Allocating the cost of labor is a crucial component of accounting for production processes. Many manufacturing companies use a job costing system that allocates the cost of labor to the products produced.
The cost of labor is a significant part of the total production costs. For example, the total cost of production may be $100,000, and $50,000 of that is paid to labor.
How this cost is allocated in the accounting system can have significant impacts on the profitability of products. If labor costs are incorrectly allocated to products, then this could result in lost revenue or profits.
This article will discuss when it is appropriate to allocate the costs of labor in a job costing system and how to do so correctly. More specifically, this article will discuss when it is appropriate to allocate the salary or wage costs of labor in a job costing system.
Calculate the total overhead for the company
Once the total direct labor cost is determined, the next step in determining unit cost is to allocate overhead to the unit. Overhead is a cost that cannot be traced to a specific unit produced.
Overhead is comprised of many things, such as rent, insurance, administration, etc. These are all costs that the company pays regardless of how many units they produce.
To accurately allocate overhead to units, a formula must be used that takes into account the number of units produced. This is done by using what are known as average production statistics.
The average production statistics take into account the average number of hours worked per week by employees, the average number of days worked per week, and the average number of weeks worked per year. Using these numbers in the allocation formula ensures an accurate reflection of production costs.
Divide wage costs by overhead to determine the wage rate
In practice, most companies do not allocate all wages to a specific job. Most companies pay their employees a basic wage and then give them bonuses or extra payments for doing extra work, like overtime work.
In addition, most companies have other overhead costs, like the cost of the equipment they use to produce their product or service. These costs are spread across all workers, so each individual worker is not paying for any of that themselves.
How does this affect job costing? Well, since an individual worker is not paying for any of the overhead costs or for their own salary, your unit price will be lower than what it should be.
To fix this, you can simply increase the unit price by dividing the total wage cost by the average hourly production rate (APR) to get a new unit price.
Multiply job time by wage rate to get the job cost
Once the total labor cost is determined, it must be allocated to the jobs performed. This is done by determining how much of each job cost is attributable to the labor cost.
The amount of each job cost attributed to labor is called the labor component. The remainder of each job cost is referred to as non-labor components.
How this is done depends on the accounting system being used. If a job costing system uses a standard accounting model, such as absorption accounting or direct accounting, then it is relatively simple to allocate the labor component.
Absorption accounting allocates all costs, including labor costs, to products sold. Therefore, in order to calculate the labor component for each job, you would simply divide the total labor cost by the number of units produced.
Add all job costs together to get total labor costs
Once all the costs associated with a job are determined, they must be allocated to the job. This is called assigning costs to products or services and is done in both manufacturing and service industries.
In manufacturing, cost allocation is typically done by hours worked. For example, if it takes one hour to assemble a widget, then one hundred widgets per hour equals one hundred hours of labor cost.
In service industries such as accounting or law, time spent on tasks or cases is often used to allocate costs. If an accountant spends one thousand dollars’ worth of time on a case, then that case cost one thousand dollars in accounting fees.
However, both of these can be flawed when factory wages paid are allocated in a job costing system.
Subtract labor costs from revenue to get net income
In a manufacturing setting, wages are considered a cost of production. That is, the money paid to workers is part of the total cost of producing an item.
In fact, under standard accounting rules, the fair value of labor paid to workers is assumed to be zero!
That may sound absurd, but there’s a method to the madness. It has to do with how companies allocate costs in their accounting reports.
When costs are allocated, they may be allocated either to products or to expenses. Accounting rules specify which costs must be allocated to products and which must be allocated to expenses.
Labor costs are one of those that must be allocated to products — that is, they must be included in the cost of each individual unit produced. Therefore, in standard accounting practices for manufacturing firms, labor costs are included in the per-unit cost of production.
Divide net income by gross profit margin to determine profit percent
The final step in calculating profit is to divide net income by the total amount of money spent on costs. This final number is called gross profit.
Profit can be calculated in two ways: by dividing net income by sales or by dividing gross profit by sales. Both of these ways yield the same answer, but they use different numbers.
The first way uses the net income of the business and divides that by the amount of sales the business made. The second way uses the total cost of goods sold and divides that by the amount of sales the business made.
Both of these methods account for all costs in the business, including internal and external costs. Internal costs are those that are paid for using revenue from sales, such as labor costs.
By dividing gross profit by sales, you are allocating internal costs paid for with revenue from sales to cost of goods sold.