Prepping Your Small Business's Direct Labor Cost Budget

Preparing a direct labor cost budget is essential for small business owners that want to stay on top of their company's finances. Learn about how to calculate a direct labor cost budget, how to sync this with a production budget, as well as what to keep in mind when doing so.

When operating a business, it's vital that employers stay on top of how much their employee labor hours impact their overall business profits.

However, when labor budget and production budgets aren't calculated properly, business owners risk not meeting their own quotas. Therefore, small business owners need to learn about the importance of having a direct labor budget, as well as how they can calculate this on their own.

Reviewing the Basics

A direct labor budget is used to help business owners anticipate the number of employees needed to staff their production lines throughout each fiscal budget period.

In other words, having a direct labor budget can help small business owners understand their future hiring needs, as well as when they might need to book overtime hours, and when they might need to start thinking about layoffs.

What is a Direct Labor Budget?

Typically presented in either a monthly or quarterly format, a direct labor budget is used to calculate the approximate number of employee labor hours needed to produce the number of units itemized in a business' production budget.

Although some direct labor budgets are simple, others can be more complex and will calculate not only the total number of labor hours required, but they'll go one step further, breaking this information down by labor type.

Example of a Direct Labor Budget

As an example, imagine that CompanyAAA has a plan to mass-produce 100,000 plastic toys during a fiscal period. Each toy is roughly the same size, therefore, the amount of manufacturing labor for each one is going to be more or less identical.

In this example, the amount of labor required for each toy might be 0.5 hours per toy for machine operators, and about 1 hour per toy for all other associated labor. This gives a total of 1.5 hours of labor required to produce each toy.

However, since the labor rates between machine operators and other staff are considerably different, they should each be recorded in the direct labor budget separately.

Potential Issues

When there are multiple labor rates and classifications, business owners may find it too tedious and time-consuming to create an in-depth budget, covering all labor categories.

In this case, it also becomes difficult to properly match the estimated pay levels to the employer's real-world staffing needs.

In other words, having multiple labor categories often results in discrepancies between the budgeted labor cost and what the employers actually end up paying.

Another potential issue is that a company's direct labor may have a fixed cost, set within a much broader range of production volumes.

In this situation, creating a direct labor budget based on current production costs won't necessarily provide accurate information. Instead, it may be more useful to calculate a direct labor budget based on past numbers. And then, adjust the budget as necessary to accommodate any future changes to labor rates.

Calculating a Direct Labor Cost Budget

To properly calculate a direct labor budget, employers will need to use some of the data set out in their production budget.

The simplest way to calculate a direct labor budget is to use the number of units of production (as per the production budget) and to multiply this figure by the estimated number of labor hours required to produce each unit.

This figure will yield the subtotal of direct labor hours needed to meet the targeted production volume. Then, multiply the subtotal of direct labor hours by the direct labor cost per hour, which will yield the total cost of direct labor.

Steps To Calculate Direct Labor Costs

1. To begin, start by finding the average wage of production. For this, add together all wages per hour and divide this number by the total number of employees. This will yield the average production wage.

2. Next, find the total of labor hours needed for manufacturing each production unit, which must include any and all departments that process said unit. Keep in mind that this calculation needs to give you the total hours needed for a single unit.

3. Then, multiply the average production cost per hour by the total number of hours required to produce each unit. For example, if it takes 0.50 hours to produce one unit, and the average wage is $10/hour, these numbers should be multiplied, which will yield a direct labor cost of $5 per unit.

4. Next, multiply the direct labor cost per unit by the total target number of units of production. So, for example, if a company foresees producing 100,000 units this period, and the cost per unit is $5, the total direct labor cost would be $500,000.

5. Finally, employers can go one step further and determine the total direct labor costs per month. To do this, simply estimate the number of units that are expected to be produced per month, and multiply this figure by the direct labor cost per unit.

Syncing Direct Labor Budgets with Production Budgets

A production budget is used to estimate the total number of units that a company plans to produce over a given period of time. On the other hand, a direct labor budget requires information from the production budget in order to properly estimate the total direct labor costs of production.

Estimating Production Needs
A production budget is used to estimate how many units will be needed in order for a company to meet its projected sales quota. Typically, this is based on previous sales, the anticipated demand from customers, and production capacity.

To calculate production needs, simply add the projected sales total to the desired ending inventory. Then, subtract the actual beginning inventory, which will yield the number of units needed to attain the desired sales quota.

Calculating Average Labor Costs
To calculate the average hourly direct labor costs, simply add together all employee hourly rates, and divide by the total number of employees.

So, for example, if three employees on the production line are paid $10, $15, and $20 per hour respectively, these numbers are added together to get $45. This number is then divided by three employees, which gives an average hourly labor cost of $15 per hour.

However, if it takes a total of 0.2 hours to produce each unit, this figure would be multiplied by $15/hour, which would give you a labor cost of $3 per unit.

Estimating Labor Costs
In order to properly estimate direct labor costs, multiply the estimated production quota by the average direct hourly labor cost.

So, if a business needs to produce 1,000 units, and the direct labor cost is $3 per unit, the total estimated labor cost would be $3,000 for that given period.

Other Production Factors to Keep in Mind

It's important to keep in mind that a business's actual sales will directly affect its production target, as well as their estimated direct labor costs. This is because the number of employees needed is based on these figures.

Therefore, if a company sells more units than expected, it will decrease the ending inventory. In other words, the company will no longer have the required number of units on hand to meet its estimated production needs.

In this case, and in order the meet the estimated sales/production quota, the company would need to start producing more units, which will, in turn, incur a higher direct labor cost.