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«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»

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The cost of labour The cost of labour can be considered either over the short term or long term. In the short term, the cost of labour is the total expense incurred in relation to that resource, which may, for direct labour, also be calculated as the cost per unit of production, for either goods or services. The cost of labour is the salary or wage cost paid through the payroll, plus the oncost. The labour oncost consists of the nonsalary or wage costs that follow from the payment of salaries or wages. The most obvious of these are National Insurance contributions and pension contributions made by the business. These oncosts can be expressed as a percentage of salary.

The total employment cost may include other forms of remuneration such as bonuses, profit shares and non-cash remuneration such as share options, expense allowances, business-provided motor vehicles and so on.

A less visible but important element of the cost of labour is the period during which employees are paid but do not work, covering public holidays, annual leave, sick leave etc. A second element of the cost of labour is the time when people are at work but are unproductive, such as when they are on refreshment or toilet breaks, socializing, during equipment downtimes etc. These unproductive times all increase the cost of labour in relation to the volume of production. The actual at-work and productive time is an important calculation in determining the production capacity of the business (see Chapter 9).

The following example shows how the total employment cost may be calculated

for an individual:

–  –  –

The total employment cost per working day for this employee is therefore £174.89 (£39,700/227 days). Assuming that the employee works eight hours per day and the employee is productive for 80% of the time at work, then the cost per hour worked is £27.33 (£174.89/(8 × 80%)).

The employee, taking home £30,000 for a 40-hour week, may consider their cost as £14.42 per hour (£30,000/52/40). This example shows the total employment cost and the effect of the paid but unproductive time on this cost, which almost doubles (what is £14.42 per hour to the employee is £27.33 per hour to the employer).

The cost per unit of production can be expressed either as the (total employment) cost per (productive) hour worked, in this case a labour cost per hour of £27.33, or as a cost per unit of production. If an employee during their productive hours completes four units of a product, the direct labour cost per unit of production is £6.83 (£27.33/4). If a service employee processes five transactions per hour, the direct labour cost per unit of production (a transaction is still a unit of production) is £5.47 (£27.33/5). An employee who is not involved in production but carries out a support role is classified as an indirect labour cost. This is referred to as a business overhead (see Chapter 11).

The calculation of the cost of labour is shown in Table 10.1.

In the longer term, a business may want to take a broader view of the total cost of employment. As Chapter 9 showed in relation to the product development phase of the lifecycle, many costs are incurred before a product/service comes to market. The same is true of employees, who must be recruited and trained before they can be productive. A longer-term approach to the total cost of employment may include these costs as additional costs of employment. In relation to short term and long term, the issue arises as to whether the cost of labour is a fixed or variable cost, following the distinction made in Chapter 8.

Table 10.1 The cost of labour

–  –  –

Accountants have historically considered labour that is consumed in producing goods or services, i.e. direct labour, as a variable cost. This is because it is expressed as a cost per unit of production, which, in total, increases or decreases in line with business activity. However, changing legislation, the influence of trade unions and business HR policies have meant that in the very short term, all labour takes on the appearance of a fixed cost. The consultation process for redundancy takes time, and legislation such as Transfer of Undertakings Protection of Employment (TUPE) secures the employment rights of labour that is transferred between organizations, a fairly common occurrence as a consequence of outsourcing arrangements. Consequently, reflecting the underlying practicality, many businesses now account for direct labour as a fixed cost.

Relevant cost of labour The distinction between fixed and variable costs is not sufficient for the purpose of making decisions about labour in the very short term as, in that short term, labour will still be paid irrespective of whether people are busy or occupied.

Therefore, in the short term, a business bidding for a special order may only take into account the relevant costs. As was seen in Chapter 9, the relevant cost is the cost that will be affected by a particular decision to do (or not to do) something.

As decision-making is not concerned with the past, historical (or sunk) costs are irrelevant. The relevant cost is the future, incremental cash flow that will result from making a particular decision. This may be an additional cash payment or an opportunity cost, i.e. the loss from the opportunity forgone. For example, in the case of full capacity, the relevant cost could be the additional labour costs (e.g.

overtime) that may have to be incurred, or the opportunity cost following from the inability to sell products/services (e.g. both the loss of income from a particular order and the wider potential loss of customer goodwill).

Costs that are the same irrespective of the alternative chosen are irrelevant for the purposes of a particular decision, as there is no financial benefit or loss as a result of either choice. The costs that are relevant may change over time and with changing circumstances. This is particularly so with the cost of labour.

Where there is spare capacity, with surplus labour that will be paid whether a particular decision is taken or not, the labour cost is irrelevant to the decision.

Where there is casual labour or use of overtime and the decision causes the cost to increase (or decrease), the labour cost is relevant. Where labour is scarce and there is full capacity, so that labour has to be diverted from alternative work involving an opportunity cost, the opportunity loss is relevant.

For example, Brown & Co. is a small management consulting firm that has been offered a market research project for a client. The estimated workloads and labour

costs for the project are:

–  –  –

There is at present a shortage of work for partners, but this is a temporary situation.

Managers are fully utilized and if they are used on this project, other clients will have to be turned away, which will involve the loss of revenue of £100 per hour.

Other staff can be hired and fired on a temporary basis. Fixed costs are £100,000 per annum.

The relevant cost of labour to be used when considering this project can be

calculated by considering the future, incremental cash flows:

–  –  –

The relevant cost approach identifies the future, incremental cash flows associated with acceptance of the order. This ignores the cost of partners as there is no future, incremental cash flow. The cost of managers is the opportunity cost – the lost revenue from the work to be turned away. The support staff cost is due to the need to employ more temporary staff. Fixed costs are irrelevant as they are unaffected by this project.

Chapter 9 introduced outsourcing as a business strategy that has been in favour to reduce the cost of labour and increase capacity utilization. The example given for the make versus buy decision in Chapter 9 related to an in-house computer processing service in which the relevant costs are shown in Table 10.2.

Table 10.2 Make versus buy – relevant costs

–  –  –

In the above example, it was implicit that TUPE required the cost of labour to be transferred to the external company, as labour ceased to be a relevant cost under the outsourcing option. However, if the labour were not transferred to the external company but retained in the organization, it could become a relevant cost and the financial calculation of the outsourcing decision may be different, depending on the alternative use of the labour.

The relevant costs for each alternative would then be those shown in Table 10.3.

Note in the example in Table 10.3 that labour is no longer a relevant cost, as it is incurred irrespective of the decision to outsource. In this case it would be more costly to outsource the service unless the underutilized labour could be directed at tasks that generated a contribution of at least £15,000. This example shows how it is important in any calculation of relevant costs to be sure about which costs are avoidable and which costs are unavoidable.

Unfortunately, one of the first business responses to a downturn in profits is to make staff redundant. Although the redundancy payments will be recognized as a cost, there is a substantial social cost, not reflected in the financial reports of a business. The social effects will be borne by the redundant employee, while the financial burden of unemployment benefits may be borne by the taxpayer (see Chapter 5 for a discussion). This short-term concern with reducing labour cost often ignores the potential for cost improvement that can arise from a better understanding of business processes.

Business processes and activity-based costs Activity-based costing (or ABC) was introduced in Chapter 9 in relation to the cost of unused capacity. ABC developed from the work of Cooper and Kaplan (Cooper and Kaplan, 1988; Cooper, 1990; and Cooper and Kaplan, 1992), who argued that many resource demands are not proportional to volume but arise from the diversity and complexity of the product and customer mix. ABC systems estimate the costs of resources used to perform activities for various outputs and directly link the cost of performing activities to the products/services and customers for which those activities are performed.

ABC achieves this through the concept of the cost driver, which is the most significant determinant of the cost of an activity. The cost driver seeks to determine cause-and-effect relationships for costs, and measures the demand for activities by each product or service. ABC is described more fully in Kaplan and Cooper (1998) and is covered in more detail in Chapter 11.


A parallel concern has been with business process re-engineering (BPR), a term

coined by Hammer and Champy (1993) and which they defined as:

the fundamental rethinking and radical design of business processes to achieve dramatic improvements in critical, contemporary measures of performance, such as cost, quality, service, and speed. (p. 32) The recognition by both ABC and BPR is that business processes flow through the organization (i.e. horizontally) and are not confined to hierarchical departments (i.e. vertically). This is not a dissimilar concept to Porter’s value chain (see Chapter 9), where activities do not follow the route of the typical business organization chart. However, accounting reports are typically structured in accordance with the organizational chart, either on a functional basis (marketing, operations, finance etc.) or on a divisionalized basis (by product/service, geographic unit etc., as described in Chapter 2). The lack of cost information in relation to business processes is a limitation of traditional accounting systems.

Two examples, one from manufacturing and one from financial services, help to understand the importance of BPR and ABC as tools that can aid in human resource decision-making.

Example 1: manufacturing Purchasing in a manufacturing business is a process that is not confined to a centralized purchasing department. The process begins with the identification of the need to order raw materials. A requisition may be raised in a production department, is approved and is submitted to a purchasing department that will have an approved list of suppliers and negotiated prices. A purchase order will be created and sent to the supplier. The process continues when the goods are received in the store, signed for and placed in a storage area. The paperwork is sent to the accounting department where the supplier’s delivery note, the purchase order and the goods receipt record are matched to await the supplier invoice. The invoice prices and quantities are checked and a cheque will be issued.

In this example, purchasing is a cross-functional process that affects the personnel in many departments. However, a traditional accounting system arranged around hierarchical departments and line items (e.g. salaries) will not recognize the total cost of the purchasing process. Building on the principles of BPR, an ABC accounting system will collect and report the total process cost. This can lead to improved management decisions.

In the motor vehicle industry, an understanding of cost drivers has led to the recognition that the number of suppliers and the number of parts had to be rationalized. It has also led to the adoption of designs that more frequently use common parts between different models (a recognition of the importance of the product design phase, see Chapter 9). This is a more sophisticated method of driving down purchasing costs than the conventional approach of reducing the personnel headcount while leaving business processes unchanged, resulting in an increased workload for the remaining personnel.


Example 2: financial services Serving customers in a bank involves many different personnel in many different departments. A customer service employee may open an account and arrange cheque books and bank cards. The teller will process deposits. A loans officer will take the details of loan applications. These are ‘front office’ or customer-facing personnel. In the ‘back office’, cheques will be processed by data-entry operators, the production of cheque books and bank cards will take place, customer funds will be invested, statements printed and so on.

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