Financial Management & Cost Accounting

Module 8. Costing

Lesson 48
LABOUR COST AND OVERHEADS

48.1 Introduction

Overheads represent spending on resources or services which benefit all or some units of products and services and therefore those cost must be assigned to cost units. Methods for assigning overheads to cost units require analysis of different factors operating in a particular situation.

Scope and objectives of overheads

Overhead is the total of indirect material, indirect labour, indirect expenses. Thus, It is any cost which not directly attribute to a cost unit. The term ‘indirect’ means which cannot be allocated, but they are absorbed by the cost centre. Overhead is a distinct element of cost, and needs different treatment in accounting and control compared to direct cost element.

48.2 Classification of Overheads

All overheads can be classified element wise into indirect material, indirect labour, and indirect expenses. As well as by nature of expense e.g. consumable stores, repair-parts, salaries, maintenance, depreciation etc. Classification of overhead with relation to its function can be classified into:

1. Factory overhead

It can also be termed as Manufacturing or production overhead. It is the total indirect costs associated with production activities; it begins with the purchase of material and ends with primary packing of product.

2. Administrative overhead

It can also be termed as Office overhead. It is the total cost of formulating the policy, it handles with the activities that are not directly associated with the production, selling, distribution, research or development activity or function. Examples of such overhead are office supplies, printing, stationary, salaries to office staff etc.

3. Selling overheads

This refers to those expenses which are associated with marketing and selling activities. For examples: Salaries and commission of salesmen, selling agents etc.

4. Distribution overhead

These are the total indirect costs associated with finished goods. It begins with primary packed product available for dispatch and ends with making reconditioned returnable empty container (If any available for reuse).

Classification of overheads can also be done as follows:

1. Fixed overhead

2. Variable overhead

3. Semi fixed overhead

Fixed overhead

These are the type of overhead that tend to remain unaffected by the volume of production or sale within a defined period of time, e.g. rent, rates, insurance, audit fees, etc. Fixed overhead changes with change in price level.

Variable overhead

These are the overhead that tend to change with the change in production volume. There is a linear relationship between the variable overhead and output. E.g. Indirect material. Indirect labour, power and fuel, lighting and heating expenses, salesmen commission etc.

Semi fixed overhead

They are also termed as semi variable overhead. These are certain expenses that neither remains fixed for all levels of activity nor vary in sympathy with the change in output. E.g. repairs and maintenance expenses remain fixed, if production does not fluctuate widely. But if production increases beyond the relevant range, additional expenditure on maintenance may be necessary, which may not vary directly with production

48.3 Labour Costs

Following are the main characteristics of labour costs

a) Labour cost is a significant element of cost especially in an organization using more manual operations. It is the cost of human endeavour in the product and requires coordinated efforts for its control.

b) The management objective of keeping labour cost as low as possible is achieved by paying higher wages to limited satisfied workmen with high productivity. Low wages do not necessarily mean low labour cost.

c) In recent labour agreements, it has been found that substantial increase in wages has been granted corresponding increase in productivity; thereby reducing labour cost per unit. The gain is reflected both in labour cost as well as in overhead expense per unit, since overheads are distributed over larger volume.

d) The productivity of labour is quite flexible. Given the right type of motivation and incentive, it can reach an amazing scale. It does not have any limitation like machines.

e) Lastly, in India, under existing regulations, wages may be considered as fixed cost or committed cost rather than discretionary cost. Once hired, it becomes very difficult to remove a worker, and therefore, efforts should be made to make best use by imparting proper training, giving better tools & providing favourable working conditions. With this in mind, the management has to design methods of controlling labour cost.

In large organizations, the following departments affect the control of labour cost:

1. Personnel Department: This department is responsible for manpower planning, recruitment, training, maintaining records of staff and workmen and reporting to chief inspector of factories and to top management on performance, overtime, absenteeism, leave, etc.

2. Industrial Engineering Department: This department prepares plans and specifications of each job, supervises production activities, undertakes time and motion studies, perform job analysis, etc.

3. Time-Office: This department is primarily responsible for collection of data relating to attendance, time spent on jobs or process by workmen, and providing information on attendance and leave to payroll department.

4. Payroll Department: This department is responsible for computing total and net earnings of each worker, preparation of payroll and maintenance of various records relating to payroll.

5. Cost Department: This department collects and classifies all cost data relating to labour utilization by departments, and allocates them to respective job or process as per available documents.

48.4 Direct and Indirect Labour Costs

Labour costs may be classified into direct and indirect labour costs. Direct labour refers to the time spent in altering the condition, construction, composition, conformation or condition of the products manufactured. Thus, the time spent by worker identifiable with a particular job or process or operation is a direct labour and is considered directly variable with the output.

All other labour hours spent for running of the factory in general, and cannot be directly identified with a job or process or operation are identified as indirect labour. Examples of indirect labour are salaries and wages paid to inspectors, supervisors, maintenance staff, assistants in purchase, stores and offices, security staff, etc.

Again, workers of the production department are engaged in productive job or processes are known as direct workers. Labour hours of direct workers which cannot be identified with a job or process, such as idle time, waiting time, etc shall be treated as indirect labour.

Same treatment is made when direct labourers assist maintenance staff in machine repairs. Strictly speaking, the distinction between direct and indirect labour depends on the nature of work – practicability and expediency. The distinction is important because while direct labour is charged to product cost, indirect labour is treated as a part of overhead expenses. Direct labour being variable can be easily controlled. But indirect labour cost has to be controlled by preparing the budget for each department and comparing actuals against budget periodically.

48.5 Manpower Planning, Recruitment and Training

Personnel department initiates action for recruitment after obtaining authorization from proper authority. The department looks for the correct candidate from within the organization, failing which releases advertisement in the paper or contacts agency or employment exchange. After screening, candidates are normally put to test and interview in one or two rounds. Appointment letter is issued to the successful candidates specifying the position, grade, job description and other usual terms and conditions of service.

Time booking

Time booking refers to actual utilization of time in the concerned department, job or process or operation.

The following documents are generally maintained for the purpose:

1. Job Card or Job Ticket: A job card or job ticket is used to record the time spent on each job, having a specified work order or job order number.

2. Daily Time Sheet: Daily time sheets are used where card time recorders are not used.

3. Weekly Time Sheet: Weekly time sheets are similar to daily time sheets with the difference that the worker records all jobs undertaken during the week.

4. Reconciliation Of Attendance Hour With Time Booked: Time recorded at the gate or at the department as evidence by clock card or attendance register must reconcile with the hours spent in the department in job or process or operation along with idle or wasted time.

If clock card shows more hours as compared to total time booked on various jobs or products or operations, the difference is reported as idle time.

48.6 Remuneration Methods and Incentive Schemes

Remuneration is the reward for labour and service while incentives are stimulation for extra effort to perform more efficiently by way of monetary and/or non-monetary inducements.

Remuneration System

Wages are paid either on time basis or on output basis. When employees are paid as per hours worked irrespective of quantum of output produced, the system is called time rate. When payment is made on the basis of production or output only, it is called a piece rate. A combination of time rate and piece rate is also used.

1. Time Rate At Ordinary Level

Under this method, payment is made on the basis of time worked irrespective of the output. However, such payments must be in conformity with the existing legislation including Minimum Wages Act.

2. Time Rate At High Wages Level

This method is similar to the earlier one, with the difference that time rates are fixed at a higher level compared to rates prevailing in the industry in the neighbouring areas. Overtime is normally not paid.

3. Graduated Time Rate

Under this method, time rate consists of two elements such as basic rate which is fixed with the nature of the job and the variable element like dearness allowance, which depends on the local cost of living index and merit awards for personal qualities of the employee.

4. Straight Piece Rate

Under this system, payment is made on the basis of a fixed amount per unit of output irrespective of time taken. Worker’s earnings equals to the number of units produced multiplied by rate per unit. Piece rate may be fixed on the basis of standard time required to produce one unit. The rate is expressed per standard hour.

5. Piece Rate With Guaranteed Daily Rate

Under this system, daily or hourly rate is guaranteed to those workmen who cannot achieve the piece rate norm, and whose earning remains below minimum wages level prescribed by the Payment of Minimum Wages Act.

6. Differential Piece Rate

F.W. Taylor, the father of scientific management introduced differential piece rates in terms of money – a lower piece rate for those who failed to achieve the standard and a higher piece rate for those who achieved or excelled the performance standard.

Workers were paid as per rates applicable to their output. The difference between the lower and higher piece rates were kept so wide, that an efficient worker was amply rewarded, while a slow worker was punished. There was no guaranteed minimum wages.

Non- Monetary Incentives

Incentives to the workmen could be given by way of good working environment, facilities for various needs of the employees, free benefits which are not related to job functions, etc.

Non-monetary incentives may be offered in several ways, some of which may be free, while others may be subsidized. A few examples are quoted below:

· Canteen – free or subsidized

· Fair price shop – subsidized

· Medical facilities for employees and their families

· Education & training facilities – to the employee and his children

· Recreation club

· Housing facility

· Other welfare facilities like holding sports, annual day, long service awards, etc.

· Funds contribution – subsidies to sick and benevolent funds

Idle Time and Overtime

Idle time refers to that portion of hours paid which are not utilized for productive purposes. Idle time can be classified under normal and abnormal idle time.

Idle time can be controlled by adoption of the following measures:

1. Preparation and analysis of labour utilization report with breakdown of idle time

2. Minimizing machine breakdown by adopting preventive maintenance

3. Proper material and production planning, and follow-up system

4. Timely purchase of materials and components

Accounting of Idle Time

Normal idle time of all workers should be collected under standing order number and charged to factory overheads. However, some of the normal idle time of direct workers which are associated with the job or the work order, such as time taken for machine setting, change-over or tool setting, can be added to the product cost as direct wages by inflating the hourly rate of wages.

Labour Turnover

Labour turnover is defined as the rate of change of labour force in an organization during a specified period.

Measurement of labour turnover should be made department-wise and for skilled and highly skilled labours, separately, instead of a blanket rate.

There are three distinct methods of measuring labour turnover based on separation and replacement of labour. The methods of computing labour turnover are:

1. Separation method labour turnover

2. Replacement method labour turnover

3. Flux method labour turnover

Causes of Labour Turnover

There are various causes of labour turnover and that can be broadly classified into the following three categories:

1. Personal causes

2. Unavoidable causes

3. Avoidable causes

Generally high labour turnover results in increased cost and low productivity due to the following situation:

(a) It disturbs the regular workforce
(b) It increases defectives and spoilage, and may adversely affect machines and equipments for inefficient handling
(c) For new recruits, selection, training and orientation expenses lead to increased costs.