HAPTER

ACCOUNTING FOR LABOUR

1. Labour costs
Who makes the “stuff”?
Take a look around you at all that “stuff” we talked about in the previous chapter: the chair,
table, computer, glass in the windows, hinges on the door...

It didn't just come from nowhere; someone (or something) had to take those raw materials
and produce a finished good ready to be used by consumers.

That doesn't come for free, so in this chapter, we'll be looking at how to account for
labour.

What is labour?
Labour is the term used to describe the work of the staff in the business. Typically,
people think of (manual) labour as physical work in factories or in construction, but it
includes everything from writing a textbook to building an F1 car.

Labour is one of the most significant costs for any business and, therefore, calculating
the labour costs is an essential job for any management accountant.

Categories of labour
For the sake of clarity, it helps to separate labour into a number of categories based on
how closely that labour is related to the actual production of goods. Labour costs come in
two main forms:
Chapter 8 Accounting for Labour

Direct labour costs

• Basic pay of direct workers who make the products - for instance, if Worker
W earns £8 an hour producing cups, then that £8 an hour is a direct labour
cost to the company.

Indirect labour costs

• Overheads - including basic pay of any indirect workers who are not involved
in making products directly (e.g. supervisors, factory security guards).

• Bonuses – this could be a payment to a manager based on hitting certain

production targets. This becomes an indirect labour costs to the company.

• Benefits - for example, the cost of a company car or other benefits afforded
to staff.

• Sick pay – this is the obligation to pay workers a certain amount whilst they
are unable to work, thus reducing productivity.

• Idle time-based – this is the cost endured by a company when machines are
faulty, for example, causing productivity to decrease.

• Indirect jobs of direct workers – this might come from the time workers
spend tidying up the factory during their shift. It may be necessary to do so,
but it is not time spent directly on production.

The direct labour costs are included in the prime cost of a product. The indirect
labour costs are included in the overheads.

Overtime
When employees work over their contracted hours, they are paid overtime pay,
which is often at a higher rate than their usual pay. Unless the overtime being
worked is for a specific order by a customer, overtime pay is classed as an indirect
cost.

However, if the overtime is being worked because of a specific contract or job,

then it can be classed as direct labour.

© Astranti 2024 194

Chapter 8 Accounting for Labour

As a rule, any extra pay that a worker receives for non-specific work due to
working overtime or unsociable hours will be classified as an indirect cost.

Labour costs and payroll

Typically, a company will have a payroll department takes the various records of
actual work done by the employees (from time sheets, time cards or job sheets) and
calculates their gross wages from these. From the gross wage figure, the payroll
department will also find the net wage figure after tax and any other deductions.

2. Accounting for labour

Double-entry bookkeeping
Accounting for Labour is done in much the same way as accounting for materials.
However, it differs in its additional entries for tax and national insurance. This is
very important as a company is under an obligation to record and pay the correct
levels of tax.

Example
A company has an employee wage bill of £100,000 for the month. Of this amount,
£20,000 goes to tax and a further £5,000 to national insurance. In addition, £60,000
of the total bill is for employees linked directly to production, with the remaining
£40,000 going to admin staff.

Wages account
Let’s put these into T-accounts then, and start by reminding ourselves of our key rule:
spending from our bank T-account is always a credit, while receiving cash is
always a debit.

The wages paid are paid from the bank account and so is a credit in that account.
The other side of the “double entry” is then registered as a debit to the ”wages”
account. Since £25,000 from of the £100,000 goes to tax and national insurance, we
are left with wages of £75,000.

© Astranti 2024 195

Chapter 8 Accounting for Labour

Wages
£ £
Cash account 75,000

Cash
£ £
Wages 75,000

Tax and NI account

Next, let’s look at Tax and National insurance (NI). Now these aren’t necessarily paid
to the tax authorities immediately, and so we hold the payment over in a creditor
account (a creditor is someone we owe money to).

The wages account records expenses and, as you see above, all new expenses are
debits. There’s another rule for you to learn then: expenses are debits in
expense accounts. No need to worry about why – there is really no why, it’s just a
rule that works as long as you follow it….

With that in mind then, we can record the tax and NI with a debit in the wages
account and a credit in the creditor accounts.

Wages
£ £
Cash account 75,000
Tax 20,000
National Insurance 5,000

Tax Creditor
£ £
Wages 20,000

NI Creditor
£ £
Wages 5,000

© Astranti 2024 196

Chapter 8 Accounting for Labour

Separating costs
As you hopefully realise by now, it’s useful for us to categorise costs into different
groups. In this case, we’re going to split them out into production and administration
costs depending on the department the staff work in.

Production and administration accounts are also expense accounts. Therefore,

we must debit these expense accounts and credit the wages account. Effectively, that
will take those costs out of wages. Notice below that, if we were to balance the
wages account now, there’s nothing left in it as both sides are the same.

Wages
£ £
Cash account 75,000 Production 60,000
Tax account 20,000 Administration 40,000
NI account 5,000

100,000 100,000

Production
£ £
Wages 60,000

Overheads
£ £
Wages 40,000

3. Remuneration methods
In most countries, companies are required to pay a basic minimum wage which is
guaranteed to all employees. Assuming that the final wage is higher than what the
minimum wage would be, the amount that employees are paid can be calculated by
two basic factors:

(1) Time worked, or

(2) Output produced.

© Astranti 2024 197

Chapter 8 Accounting for Labour

Time-based system (time worked)

If an employee is paid by the time worked, it means their wage is calculated on the
basis of the number of hours, days, weeks or months which have been worked.
Overtime is paid if the hours worked go above the basic contracted hours.

The formula to calculate wages in a time-based system is:

Total Hours Basic Overtime Overtime

wages
= ( worked
x
hourly rate )+ ( worked
x
hourly rate )

The drawback to a time-based system is that there is no incentive to increase

productivity as the employee is paid whether they work hard or not! Therefore, a
greater amount of supervision of workers is required.

Piecework-based systems (output produced)

A piecework system pays per unit produced. The formula to calculate wages is:

Total wages = Units produced x Rate of pay per unit

Often, a piecework system is combined with a time-based system to provide an

incentive to workers.

Bonuses
Many businesses will use some form of an incentive scheme to try and increase the
motivation and productivity of its workforce. You may be asked to calculate the
bonus of an employee or group of employees based on specific criteria.

The basic rules for a bonus are:

• It should be closely related to the effort expended by the employees

• It should be agreed with the employee/employer before being

implemented

• It should be simple to understand and calculate

• It must be beneficial to all employees who take part.

© Astranti 2024 198

Chapter 8 Accounting for Labour

Premium bonus plan

A premium bonus plan is calculated by finding the time taken to complete a
task and the time agreed prior to the task being undertaken, and using the
difference between the two to calculate the bonus based on the normal rate of pay.

For example, Julie is paid £100 per day but completes the task of making 100
widgets in three days, even though it was expected to take four days.

Her bonus could be calculated as:

Bonus = 3 days – 4 days x 100 = £50

2
Alternatively, her bonus could be calculated as a ratio of time taken:

Bonus= 3 days x 100 = £70

4 days
Let's hope that Julie agreed to the second scheme!

Time-rate-based incentives
A different way to incentivise staff is to pay a high time-rate based on an analysis of
past performance. This rewards an employee to be more productive over a
shorter period of time.

For example, Julie was paid £100 per day, but it has now been agreed she will be
paid £150 per day on the agreement that she will aim to produce 33 widgets per day
when the allowed production output was only 25 widgets previously.

Group incentives
Sometimes, companies use group incentives where all staff and management and
labour are paid a flat bonus based on the improved performance of the entire
company. Therefore, improved performance and cost savings that leads to an
increase in the profits will result in a bonus for staff.

© Astranti 2024 199

Chapter 8 Accounting for Labour

4. Labour ratios
So far, so good, but we need a way to analyse productivity so that an
organisation knows if its resources are being used to their full capacity. Luckily,
there are a number of standard ratios used to measure this area of production. We
will be looking at some of the key ratios in the following section.

Idle time
Idle time accounts for the time that employees are paid when they are not
working on production. This can be due to machine breakdowns or other delays,
such as maintenance or setups.

The calculation for idle time is:

Idle time = Idle hours x 100

Total hours

So, let's say Tim spent 7 hours of his shift working directly on production, but 1.5
hours were unproductive due to a breakdown.

Idle time = 1.5 x 100

7 + 1.5

Idle time = 17.6%

Turnover
A big problem for an organisation arises when there is a high labour turnover (this
means employees tend to only stay for a short period). The cost of training
employees to work effectively is often significant and, whenever an employee leaves,
the cost is incurred again for their replacement.

Therefore, organisations will carefully analyse labour turnover and make decisions to
try and improve the turnover rate (make staff stay longer).

Labour turnover can be calculated with the following equation:

© Astranti 2024 200

Chapter 8 Accounting for Labour

Labour turnover = No. of leavers who require replacement x 100

Average no. of employees
The factory where Tim works has recently lost 20 employees who need replacing. The
average number of employees is estimated to be around 500.

Labour turnover = 20 x 100 = 4%

500

Efficiency
Labour efficiency is a way of calculating how efficient staff are at getting work
done and can be calculated by the following formula:

Labour efficiency = Standard hours for actual output x 100

Actual hours worked to produce output

Where standard time is the time it should take to complete the actual output.

On the same day that Tim was idle for 1.5 hours due to breakdown, the interruption
caused him to lose focus, and so it took him 8 hours to produce what would usually
be done in 6 hours.

Labour efficiency = 6 x 100

8
Labour efficiency = 75%

Labour capacity ratio

The labour capacity ratio calculates the percentage of actual hours worked on
production against the total budgeted hours. It is a way for the company to see if
manpower is being utilised in the most efficient manner and will show either low
performance in staff, or unrealistic targets in the budget. It can be calculated
using the following formula:

Labour capacity = Actual hours worked to produce output x 100

Budgeted (expected) hours

© Astranti 2024 201

Chapter 8 Accounting for Labour

Although it usually takes 6 hours, Tim was budgeted 7 hours to get his work done.
However, as we know, it ended up taking 8.

Labour capacity = 8 x 100

7

Labour capacity = 114%

Production volume ratio

This final ratio compares the expected hours taken to produce the actual output
with the total budgeted (expected hours). It indicates if the production is making
more products in less time (more efficient) or fewer products in more time (less
efficient). The formula is:

Production volume = Standard hours for actual output x 100

Total budgeted (expected) hours

So, to recap, Tim took 8 hours to produce something that would usually take 6 hours,
and was given 7 hours to do it in.

Production volume = 6 x 100

7

Production volume = 86%

© Astranti 2024 202