Academic journal article Management Accounting Quarterly

Cost Terminology in the 21st Century: Using Direct Labor Cost in a Costs vs. Resources Framework

Academic journal article Management Accounting Quarterly

Cost Terminology in the 21st Century: Using Direct Labor Cost in a Costs vs. Resources Framework

Article excerpt


Activity-based costing measures resources used for an activity by the cost driver . . . The resources supplied to an activity are the expenditures or the amounts spent on the activity . . . The difference between resources supplied and resources used is unused capacity.1 (Emphases authors)

Labor costs have caused both confusion and controversy in costing circles. Labor costs were originally flexible costs, because workers were paid in proportion to the hours they worked . . . scheduling and union considerations have changed most labor costs into capacity-related costs, because even though many workers are paid on an hourly basis, their wages are guaranteed to be paid, at least in the short run, regardless if work is available. For this reason, most organizations now treat labor costs as capacity related rather than flexible.2

Two developments have influenced recent evolution in cost/managerial accounting literature. The first issue, suggested by Robin Cooper and Robert Kaplan, emphasizes the distinction between the cost of avail able,or supplied, resources and the cost of used resources.3 It is argued that the difference between the cost of available resources and those used should not be allocated to the units produced but written off separately as a loss. Most traditional cost/managerial accounting textbooks, however, do not generate the cost of unused resources.

The other issue brings accounting terminology in line with today's business environment. Most traditional cost/managerial accounting textbooks assume that direct or assembly labor is acquired when these services are required, thereby suggesting that direct labor costs are avoidable or are relevant for deciding the cost of a job that uses this labor. Assembly labor in today's business environment, however, is often acquired before it is used, in which case these direct labor costs are really not avoidable or relevant in determining the cost of a certain job that uses this labor because the direct labor has already been acquired. Following this line of thought, one might reasonably argue that direct labor cost should be a fixed cost because it is paid for in advance and its payment does not vary with the number of units produced.

I argue that direct labor cost (for example, assembly cost) will always be a variable cost, whether it is acquired in advance of use or acquired when needed. Many textbooks have incorporated this and other issues.4 But such incorporation has generally been piecemeal, and no textbook, to my knowledge, has provided a comprehensive framework of cost terminology after incorporating these two developments.


Traditional cost/managerial accounting usually defines three categories of costs. A cost can be:

* Fixed or variable with respect to a level of activity for cost estimation and cost prediction purposes.5

* Direct or indirect to a cost object, and, in particular, be direct (or traceable) to a unit of product (e.g., direct material and direct labor) or indirect (or allocated) to a unit of product (e.g., overhead and nonmanufacturing expenses) for cost determination purposes.6

* Relevant (or avoidable) or irrelevant (or unavoidable) when choosing between decision-making alternatives such as make-or-buy.7

I use direct labor cost to highlight the differences between the traditional and contemporary treatments discussed later.8 Assume two assembly line workers are hired at the rate of $10 per hour. Both work six hours assembling 120 units in batch #439, and together they are paid $120 (12 hours * $10 an hour) for their effort. Figure 1 shows how this transaction would be reflected using the traditional treatment of direct labor cost. For example:

* The actual cash outflow of $120 is an avoidable or relevant cost; that is, it would only be incurred if the 120 units in batch #439 need to be assembled. …

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