To avoid misstating quantities on a balance sheet or income statement, it is necessary to have a thorough understanding of generally accepted accounting standards. Direct labor is an important component of inventory accounting in manufacturing and service businesses. To completely comply with GAAP inventory accounting requirements, it’s critical to understand how to categorize and account for direct labor.
About Direct Labor
Employees who are directly involved in the production of a product or providing a service are referred to as direct labor. Employees on the production line, roofers, and lawn-mowing crews are all examples. All other employees, such as administrative, custodial, and warehouse workers, are classified as indirect labor and are classified as overhead. Both must be absorbed into the cost of the product or service to report the costs of doing business in the same period as the revenue they create, according to GAAP. Direct labor is a prime or direct production cost, along with direct materials, whereas indirect labor is an overhead cost.
Direct Labor Components
The hourly salaries provided to a production or service employee, as well as payroll taxes and expenses that you are accountable for, are all considered direct labor. Social Security, unemployment insurance, Medicare, and worker’s compensation insurance are all included. This also covers any payments you make to an employee’s retirement plan as well as your share of health insurance premiums. You can include employee training and development costs in a pay calculation even if it isn’t needed.
Using Direct Labor in Overhead Allocations
Guidelines for allocating overhead costs using direct labor hours are provided by GAAP. The most popular and simplest method is to divide total overhead costs by direct labor costs. You can break down direct labor by the number of employee hours spent per unit of production or service rendered, or by the number of employees required to execute a task, depending on your business needs. Overhead, which includes indirect labor, follows costs through production in the same way that direct labor does.
Accounting for Direct Labor
Direct labor is critical to the work-in-process, finished goods, and cost-of-goods-sold accounts because it must track costs from the start of production to the point of sale. A debit to the work-in-process inventory account and a credit to wages payable are the first steps in accounting. A debit to the finished products accounts and a credit to work-in-progress, as well as a debit to cost-of-goods-sold and a credit to the finished goods account, complete the process as jobs travel through the production line. The income statement includes the cost of goods sold, while the balance sheet includes the amount of work-in-process and finished goods inventory.
GAAP-Approved Costing Methods
The generally recognized accounting matching principle requires manufacturing and service organizations to incorporate direct and overhead expenses in product and service costs and, when applicable, in inventory valuations. This means absorption costing is the sole GAAP-approved costing method. The purpose is to report items and services using total costs. Although overhead isn’t always straightforward to identify and quantify, it nevertheless remains a substantial component in a total cost accounting computation.
The GAAP Matching Principle
The GAAP matching principle focuses on deferred taxation and revenue recognition as reported on the balance sheet and income statement. It requires production and service-related enterprises to charge production costs and the revenue obtained by the product or service in the same accounting period. Matching incurred expenditure and revenue collected in the same accounting period improves the accuracy of work-in-process and finished goods inventory recorded on the balance sheet and cost-of-goods-sold reported on the income statement. It also boosts the accuracy of income tax reporting.
Characteristics of Absorption Accounting
Absorption costing considers constant and variable industrial expenses like overhead. Fixed expenses are expenses like property taxes, salar,y, and depreciation that are constant, regardless of employee productivity or industrial output. Variable expenses such as utilities and supplies alter as employee productivity or production output changes. GAAP-approved absorption costing methods total and allocate indirect overhead by allocating each unit an equal share of the overall overhead cost. Most organizations accomplish this utilizing a predefined rather than an actual overhead rate.
Types of Absorption Costing
The two basic GAAP-approved costing systems are job-order and process costing. In service-related businesses, custom order manufacturing enterprises, and the construction industry, job-order costing is frequent. Overhead expenses are accumulated and allocated separately for each order, project, or task in work-order costing. Overhead is accumulated and allocated separately for each stage of production in process costing. Manufacturing companies that mass produce things in phases along a production line frequently use process costing. Manufacturers of computers, vehicles, and equipment are examples.
Absorption Costing Process
As soon as products are put into production, absorption costing begins. From work-in-process to finished goods inventory account, per-unit cost allocations follow things through production. Items that are not sold during the current reporting period are added to the completed goods inventory valuation on the balance sheet. The overhead cost allocation is transferred from the finished goods inventory account to the cost of goods sold account at the moment of sale. As required by GAAP, the income statement for the current reporting period reflects the total cost of the item, including overhead.