# Use Utilization Ratios To Determine Direct And Indirect Labor Costs

## What is the 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 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. The direct labor utilization ratio indicates how much a company is spending each year on direct labor.

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

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

## How to Calculate Direct Labor Utilization Ratio

The calculation needed for the direct labor utilization ratio includes dividing the total payroll amount associated with direct labor by the total cost of payroll for that specific period, giving the direct utilization ratio. For example, suppose your company is spending \$4,000 on the payroll for a specific pay period and pays an additional \$3,000 in direct labor expenses. In that case, the utilization ratio for direct labor is 75%. (3,000/4,000 = 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 fewer 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, they 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 =1,720 hours.

Hence, the 1,720 hours are our total hours spent by one employee as indirect labor utilization.

## Conclusion

Utilization ratios are vital when calculating labor costs. Most business accountants know how to use these ratios to manage the cost of labor for a business, so hiring a professional business accountant is the ideal way to handle these calculations.

However, if you don’t have the budget to hire a professional accountant, understanding utilization ratios and calculating labor costs will be vital to your business accounting plan.

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