Accounting for Labour

Direct and Indirect Labour

For accounting purposes, labour costs are divided into direct and indirect costs.

Definitions

Direct labour – Labour whose work is directly attributable to producing a product or service.

Indirect labour – Labour not directly attributable to the production of a product or service.

1.1.1 Direct labour costs

Direct labour costs are the costs of labour that can be specifically attributable to a product
or service provision.

Examples of direct labour costs:

• The wages and salaries of workers making a particular product in a factory that
manufactures several products.

• The wages and salaries of workers directly involved in production on a building site
where new houses are being constructed, such as a plumber.

1.1.2 Indirect labour costs

Indirect labour costs are labour costs that cannot be specifically attributable to a product or
service provision.

For example, the wages and salaries of the project managers overseeing the construction of
new houses on a building site are indirect labour costs. This is because they are not directly
involved in the building process.

Activity 1

Determine if the work described is direct or indirect labour

Classification

Labour work (direct or indirect)

Plumber fitting bathrooms into new houses

 Project manager overseeing the building projects

Bricklayers who build the houses

Marketing manager − advertising new house for sale

Carpenter making doors in new houses

Electrician fixing electrical cables in new houses

The architect who visits the site to check that plans are followed

Project manager’s secretary

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Labour work Classification (direct or indirect)

Plumber fitting bathrooms into new houses direct

Project manager overseeing the building projects indirect

Bricklayers who build the houses direct

Marketing manager − advertising new house for sale indirect

Carpenter making doors in new houses direct

Electrician fixing electrical cables in new houses direct

The architect who visits the site to check that plans are followed indirect

Project manager’s secretary indirect

Activity 2
Classify the labour as either direct or indirect.

Classification

Labour (direct or indirect)

Sewing machinist at a clothes manufacturer

Factory manager

A hairdresser that cuts hair at a salon

Office receptionist

A mechanic who fixes cars at a car workshop

A mechanic who fixes trucks at a logistics firm

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Labour Classification (direct or indirect)

Sewing machinist at a clothes manufacturer direct

Factory manager indirect

A hairdresser that cuts hair at a salon direct

Office receptionist indirect

A mechanic who fixes cars at a car workshop direct

A mechanic who fixes trucks at a logistics firm indirect

The difference between direct and indirect labour depends on the organisation. It is not
always the case that a type of labour will always be either direct or indirect across all
organisations.
However, there are some other points to be aware of. When direct labour (production)
workers receive holiday pay and sick pay, this is treated as an indirect labour cost because it
is not a cost (in this case, ‘time’) directly involved in producing products.

Another indirect labour cost is idle time. This is when employees are unable to work when it
is not their fault, but they are still paid. An example of when idle time might occur is when a
machine breaks down, and work cannot start until it is fixed.

Generally, the basic pay of direct workers is a direct cost, and all other costs of direct
workers are indirect costs. All costs of indirect workers are indirect costs.

Key Point

Only hours spent directly producing a product/service are considered direct labour costs.

All other costs are indirect, even if paid to direct workers.

A bonus paid to direct workers is an example of an indirect cost paid to direct workers.

Here are some direct worker costs that require further classification:

Labour cost Description Classified as

Time in which direct workers are paid, but no work is being Indirect
Idle time done. cost

The premium above the basic rate paid to workers for hours
beyond their regular (agreed) hours.

It is usually calculated as a multiple of the basic rate.

General overtime For example, if the basic rate is $10 per hour and the overtime Indirect
premium rate is $15 per hour, the overtime premium is $5 per hour. cost

Overtime spent by workers to fulfil a customer’s specific request

(for example, to complete a job earlier)

Overtime worked for In this case, the overtime rate includes the basic rate and Direct
customer request overtime premium. cost

Activity 3
Classify the following labour costs of Furniture Co as either direct or indirect.

Classification

direct or
Cost element indirect

Holiday pay to direct workers

Pay for hours spent delivering orders to customers

Pay for hours spent producing furniture to direct workers

Overtime premium paid due to holiday cover to direct workers

Pay to direct workers for additional work carried out after regular production hours to
produce an order of customised furniture for a customer at short notice.

*Please use the notes feature in the toolbar to help formulate your answer.

direct or
Cost element indirect

Holiday pay to direct workers indirect

Pay for hours spent delivering orders to customers indirect

Pay for hours spent producing furniture to direct workers direct

Overtime premium paid due to holiday cover to direct workers indirect

Pay to direct workers for additional work carried out after regular production hours to
produce an order of customised furniture for a customer at short notice. direct

1.1.3 Overtime

It is usual for staff to be paid an additional amount of money when they work extra hours.
This additional payment is known as an overtime premium. It is often, but not always, above
their normal rate of pay.
Overtime premiums are indirect labour costs.

Example

Sarah earns $15 per hour for each hour she works in a café. Her standard shift is for 7 hours.

Sometimes Sarah’s boss needs extra help and asks Sarah to work longer than her shift, paying her an
additional 50% per hour for this.

Today, Sarah worked 9 hours.

Calculate her total pay, and classify it as direct and indirect costs.

Answer:

$ Classification

Basic pay 9 hours × $15 135 direct

overtime premium 2 hours × $15 × 50% 15 indirect

Total pay 150

• Normal (standard) pay

A seven-hour shift’s standard direct labour cost will be $15 × 7 = $105. This is her normal pay.

• Overtime

Sarah earns $22.50 for each hour of overtime that she works. This consists of the standard $15 per hour,
plus the overtime premium of $7.5 per hour (15 ×50%).

• Basic pay

Basic pay is the total hours worked multiplied by the basic rate.

Sarah’s basic pay is 9 hours multiplied by $15, which is $135.

This would be classified as direct labour cost to the café.

• Overtime premium

The extra $7.50 on overtime hours Sarah earns is called the overtime premium. In this case, the
overtime premium of $ 15 that Sarah made is an indirect labour cost to the café.

• Total labour costs

Sarah works nine hours one day. For the nine hours worked, the direct labour cost = 9 × $15 = $135 and
the indirect labour cost = 2 × $7.50 = $15
The main thing to remember when deciding if labour costs are direct or indirect is whether
the work done was directly involved in producing the product or service.

The exception to this rule is overtime, which is split between direct costs (basic pay) and an
indirect cost (overtime premium) unless stated otherwise.

If the company’s overall workload causes the need for overtime, the overtime premium is
classified as an indirect labour cost.

If overtime is requested specifically by a customer (to rush product delivery, etc.), then the
basic rate and overtime premium of those overtime hours is classified as direct labour cost
for that job.

Example: Direct Workers

The following information is available regarding direct workers of a company:

Hours worked Hourly rate ($)

Basic hours (including 50 hours of idle time) 900 7.50

Overtime 150 10.50

Calculate the amount to be classified as direct and indirect labour costs.

Answer:

Direct labour cost Indirect labour cost

$ per hour $ $ per hour $

900 basic hours:

850 active hours 7.50 6,375

50 idle time hours 7.50 375

150 overtime hours:

150 active hours 7.50 1,125

150 hours of overtime premium 3.00 450

Total 7,500 825

Example: Direct Workers

Observations:

• The active basic hours of direct workers are direct costs.

• Idle time of direct workers is an indirect cost.

• Basic pay earned from overtime hours is a direct cost.

• Overtime premium of direct workers is an indirect cost.

Example: Indirect Workers

The following information is available regarding the workers of a company:

Hours worked Hourly rate ($)

Basic hours, direct workers (including 50 hours of idle time) 900 7.50

Overtime, direct workers 150 10.50

Basic hours, indirect workers 350 6.00

Overtime, indirect workers 50 8.50

Calculate the amount to be classified as direct and indirect labour costs.

Answer:

Direct labour cost Indirect labour cost

$ per hour $ $ per hour $

900 direct worker basic hours:

850 active hours 7.50 6,375

50 idle time hours 7.50 375

150 direct worker overtime hours:

 Example: Indirect Workers

150 active hours 7.50 1,125

150 hours of overtime premium 3.00 450

350 indirect worker basic hours

350 hours 6.00 2,100

50 indirect worker overtime hours

50 hours 8.50 425

Total 7,500 3,350

Observations:

• The cost of indirect workers is indirect.

Activity 4

Remont employs 15 workers in a factory at an hourly rate of $3.60. A working day is 9 hours,
and 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 compensate 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.

Calculate the direct labour cost for October.

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Direct Labour Costs $

15 workers × 14 days × 9 hours × $3.60 6,804

15 workers × 45 hours × $3.60 2,430

Total direct labour costs 9,234

As the overtime premium ($1,215) is incurred in the making up for time lost due to "natural
causes", it most likely will be recognised as a separate, indirect cost. Again, however,
variations are possible.

Normal hours per month are 2,700 for 450 units (i.e. 6 hours per unit).

If 315 units were produced in 1,890 hours of normal working (15 × 14 × 9), then 115 units
were produced in 675 hours of overtime (i.e. less than 6 hours per unit).

Activity 5

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 worked due
to general work pressures.

Basic pay is $15 per hour, and overtime is paid at a premium of .

Calculate the indirect labour cost for October.

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The overtime premium and the cost of idle time are indirect labour costs.

Indirect labour costs $

Overtime premium (1,000 × 33 1/3% × $15) 5,000

Idle time (500 × $15) 7,500

Total indirect labour costs 12,500

Recording Labour Costs

Organisations record all labour costs associated with work done by employees. Time spent
working will often be charged to a job or a client.

2.1.1 Recording Work Done

Key Point

MA assumes the use of a computerised accounting system for the recording, processing, and reporting
of labour costs.

There are two reasons for recording time spent working:

• Employees can be paid for the hours that they have worked

• Time can be charged to specific jobs or clients (especially if work is done on several
of these simultaneously).

Hours worked can be recorded by attendance records and timesheets. These are usually
linked to the computerised accounting system, which verifies the employee and
automatically calculates the hours worked.

Sometimes it might be necessary to break down the time that an employee has been
working into different jobs. This is so that time can be charged to specific jobs or clients. In
such cases, it will be necessary to use time records that specify the activities worked on
during a period.

Examples include:

• Timesheets − these are commonly used in many service industries. Solicitors and
accountants often use them because they charge for their work based on how long
they have spent on a client’s project.

• Job sheets − these are often known as task-related timesheets and are used to list
the time spent on one particular job by several employees. The total time spent on a
job can be determined and accounted for at the end of the job.

When a worker is paid, that worker’s total pay, including any overtime premium, will be
administered by the payroll system. Therefore, the payroll system will need to work out the
total cost and be able to apportion this back to the job the worker is doing.

Recording Labour Costs in Accounts

The first step in accounting for labour costs is to record the gross pay, net pay and any
deductions in the wages control account.
2.2.1 Paying Wages

• Payment of net pay to employees

Dr Wages control

Cr Bank / Cash (net pay)

• Payment of employee deductions and employer contributions to external entities

Dr Wages control

Cr Payables (tax / national insurance)

Pay-as-you-earn (PAYE) is the tax deduction system in the UK. Each time an employee is paid,
tax is deducted from their gross pay and remitted to the tax authority.

The term “PAYE” is applicable to the UK. Other jurisdictions may label mandatory tax
deductions with other terms.

2.2.2 Accounting for Labour Costs in Wages Control

• Accounting for costs of labour (including employer contributions)

Dr Work-in-progress / production overheads / employer contributions

Cr Wages control

Labour costs are then accounted for using the same principles applied to direct and indirect
materials costs.

• Direct labour costs are debited to the work-in-progress account

• Indirect labour costs are debited to the production overhead control account

• Both direct and indirect labour costs are credited to the wages control account.

2.2.3 Accounting for Direct Labour Costs

Direct labour costs would be directly accounted for in work-in-progress.

• Direct labour costs associated with production

Dr Work-in-progress

Cr Wages control
2.2.4 Accounting for Indirect Labour Costs

Indirect labour costs would be transferred into a Production overheads account for
subsequent absorption into work-in-progress.

• Transfer of indirect labour costs to production overheads

Dr Production overheads

Cr Wages control

2.2.5 Absorption of Production Overheads

Production overheads (which include all indirect production costs) would be absorbed into
production.

• Absorption of production overheads into production

Dr Work-in-progress

Cr Production overheads

2.2.6 The Wages (Labour) Control Account

Wages Control Account

$ $

Bank X Work-in-progress X

(Payment of net wages) (Direct labour costs)

Payables X Production overheads X

(Mandatory deductions and contributions (Indirect labour costs)

e.g. tax, national insurance etc)

Statement of profit or loss X

(Other labour costs e.g. employer

contributions, etc.)

National insurance is a mandatory contribution by employees to a regulated fund that

disburses certain employee protections, such as statutory redundancy payments and medical
care provisions for injuries sustained at the workplace, etc.
The term “National insurance” applies to the UK. Other jurisdictions may use other terms for
mandatory insurance contributions.

Example

The following illustrates entries into the wages control account:

1. Post $100,000 of wages and salaries paid for the period as a credit to the Bank account and a
debit to the labour account (where they are an expense).

Wages Control Account

Bank 100,000 To production (WIP)

To production overhead

2. After analysing the $100,000 into direct labour costs of $80,000 and indirect labour costs of
$20,000, the labour account for the period can be completed.

3. Post the direct labour costs of $80,000 to the production department by crediting the labour
account and debiting the WIP account (where the production costs are held).

Wages Control Account

$ $

Bank 100,000 To production (WIP) 80,000

To production overhead

Production (WIP) Account

$ $

Wages Control 80,000

4. Indirect labour costs of $20,000 are not a direct cost of production; they are production
overheads credited to the labour account and debited to production overheads account

Wages Control Account

$ $
 Example

Bank 100,000 To production (WIP) 80,000

To production overhead 20,000

Production Overheads Account

$ $

Bank 20,000

Indirect labour costs include overtime premium, sick pay, holiday pay and idle time.

5. Ensure labour account balances. The labour costs will flow through the cost accounts and
eventually be reflected in the statement of profit and loss as expenses.

Wages Control Account

$ $

Bank 100,000 To production (WIP) 80,000

To production overhead 20,000

100,000 100,000

Remuneration methods

Key Point

For the MA exam, assume labour costs are variable unless specified otherwise.

Remuneration methods are the different ways an organisation can pay its employees for
their work. For example, an employee can be paid a constant salary for a fixed period (per
week, month or year). Alternatively, remuneration can be one of the following systems:

3.1.1 Time-Based System

Payment is based on the hours an employee works.

If they work overtime, they are usually paid a higher rate.

There are some distinctions to make when it comes to how employees are paid:

• Salary: Organisations pay salaried employees an agreed amount per month

• Wages: Waged employees are paid based on an agreed hourly rate, depending on
how many hours they work

• Overtime premiums are paid to persuade workers to work longer hours than normal.
An overtime premium will be in addition to the standard pay rate.

Salary, wages and overtime are time-based remuneration systems: payment is based on the
time employees work.

Advantages Disadvantages

• In time-based systems, there is no incentive for

employees to be efficient

• Time-based payment systems are • Everyone is paid the same regardless of

simple to administer performance

• One standard rate applies to all • More supervision is needed because employees
employees in the same role (which are not as highly motivated as they are when
seems fairer to employees) working under an incentive scheme

3.1.2 Piecework System

Payment is based on the number of products that an employee produces.

Piecework systems are straight or differential:

• Straight piecework - employees are paid a set amount for each unit of product they
produce.

• Differential piecework - employees are paid different rates per unit depending on
how many units they have produced. They may be rewarded with higher rates as
their production level increases above agreed targets.

Within a piecework system, employees may receive a guaranteed minimum wage despite
the number of units produced. This is known as piecework with a guaranteed minimum
wage.

Example

Furniture Co pays its employees using a differential piecework scheme that includes a guaranteed wage.
Example

Details of the scheme are:

• $5 per unit for up to 20 units per day

• $5.20 per unit for each unit between 21 and 25 per day

• $5.50 per unit for units 26 and each further unit per day

There is a guaranteed wage of $90 per day.

Calculate three different employees' wages based on producing the following in a day using the above
information:

Rohan produced 17 units

Divya produced 22 units

Solomon produced 27 units.

Answer:

1. Rohan (17 units)

2. $

17 units at $5 85.00

85.00

However, as Rohan has earned less than the guaranteed minimum daily wage, he will earn $90.

2. Divya (22 units)

3. $

20 units at $5 100.00

2 units at $5.20 10.40

110.40

Divya has earned more than the guaranteed daily minimum wage, so he will make $110.40.

3. Solomon (27 units)

4. $
 Example

20 units at $5 100.00

5 units at $5.20 26.00

2 units at $5.50 11.00

137.00

Solomon has earned more than the guaranteed daily minimum wage, so he will make $137.00

Activity 6

Sarah Kowalski carves wooden animals for a small company supplying the tourist market. In
week 26, her production was as follows:

Product Standard time allowed/unit Units produced

Deer 2 hours 6

Mink 1.5 hours 5

Owls 1 hour 12

Eagles 2 hours 6

She is paid $6 per standard hour of production (irrespective of actual time worked).

Calculate Sarah's earnings for week 26.

*Please use the notes feature in the toolbar to help formulate your answer.

Sarah's week 26 earnings are as follows:

Deer 72 6 × 2 × $6
 Mink 45 5 × 1.5 × $6

Owls 72 12 × 1 × $6

Eagles 72 6 × 2 × $6

Sarah’s earnings for week 26 261

3.1.3 Incentive-based systems

Employees may be paid a bonus if they have reached targets set by their employers. These
can be either individual or group-based schemes.

Employees may be given incentives to produce output more quickly than expected. They are
usually rewarded with extra pay (a bonus). These are also known as bonus schemes and may
be for individuals or teams (groups).

Incentive schemes can be either output- or performance-based remuneration schemes. They

are designed to encourage employees to work harder or more efficiently.

Incentive type Description

payment is a fixed amount for each item (each piece of work) completed,
regardless of how long it takes.

This means that more efficient workers get paid more than inefficient workers.

This method can guarantee the cost per unit for organisations, which helps
Piecework planning accuracy.

a monetary incentive based on the performance of an individual, group, or whole

organisation.

Employees could receive a bonus based on their performance, or all employees

Bonuses might receive a share of a group bonus.

Commissions are paid based on a successful outcome.

Commission They are often used in sales as a percentage of the sales amount.
Profit-sharing
schemes Employees are given a share of the profit made by the organisation in the year.

Advantages Disadvantages

• Help to increase production while controlling costs

per unit, which helps the accuracy of planning
• Incentive schemes are more
• More efficient employees are paid more than expensive to administer
inefficient or less hardworking employees
• Quality control is needed to
• May attract more skilled workers ensure output meets standards.

Example: Types of Remuneration

Some examples of how specific roles at Furniture Co are compensated are as follows:

Role Remuneration scheme

Hourly wage

• Paid based on hours worked.

Factory Worker • Shift is 7 hours.

Operates cloth printing • Hours worked more than 7 hours are paid overtime at a
machine in the factory. “time and a half” of the standard hourly rate.

Pieceworker
Piecework
Embroiders furniture covers in
the factory. • Paid for each piece of work completed to standard.

Job-based
IT project worker
• Paid a fixed amount for the entire project.
Works on a project for the
company. • Timing of payment depends on project deliverables achieved.

Junior worker Fixed salary

 Example: Types of Remuneration

Purchasing for head office. • Paid a fixed monthly salary.

• May work additional hours without additional

compensation.

Fixed salary and commission

Sales manager • Paid a fixed monthly salary

Makes sales. • Also earns a commission based on a percentage (%) of sales

Fixed salary and profit-sharing scheme

• Paid a fixed monthly salary.

• May work additional hours without additional compensation

Senior Manager
• Will receive a share of profit at the end of the year as an
Manages entire division. incentive.

Labour Turnover

Labour turnover is the rate at which employees leave an organisation.

Employees may look for new jobs for various reasons:

• Offered a higher salary elsewhere

• Non-conducive work environment or inflexible working hours.

• Seeking a better social environment.

• looking for a new challenge or career advancement.

• Seeking a more secure position during a challenging economic period.

• Retirement or extended leave.

Example

Some reasons why employees leave their organisations are discussed below:
Example

Character Description

Desmond

Gaining a qualification

I’ve been working as a waiter while studying

for a marketing qualification outside work.
I’ve now finished my studies and want to use
this qualification, so I’m currently looking for
a marketing and Public Relations (PR) job.

Karishma

A new work atmosphere

I’ve been with my company for a couple of

years now, but I don’t feel like my colleagues,
and I work as well together as we’d like. So I
want to find a team which suits the way I
work.
 Example

Hanna

Career change

I’ve been a financial consultant for over ten

years, but I’d like to try something different.
I’m considering starting my own business or
working in a new industry.

The Costs of Labour Turnover

Labour turnover creates costs for an organisation. The costs of labour turnover can be
analysed as follows:

• Preventative costs: the costs involved in preventing employees from leaving an

organisation

o Giving them more attractive benefits, such as improved bonus schemes or

perks like insurance

o Offering flexible working hours and structures

o Employee development programmes, such as training, to help with their

career progression

o Increasing salaries

o Improving the working environment; this could be anything from

redecorating and hiring additional staff who fit the company and team ethos
to buying new computers.
 • Replacement costs: the costs involved in replacing those employees who have left an
organisation.

Preventative costs Replacement costs

• Loss of output due to the time gap

between an old employee leaving and a
new employee starting

• Cost of recruitment (advertising,

recruitment agency fees)

• Cost of benefits and incentive schemes • Costs of training (training courses and
existing staff providing instruction)
• Cost of development training to encourage
employees to progress in their careers at • Lower production volumes while new
the organisation employee learns how to do the job

Activity 7

Classify the measures as preventive or replacement costs.

Preventive or
Measure Replacement

Pay competitive salaries and research to work out what figures are competitive

Cost of training new staff

Provide employee benefits, for example, gym membership, staff discounts

Offer employees training and development programmes

Cost of advertising for new staff

Cost of recruiting temporary staff to cover work when a position becomes vacant and
before new staff is appointed.
 Cost of working hours lost while interviewing job applicants

Offer bonuses for increased productivity

*Please use the notes feature in the toolbar to help formulate your answer.

Preventive or
Measure Replacement

Pay competitive salaries and research to work out what figures are competitive Preventive

Cost of training new staff Replacement

Provide employee benefits, for example, gym membership, staff discounts Preventive

Offer employees training and development programmes Preventive

Cost of advertising for new staff Replacement

Cost of recruiting temporary staff to cover work when a position becomes vacant
and before new staff is appointed Replacement

Cost of working hours lost while interviewing job applicants Replacement

Offer bonuses for increased productivity Preventive

Labour Turnover Rate

Organisations measure labour turnover and compare it to a base rate. This is so that the
company can understand if its turnover rate is unusual or in line with expected rates.

The labour turnover rate measures the number of employees replaced in a period and
expresses this as a percentage of the total labour force.

The formula is:

The average number of employees = (Opening employees + Closing employees) ÷ 2

Replacements in this formula refer to employees leaving and being replaced.

For example, if 250 employees resigned in a year and the decision was made to hire another
200, the number of replacements would be 200.

Example

Magazine Co made a series of redundancies after a decrease in its business’ profits. It had 25,000
employees at the beginning of 20X4 and 19,000 employees at the end of 20X4. As well as the
redundancies, 2,000 employees resigned in the year and were replaced by new employees.

What is the labour turnover rate in 20X4 to the nearest whole per cent?

Answer:

Average number of employees = (25,000 + 19,000)/2 = 22,000

Number of replacements = 2,000

Using the formula:

= 2,000/22,000 × 100% = 9% (to the nearest whole per cent)

Activity 8

1. Furniture Co had 300 employees at the beginning of 20X0. At the end of 20X0, there
were 500 employees.

45 employees resigned in the year and were immediately replaced. An additional 200
employees were recruited for new jobs during the year.

What is the labour turnover rate?

1. Oogie Co had 15,000 employees at the beginning of 20X0 and 11,000 employees at
the end of 20X0, following a downturn in its business. In addition to the
redundancies, 1,500 employees resigned in the year and were replaced immediately
by new employees.
What is the labour turnover rate?

Answer in % to the nearest two decimal places

*Please use the notes feature in the toolbar to help formulate your answer.

1. 45 / ([300 + 500] / 2) = 11.25%

2. 1,500 / ([15,000 + 11,000] / 2) = 11.54%

Labour ratios

There are several ratios that organisations use to measure the performance of their
employees.

Exam advice

These formulae must be memorised as they will not be provided in the MA exam.

5.1.1 Efficiency Ratio

The efficiency ratio measures whether the production output took more or less direct labour
time than expected.

A ratio of > 100% indicates greater labour efficiency than budgeted.

A ratio of < 100% indicates poorer labour efficiency than budgeted.

5.1.2 Capacity Utilisation Ratio

The capacity utilisation ratio measures whether the total direct labour hours worked were
greater or less than budgeted.

A ratio > 100% indicates more labour hours were worked than budgeted.

A ratio of < 100% indicates fewer labour hours were worked than budgeted.

5.1.3 Production Volume Ratio

The production volume ratio measures how the actual production output for a period (in
direct labour hours) compares with the budgeted output.
A ratio > 100% indicates higher than budgeted performance.

A ratio of < 100% indicates a lower-than-budgeted performance.

5.1.4 Relationship Between Labour Ratios

The relationship between the ratios is:

Efficiency ratio × capacity utilisation ratio = production volume ratio

Key Point

The labour ratios are based on direct labour hours.

Example

A company has 2,000 hours available (budgeted) to make 20,000 units of a product in March.

The company produced 18,000 units which took the workforce 1,750 hours.

Calculate the efficiency, capacity, and production volume ratios for March.

Answer:

Hours available = hours budgeted = 2,000

Each unit is expected to take 2,000/20,000 = 0.1 hours

Actual output = 18,000

Actual output is expected to take 18,000 × 0.1 = 1,800 hours

Actual hours taken to make actual output = 1,750

1. Efficiency ratio

Each unit is expected to take 2,000/20,000 = 0.1 hours

Actual output = 18,000

Actual output is expected to take 18,000 × 0.1 = 1,800 hours

Actual hours taken to make actual output = 1,750

 Example

Efficiency ratio = 1,800/1,750 × 100% = 102.86% (to 2 decimal places)

2. Capacity ratio

Hours available = hours budgeted = 2,000

Actual hours taken to make actual output = 1,750

Capacity ratio = 1,750/2,000 × 100% = 87.50%(to 2 decimal places)

3. Production volume ratio

Each unit is expected to take 2,000/20,000 = 0.1 hours

Actual output = 18,000

Actual output is expected to take 18,000 × 0.1 = 1,800 hours

Hours available = hours budgeted = 2,000

Production volume ratio = 1,800/2,000 × 100% = 90%

Activity 9

Brownie Co budgeted to make 100 units of output in June. Each unit was expected to take 3
hours of direct labour.

The actual production volume in June was 110 units, which took 350 hours of direct labour.

For June,

1. What is the labour efficiency ratio for Brownie Co?

2. What is the capacity utilisation ratio for Brownie Co?

3. What is the production volume ratio for Brownie Co?

 4. Show the relationship between the ratios.

*Please use the notes feature in the toolbar to help formulate your answer.

1. Efficiency ratio = ((110 × 3) / 350) × 100% = 94.29%

2. Capacity utilisation ratio = (350 / 300) × 100% = 116.67%

3. Production volume ratio = (110 × 3) / 300 × 100% = 110%

4. Efficiency ratio × Capacity utilisation ratio = Production volume ratio

94.29% × 116.67% = 110.00%

Activity 10

A company budgeted to make 800 units of output in December. Each unit was expected to
take 1 hour and 30 minutes of direct labour.

The actual production volume in December was 760 units, which took 950 hours of direct
labour.

For December,

1. What is the labour efficiency ratio?

2. What is the capacity utilisation ratio?

3. What is the production volume ratio?

4. Show the relationship between the above ratios.

*Please use the notes feature in the toolbar to help formulate your answer.

1. Efficiency ratio = (760 × 1.5) / 950 × 100% = 120%

2. Capacity utilisation ratio = 950 / (800 × 1.5) × 100% = 79.17%

3. Production volume ratio = (760 × 1.5) / (800 × 1.5) × 100% = 95%

4. Efficiency ratio × Capacity utilisation ratio = Production volume ratio

= 120% × 79.17% = 95%