension schemes.
>>> Illustration
Company BC which operates a flat time rate method of remuneration has won a tender to do Job XYZ which requires 30 hours of labour input. On negotiation, the employer agreed to pay to the employee Shs.500 per normal hour of input. The company has a policy of paying overtime at 1
½. The job was due in three days time. Each working day has 8 normal working hours.
Compute the actual cost of labour incurred in the completion of the job.
Note that the normal working hours available in three days are 24. This means that the employee has to work overtime for 6 hrs to meet the deadline.
Therefore the actual analysis of labour cost incurred would be:

>>> Illustration 1
Under a premium bonus scheme, workers receive a guaranteed basic hourly minimum rate of pay plus a bonus of 50% of the time saved. No payment is paid beyond the time allowed but the bonus which is paid at the basic hourly rate is applicable to the accepted output only. No penalty is imposed on rejected output. The following details are available for the month of January 2003

From the above information, calculate for each employee

(a) Bonus hours and amount of bonus paid
(b) Gross wages earned
(c) Labour cost for each good unit sold

Gross Wages = Regular wage by Bonus

Labour cost for each good unit sold

>>> Illustration 2
Based on the data below, you are required to calculate the remuneration of each employee as determined by each of the following methods

i. Hourly rate
ii. Basic piece rate
iii. Individual bonus scheme where the employee receives the bonus in proportion of the
time saved to time allowed

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