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What is Utilization Ratio?

The utilization rate is an important ratio that companies can use to charge their clients. The ratios are used for maximizing the productivity time for employees. It can reflect the effectiveness of billing and the overall productivity of the company. There are two different types of methods used in bookkeeping for calculating indirect and direct labor expenses utilization ratios.

Method One

The first method is used for calculating the total billable hours divided by the number of hours recorded in a particular time period. For example, if the total hours are 60 but the hours billable are 30, then the utilization rate would be 30/60 = 50%. Using this utilization ratio, if the company is willing to cease recording their non-billable time, the ratio will always be equal to 100%.

Method Two

The second method used for calculating labor utilization rate uses the total hours billable divided by a fixed number of hours for each week. An example will help elaborate this formula. If there are 22 billable hours recorded in a predetermined 40 hours per week, then the utilization ratio will be calculated as 22/40 = 55%.

Why are Labor Utilization Ratios Important?

Company leaders rely on utilization ratios to significantly identify how much of the company’s workforce is currently employed and productive. It provides how the current workforce is performing and the required performance from current employees. If the ratio indicates an overproduction, then the company must hire more people to improve and balance productivity based on utilization rates.

Direct Labor Utilization

A company’s payroll is considered the largest organizational expense. Companies want to make sure that their payroll costs are generating sufficient income. Direct labor utilization ratio indicates how much a company is spending each year for direct labor.

The remainder payroll associated costs are considered as indirect labor costs. Examples of indirect labor costs are:

  • Amount spent on training employees
  • Administrative expenses
  • Marketing expenses
  • Paid vacations
  • Taxes

How to Calculate Direct Labor Utilization Ratio

The calculation needed for direct labor utilization ratio includes: dividing the total payroll amount associated with direct labor by the total cost of payroll for that specific period which will give the direct utilization ratio. For example, if your company is spending $4000 on the payroll for a specific pay period and pays an additional $3000 in direct labor expenses, then the utilization ratio for direct labor is 75%. (3000/4000 = 75%)

On average, the direct labor utilization ratio must be around 65%. A value higher than 65% will indicate that the company is utilizing its labor force efficiently. Companies that have less paid vacations and paid training will have a lower utilization cost.

Indirect Labor Utilization

Overhead costs are also called indirect labor costs. Labor overhead costs are directly associated with the different materials used for direct labor. Calculating indirect labor utilization is different and here’s what we need:

  • The number of hours an employee has worked: if the employee worked for 52 weeks per year * 40 hours per week, then he/she worked for almost 2,080 hours.
  • Deduct the total time spent on holidays per year: 45 days or 360 hours (including sick leaves, public holidays, training and seminars) 360 – 2,080 =1720 hours

Hence, the 1720 hours is our total hours spent by one employee as indirect labor utilization.

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About Complete Controller® – America’s Bookkeeping Experts Complete Controller is the Nation’s Leader in virtual accounting, providing services to businesses and households alike. Utilizing Complete Controller’s technology, clients gain access to a cloud-hosted desktop where their entire team and tax accountant may access the QuickBooks file and critical financial documents in an efficient and secure environment. Complete Controller’s team of  US based accounting professionals are certified QuickBooksTMProAdvisor’s providing bookkeeping and controller services including training, full or partial-service bookkeeping, cash-flow management, budgeting and forecasting, vendor and receivables management, process and controls advisement, and customized reporting. Offering flat rate pricing, Complete Controller is the most cost effective expert accounting solution for business, family office, trusts, and households of any size or complexity.

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When defining the price of a product, you need to set it at a point that covers total production costs. Production costs, however, include more than just the cost of raw materials or equipment. Payroll, marketing, and every expense of the company needs to be factored in. Direct costs and indirect costs are a combination of all expenses and resources that are expended by a business in order to run its operations.

The basic difference between direct and indirect costs is based on their relation to the product or service being produced. The costs that have an immediate relation to the product and service’s production are referred to as direct costs, such as direct labor, direct material, etc. While the indirect association is closely related to costs that cannot be directly assigned to the production of a product such as a payroll, cost of employees, depreciation, general expenses, etc. Indirect costs are also known as overhead expenses. The concept may sound simple, but understanding the key differences between direct costs and indirect costs will allow you to correctly allocate them in your accounting ledger.

Direct Costs

Direct costs are the costs that can be easily attributed to a specified cost object which can be a product, service, project or a department.  For example, raw material, manufacturing equipment, software, and direct labor costs. Raw material and direct labor costs are two of the major direct production costs. For instance, making furniture would include the cost of acquiring the wood and labor charges of the carpenter.

The costs of finished raw material are usually also counted as directly incurred costs and they are tracked by FIFO (first in first out) and LIFO (last in first out), which are two of the most popular accounting methods to record availability of the product in stock.

To further understand how direct costs and indirect costs work, you must first gain an idea about fixed and variable costs. As the name suggests, fixed costs remain the same over time while variable costs may alter periodically. Direct production costs are usually variable costs, however, payroll cost is one of the few exceptions that is fixed. Similarly, buying a hardware for a smartphone would be counted as a direct, variable cost because it depends on the number of units to be produced.

Indirect Costs

Indirect costs are associated with all of the expenses that go beyond the production of a product. This is the cost of running the business after all the direct costs are attributed. Everything that is required by a company to run its operations such as indirect labor, rent, utility bills, and supplies are counted as indirect costs. These costs are not specified in the production or single product or service.

Labor costs can also be counted as direct or indirect costs, depending upon the situation. If an HR resource is specifically assigned to the production of a product, the costs are direct. However, the salaries of cleaners and guards are indirect labor costs.

Marketing and advertising are also indirect costs because they do not have any direct relation to the production of a product. Employee benefits and costs of acquiring accounting services are also indirectly related to the production. Indirect cost can also be fixed or variable, depending on how they occur. Rent is a fixed indirect cost, while utility bills are indirect variable costs.

Ambiguity

There are certain costs that lie in the grey area to be counted as a direct or indirect cost. Hiring a consultant, printing, postage, and traveling costs are sometimes the cause for concern because it’s hard to place them in any one category. What companies do is, based on their usage and relevance, place these costs in their respective categories.

An overhead rate by companies is used to preserve liability and to assist in determining the allocation of administration costs between various departments. It is basically a ratio of total indirect costs and related direct costs. Departments that bear the highest ratio are allocated a greater share of the indirect cost.

Significance

The way you allocate costs as direct or indirect has an effect on your tax payments as well. All overhead charges such as your electricity and gas bill to run the equipment and machinery are tax deductible. Therefore, according to IRS rules and regulations, you are supposed to classify all direct and indirect expenses accordingly.

Classifying government grants and funds as direct or indirect costs is highly important as they come with strict policies, which must be adhered to. Failing to do so can have significant consequences for your business at the time of auditing.

Indirect and direct costs are the key to calculating your cost of goods sold and you cannot really set a price of the product unless you exactly figure out the manufacturing cost. Understanding each of them is vital for every business as it helps them to make key strategic decisions.

Check out America's Best Bookkeepers
About Complete Controller® – America’s Bookkeeping Experts Complete Controller is the Nation’s Leader in virtual accounting, providing services to businesses and households alike. Utilizing Complete Controller’s technology, clients gain access to a cloud-hosted desktop where their entire team and tax accountant may access the QuickBooks file and critical financial documents in an efficient and secure environment. Complete Controller’s team of  US based accounting professionals are certified QuickBooksTMProAdvisor’s providing bookkeeping and controller services including training, full or partial-service bookkeeping, cash-flow management, budgeting and forecasting, vendor and receivables management, process and controls advisement, and customized reporting. Offering flat rate pricing, Complete Controller is the most cost effective expert accounting solution for business, family office, trusts, and households of any size or complexity.