Indirect Labor Costs

Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on April 29, 2023

Indirect labor cost is the portion of an employee’s salary or wage that is attributable to indirect manufacturing costs.

This includes all of the overhead costs of employment, such as social security, fringe benefits, and workman’s compensation insurance.

It also includes the time spent by employees on activities that are related to manufacturing but do not directly produce a finished product.

For example, indirect labor costs may include time spent on quality control inspections and time spent cleaning machines.

Why Do We Need to Know About It?

We should look at the total cost of employment when making decisions about how many employees are needed for production.

For example, consider an employee who works three jobs: One producing a finished product, one performing quality control inspections, and the third cleaning machines.

If this employee worked on all three jobs for eight hours a day, then she would be spending 24 hours per week on indirect labor activities.

The more production is increased, the greater the amount of time that must be spent on these activities.

This can lead to increased costs in the form of higher employee wages or salaries, greater numbers of employees, or lower productivity.

The final product becomes less competitive because it may cost more to produce than the price being offered for sale.

The Different Types of Indirect Labor Costs

There are two main types of indirect labor costs: fixed and variable.

Fixed Indirect Labor Costs

Fixed indirect labor costs are expenses that remain unchanged even when production increases or decreases.

A company’s office rent, utilities, and property taxes are examples of fixed indirect labor costs because they do not fluctuate when the number of employees working in a factory changes.

Other examples include insurance, depreciation on equipment, and administrative salaries.

This type of indirect cost is typically between 20% and 30% of total direct labor costs.

Variable Indirect Labor Costs

Variable indirect labor costs are expenses that can be directly attributed to the number of employees in a factory.

The cost of raw materials, quality control inspections, utility usage, and workman’s compensation insurance are examples of variable indirect labor costs because they increase as the number of employees working in a factory increases.

Other examples include packaging materials and freight costs on raw materials.

This type of indirect cost is typically between 80% and 20% of total direct labor costs.

How Can We Calculate the Indirect Labor Cost?

Typically, three figures are needed to compute an indirect labor cost:

  • The total direct labor cost paid out to those employees who work directly on the production of a product or service
  • The total number of hours that are spent by all employees on indirect labor activities, including performing quality control inspections, cleaning machines, and inspecting finished products for defects
  • A predetermined indirect labor rate based on the percentage of an employee’s salary or wage that is attributable to indirect labor activities

For example, if a company pays out $500,000 indirect labor costs per month and the number of hours spent by employees on indirect labor activities equals 5,000 hours per month, then the total monthly indirect labor cost would equal 20% ($100,000) of the total direct labor cost ($500,000).

The Formula on Calculating for Indirect Labor Cost

Indirect Labor Cost Formula

How Can We Use This Information in Our Business?

The first step is to compute an indirect labor rate based on a percentage of direct labor costs.

The company’s accountant should be able to provide the necessary figures.

Once the indirect labor rate has been calculated, it can then be applied to any increase or decrease in direct labor costs necessary for calculating the indirect labor cost.

This will allow a company to more readily identify how much it should budget for indirect labor costs.

The Importance of Knowing About Indirect Labor Costs and Why They Are Important for Our Business

This knowledge is important because it allows us to accurately predict our future expenses.

The company can more readily estimate how much it should budget for these costs, helping to avoid a situation where indirect labor costs are higher than expected and the business suffers as a result.

A good first step is for a company to calculate its own indirect labor cost.

This can be done by simply increasing direct labor hours by 10% and then determining the indirect labor cost by multiplying the number of hours worked by the indirect labor rate.

By doing this, a company will be able to see where price reductions can take place while still achieving desired margins.

Steps for Reducing the Cost of Indirect Labor

    1. Decrease or eliminate waste in production and supply chain processes. This means adopting lean practices such as utilizing single-piece flow, implementing Kanban pull systems, and minimizing the amount of work in progress.
    2. Utilize lean accounting principles such as activity-based costing to identify under or overvalued assets
    3. Use lean six sigma tools such as statistical process control (SPC) to ensure quality processes are in place
    4. Train employees on lean principles and techniques
    5. Communicate the business case for lean-to management and employees
    6. Measure and track cost savings and continuous improvement efforts
    7. Benchmark performance against other like organizations
    8. Consider outsourcing activities that do not add value to your business or customers

Key Takeaways

Indirect labor cost is the sum of all salaries or wages attributed to employees who perform work that is directly related to producing a product or service. Indirect labor cost is also known as factory burden.

Indirect Labor Costs FAQs

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.