The difference between direct labor and indirect labor is that only labor involved in the hands-on production of goods and services is considered to be direct labor. All other labor is, by default, classified as indirect labor. This distinction is important from an accounting perspective, since the two types of labor are treated differently. The accounting is as follows:
- Direct labor: This cost is charged to all units produced during the reporting period. The basis for charging the cost is the number of hours of labor actually used in the production process.
- Indirect labor (factory): This cost is assigned to a cost pool, from which it is allocated to the units produced during the reporting period. Depending on the level of allocation sophistication, several cost pools may be used, each of which has a separate allocation methodology. For example, a cost pool for real estate costs could accumulate factory rent, and then be allocated out based on the amount of square footage used. Meanwhile, another cost pool for maintenance costs could accumulate maintenance labor and equipment costs, and be allocated based on machine hours used.
- Indirect labor (administrative): This cost is charged to expense in the period incurred. It never appears in the balance sheet as an asset.
The only type of labor that should be included in the direct labor classification is for those employees directly involved in the manufacturing process, such as people working on an assembly line or operating machinery. It does not include any support or supervisory staff, such as the factory janitorial, maintenance, administrative, and management employees.
Direct labor should vary in concert with the amount and types of units produced, since this type of labor is considered to be entirely variable. Indirect labor is much less likely to change with production volume, since it represents the overhead of a business that is needed to support any level of operations.