Cost Accounting Techniques

Accounting for Labour

Facilitator:
Dr Irfan Sahibzada
Contact Details:
[email protected]
Ph. Office: 051 90853154
Mob: 0342 5093739
Office: Room 311
 Accounting for Labour
• Just as management need to control inventories and
operate an appropriate valuation policy in an attempt to
control material costs.
• Similarly they must also be aware of the most suitable
remuneration policy for their organisation.
• This chapter details various methods by which labour
may be paid (remuneration methods), and also looks at
various ratios which can be useful in relation to labour.
 Direct and Indirect Labour Costs
• All costs of indirect workers (i.e. those not directly involved in
making products, such as maintenance staff and supervisors)
are indirect costs.
• For workers directly involved in making products:
• Direct costs are their basic pay, and any overtime premium
paid for a specific job at the customer’s request.
• Indirect costs are general overtime premiums, bonus
payments, idle time, and sick pay etc.
 Example
• A direct labour employee's wage in week 5 consists of the
following:
Basic pay for normal hours worked, 36 hours at $4 per hour 144
Pay at the basic rate for overtime, 6 hours at $4 per hour 24
Overtime shift premium, with overtime paid at time and a 6
quarter ¼ x 6 hours x $4 per hour
A bonus payment under a group bonus (or 'incentive') scheme 30
– bonus for the month
Total gross wages in week 5 for 42 hours of work 204

• Establish which costs are direct costs and which are indirect
costs.
 Example: Indirect Labour Cost
• A summary of Perky's factory payroll for October showed the
following:
• Basic hours 7,000
• Hours of overtime 1,000
• Hours of idle time 500
• The idle time, which arose due to a power cut, increased the
hours of overtime which are normally worked due to general
pressures of work. Basic pay is $15 per hour and overtime is
paid at a premium of .
• Required: Calculate the indirect labour cost for October.
 Example: Direct Labour Cost
• Remont employs 15 workers in a factory at an hourly rate of
$3.60.
• A working day is 9 hours and there are usually 20 working days
in a month.
• The firm budgets 6 hours per unit.
• During October there were only 14 working days because of a
hurricane.
• To make up for lost production, each worker worked 45 hours
over weekends for an overtime premium of 50%.
• Actual production for October was 430 units, 20 units fewer
than budgeted.
• Required: Calculate the direct labour cost for October.
 Measuring Labour Activity
• Production and productivity are common methods of
measuring labour activity.
• Production is the quantity or volume of output
produced.
• Productivity is a measure of the efficiency with which
output has been produced.
• An increase in production without an increase in
productivity will not reduce unit costs.
 Production & Productivity
• An employee is expected to produce 3 units in 1 hour.
• If, during one week, the employee makes 126 units in 40 hours of
work, the following comments can be made:
a) Weekly production is 126 units.
b) Productivity is a relative measure of the hours actually taken and
the hours that should have been taken to make the output.
a) Either, 126 units should take 42 hours
But did take 40 hours
Thus productivity ratio = 42/40 x 100% = 105%
b) Or alternatively, they should make (40 hours x 3)120 units
But did make 126 units
Thus productivity ratio = 126/120 = 105%
• A productivity ratio greater than 100% indicates that actual
efficiency is better than the expected or 'standard' level of efficiency.
 Productivity and its Effect on Cost
• Improved productivity is an important means of
reducing total unit costs. In order to make this point
clear, the following example is used:
• Clooney Co has a production department in its factory
consisting of a work team of just two men, Doug and
George. Doug and George each work a 40 hour week and
refuse to do any overtime. They are each paid $100 per
week and production overheads of $400 per week are
charged to their work.
(a) In week one, they produce 160 units of output between them. Productivity is
measured in units of output per man hour.

Production 160 units

Productivity (80 man hours) 2 units per man hour
Total cost $600 (labour plus overhead)
Cost per man hour $7.50
Cost per unit $3.75

(b) In week two, management pressure is exerted on Doug and George to increase
output and they produce 200 units in normal time.

Production 200 units (up by 25%)

Productivity 2.5 units per man hour (up by 25%)
Total cost $600
Cost per man hour $7.50 (no change)
Cost per unit $3.00 (a saving of 20% on the previous
cost)

(c) In week three, Doug and George agree to work a total of 20 hours' overtime for
an additional $50 wages. Output is again 200 units and overhead charges are
increased by $100.

Production 200 units (up 25% on week one)

Productivity (100 man hours) 2 units per hour (no change on week one)
Total cost ($600 + $50 + $100) $750
Cost per man hour $7.50 (no change)
Cost per unit $3.75

(d) Conclusions

I. An increase in production without an increase in productivity will not reduce

unit costs (week one compared with week three).
II. An increase in productivity will reduce unit costs (week one compared
with week two).
 Automation
• Labour cost control is largely concerned with
productivity.
• Rising wage rates have increased automation, which in
turn has improved productivity and reduced costs.
• Where automation is introduced, productivity is often,
but misleadingly, measured in terms of output per man
hour.
 Example: Automation
• Suppose, for example, that a work team of six men (240 hours per
week) is replaced by one machine (40 hours per week) and a team
of four men (160 hours per week), and as a result output is
increased from 1,200 units per week to 1,600 units.
  Production Man hours Productivity
Before the machine 1200 units 240 5 units per man hour
After the machine 1600 units 160 10 units per man hour

• Labour productivity has doubled because of the machine, and

employees would probably expect extra pay for this success.
• For control purposes, however, it is likely that a new measure of
productivity is required, output per machine hour, which may then
be measured against a standard output for performance reporting.
Other Measures of Labour Activity
• Other measures of labour activity include the following:
• Production volume ratio (or activity ratio)
• Efficiency ratio (or productivity ratio)
• Capacity ratio

• These ratios are usually expressed as percentages.

 Example
• Rush and Fluster Co budgets to make 25,000 standard units of
output (in 4 hours each) during a budget period of 100,000
hours.
• Actual output during the period was 27,000 units which took
120,000 hours to make.
• Calculate the efficiency, capacity and production volume
ratios.
 Remuneration Methods
• There are three basic remuneration methods:
• Time work
• Piecework and
• Bonus schemes
• Labour remuneration methods have an effect on the
following:
• The cost of finished products and services
• The morale and efficiency of employees
 Time Work
• Wages are paid on the basis of hours worked. The most
common form of time work is a day-rate system in which
wages are calculated by the following formula.

• For example, if an employee is paid at the rate of $5 per hour and

works for 8 hours a day, the total pay will be $40 for that day.
• Employees paid on an hourly basis are often paid extra for
working overtime.
• For example, an employee is paid a normal rate of $5 per hour
and works 4 hours overtime for which he is paid at time-and-a
half. The amount paid for the overtime will be 4 x 1.5 x $5 = $30.
• Overtime Premium
• The overtime premium is the extra rate per hour which is paid,
not the whole of the payment for the overtime hours.
 Summary of Day-rate Systems
1. They are easy to understand.
2. They do not lead to very complex negotiations when
they are being revised.
3. They are most appropriate when the quality of output
is more important than the quantity, or where there is
no basis for payment by performance.
4. There is no incentive for employees who are paid on a
day-rate basis to improve their performance.
 Piecework Schemes
• Wages are paid on the basis of units produced.

• For example an employee is paid $0.20 for every unit

produced, with a guaranteed minimum wage of $750 per
week.
• In week 1, they produce 5,000 units and so the pay will be 5,000 x
$0.20 = $1,000 for the week.
• In week 2, they only produce 3,000 units, for which the pay would
be 3,000 x $0.20 = $600. However, since this is below the
guaranteed minimum the employee will receive $750 for the
week.
 Differential Piecework Scheme
• This scheme offer an incentive to employees to increase their
output by paying higher rates for increased levels of
production. For example:
• Up to 80 units per week, rate of pay per unit = $1.00
• 80 to 90 units per week, rate of pay per unit = $1.20
• Above 90 units per week, rate of pay per unit = $1.30
• Employers should obviously be careful to make it clear
whether they intend to pay the increased rate on all units
produced, or on the extra output only.
 Summary of Piecework Schemes
1. They enjoy fluctuating popularity.
2. They are occasionally used by employers as a means of
increasing pay levels.
3. They are often seen to drive employees to work too hard to
earn a satisfactory wage.
• Careful inspection of output is necessary to ensure that quality
doesn't fall as production increases.
 Bonus (or Incentive) Schemes
• There are many different ways in which a bonus scheme
can operate, but essentially in all cases the employee is
paid a standard wage but in addition receives a bonus if
certain targets are achieved.
• The characteristics of such schemes are as follows:
• Employees are paid more for their efficiency.
• The profits arising from productivity improvements are shared
between employer and employee.
• Morale of employees is likely to improve since they are seen to
receive extra reward for extra effort.
 Other Schemes
• High Day-rate system
• It is a system where employees are paid a high hourly wage rate
in the expectation that they will work more efficiently than similar
employees on a lower hourly rate in a different company.
• Individual bonus schemes
• An individual bonus scheme is a remuneration scheme whereby
individual employees qualify for a bonus on top of their basic
wage, with each person's bonus being calculated separately.
• Group bonus schemes
• A group bonus scheme is an incentive plan which is related to the
output performance of an entire group of workers, a department,
or even the whole factory.
 Recording Labour Costs
• Labour attendance time is recorded on, for example, an
attendance record or clock card.
• Job time may be recorded on daily timesheets, weekly
timesheets or job cards depending on the circumstances.
• The manual recording of times on timesheets or job
cards is, however, liable to error or even deliberate
deception and may be unreliable.
• The labour cost of pieceworkers is recorded on a
piecework ticket/operation card.
 Accounting for Labour Cost
Example: The wage control account
• The following details were extracted from a weekly payroll for
750 employees at a factory.
Analysis of Gross Pay      
  Direct Indirect Total ($)
Workers ($) Workers ($)
Ordinary time 36,000 22,000 58,000
Overtime: Basic wage 8,700 5,430 14,130
Overtime: Premium 4,350 2,715 7,065
Shift allowance 3,465 1,830 5,295
Sick Pay 950 500 1,450
Idle time 3,200 3,200
  56,665 32,475 89,140
Net wages paid to 45,605 24,220 69,825
employees

• Required: Prepare the wages control account for the week.

 Idle Time Ratio
• The idle time ratio is useful because it shows the
proportion of available hours which were lost as a result
of idle time.
 Labour Turnover
• Labour turnover is the rate at which employees leave a
company and this rate should be kept as low as possible.
• The cost of labour turnover can be divided into preventative and
replacement costs.
• Measuring labour turnover
• Labour turnover is a measure of the number of employees
leaving/being recruited in a period of time expressed as a
percentage of the total labour force.
 Example: Labour Turnover Rate
• Revolving Doors Inc. had a staff of 2,000 at the beginning of
2001 and, owing to a series of redundancies caused by the
recession, 1,000 at the end of the year.
• Voluntary redundancy was taken by 1,500 staff at the end of
June, 500 more than the company had anticipated, and these
excess redundancies were immediately replaced by new
joiners.
• The labour turnover rate is calculated as follows:
 The Reasons for Labour Turnover
• Some employees will leave their job and go to work for another
company or organisation. Sometimes the reasons are unavoidable:
• Illness or accidents
• A family move away from the locality
• Marriage, pregnancy or difficulties with child care provision
• Retirement or death
• Other causes of labour turnover are to some extent controllable:
• Paying a lower wage rate than is available elsewhere
• Requiring employees to work in unsafe or highly stressful conditions
• Requiring employees to work uncongenial hours
• Poor relationships between management and staff
• Lack of opportunity for career enhancement
• Requiring employees to work in inaccessible places (e.g. no public transport)
• Discharging employees for misconduct, bad timekeeping or unsuitability
 The Prevention of High Labour
Turnover
• Labour turnover will be reduced by the following
actions.
• Paying satisfactory wages
• Offering satisfactory hours and conditions of work
• Creating a good informal relationship between members of
the workforce
• Offering good training schemes and a well-understood
career or promotion ladder
• Improving the content of jobs to create job satisfaction
• Proper planning so as to avoid redundancies
• Investigating the cause of an apparently high labour
turnover
 Organisations for Controlling and
Measuring Labour Costs
• Several departments and management groups are
involved in the collection, recording and costing of
labour.
• These include the following:
• Personnel
• Production planning
• Timekeeping
• Wages
• Cost accounting
 Personnel or Human Resources
Department
• The personnel department (or human resources
department) is responsible for the following:
• Engagement, transfer and discharge of employees
• Classification and method of remuneration
 Production Planning Department
• This department is responsible for the following:
• Scheduling work
• Issuing job orders to production departments
• Chasing up jobs when they run late
 Timekeeping Department
• The timekeeping department is responsible for recording
the attendance time and job time of the following:
• The time spent in the factory by each worker
• The time spent by each worker on each job
• Job time
• Continuous production
• Idle time
• It occurs when employees cannot get on with their work,
through no fault of their own. Examples are as follows:
• Machine breakdowns
• Shortage of work
 Wages (Payroll) Department
• Responsibilities of the payroll department include the
following:
• Preparation of the payroll and payment of wages
• Maintenance of employee records
• Summarising wages cost for each cost centre
• Summarising the hours worked for each cost centre
• Summarising other payroll information e.g. bonus
payment, pensions
• Providing an internal check for the preparation and
payout of wages
 Cost Accounting Department
• The cost accounting department has the following
responsibilities:
• The accumulation and classification of all cost data (which
includes labour costs)
• Preparation of cost data reports for management
• Analysing labour information on time cards and payroll
• In order to establish the labour cost involved in
products, operations, jobs and cost centres, the
following documents are used:
• Clock cards
• Idle time cards
• Job cards
• Payroll