Direct Labor – Is It Fixed or Variable?

Mar 28, 2014

For many of my clients, this question is almost laughable. They have considered direct labor a variable cost for so long to think of it in any other terms would be outside the realm of reality. But in today’s ever increasing mechanized manufacturing environment, the question of whether or not labor should be accounted for as fixed or variable is being asked more often.

I was having lunch with the CFO of one of my clients recently and he was struggling with this very issue in his organization. His question, however, was the reverse of what you might think. His manufacturing environment was highly machine controlled and for years his entire manufacturing team had considered direct labor as fixed overhead and part of the machine cost. The problem that he was facing was the entrenched thought process in considering labor a fixed cost, and therefore, not available for modification as volumes changed. Above this, his primary concern was that short-term fluctuations in volume should be met with short-term fluctuations in cost where possible. The CFOs goal of course was to have good management. Rather than considering labor fixed, he recognized that some portion of his crew was talented and experienced in their operations and was not readily replaced by other inexperienced, untrained individuals. However, a portion of the fixed labor crew truly was relatively untrained and could more easily be replaced if necessary after a downturn in volume.

The real challenge was to convince his management team that such fluctuation in crew size makes sense in an environment where virtually all of the costs are related to machinery and all production was in a machine controlled environment.

His thought process did call to mind other components of his operation, which could be available for modification in times of decreased volumes. As volumes fall off, a good cost manager will attempt to match the lower volumes with decreased costs where possible.

In many cases, truly fixed costs are unavailable to be modified by temporary changes in volume. However, it’s worthwhile thinking through the process of those costs that might be available and assuring that changes in volume are met with changes in expenses.

Years ago one of my largest manufacturing clients experienced substantial reductions in volume as their industry protracted in the early stages of the recession. However in this case, the cost manager was able to significantly reduce manufacturing costs and in fact used the volume variance calculation to help guide cost cutting initiatives by providing a guide post about how many dollars in cost need to be removed. At the end of that year, there was a very large negative volume variance which was almost completely offset by a very large positive spending variance.

The ability to manage a cost in spite of their nature in times of fluctuating volumes is one of the hallmarks of a good cost manager.

Categories: Cost Accounting