In a manufacturing company we can find a wide variety of positions and professional profiles (unskilled and skilled): operators, forklift drivers, engineers, quality auditors, HR specialists… However, in this post we will focus on how that positions can be classified from a cost perspective and where they are allocated in the profit and loss statement (P&L).
Basically, the HR department manages three types of labor: Direct labor (DL), Indirect labor (IL), and Staff.
Direct Labor (DL)
Direct labor refers to all employees who work directly in the manufacturing process -e.g., a welding line operator.
Direct labor cost is always a variable cost, so as a general rule, higher level of production will require to hire additional workers in direct labor positions resulting in higher expenses. On the other hand, if a company suffers a decrease of the production and no externalities exist (trade unions, labor market conditions…), it should be able to adjust the headcount to the lower level of production.
Indirect Labor (IL)
It groups the employees that:
- Supervise the manufacturing process (-e.g., production line leader).
- Work in auxiliary departments to the production (-e.g., quality auditor, maintenance technician).
Indirect labor can be both, variable or fixed cost. This depends on its relation with the level of production. Will we need to hire additional workers in a specific position to increase production? If yes, it is a variable indirect labor position, otherwise it is fixed. In my personal experience most of the indirect labor positions are variable.
Staff is always a fixed cost and refers to workers within these two categories:
- Management positions in production or auxiliary departments -e.g., production manager, logistic manager.
- All personnel in administrative departments -e.g., sales, purchasing, HR, finance.
Labor costs in the P&L
|– Cost of good sold|
|= GROSS PROFIT|
|– Variable labor (Direct + Indirect variable)|
|– Variable overhead|
|= CONTRIBUTION MARGIN|
|– Fixed labor (Staff + Indirect fixed)|
|– Fixed overhead|
As you can see, variable labor and fixed labor are allocated before and after contribution margin respectively. It is important to classify all company positions correctly in order to know which costs can be adjusted (and which ones not) to face a change in the level of production. Furthermore, it is a key aspect to ensure the accuracy of budget and forecasts, as the base to calculate variable costs is often the production planning.
|Type of labor||Nature of cost||Example|
|Direct labor (DL)||Variable||Operator|
|Indirect labor (IL)||Variable of fixed||Production line leader, quality auditor|
|Staff||Fixed||Industrial director, IT technician|