See below
BUS315 Week 6 SolarCal Case Analysis
Analysis of Direct Labor Costs
Participants:
Sally- Intern
Dominic- CEO of SolarCal
Luke- Head of Productions
Jake- Head of Accounting/Finance
Melissa- Head of Government Contracting
Dominic: Welcome back again Sally! I hope you had a very productive week and learned a lot while working with Luke last week! He is very knowledgeable in his field and is truly an asset to our team.
Sally: Thanks Dominic! Luke and I worked really well together, and we went over quite a bit of information pertaining to cost and pricing data in his department. I took a lot of notes and several of the key points we went over.
Dominic: I’m glad you learned a lot from Luke and have some notes to go back to regarding the key concepts you learned. I hope you are ready to complete another portion of the project I have assigned you. You will again be working with Luke this week; I need him to cover a few more concepts involving direct labor costs. Be sure to take some more notes and pay attention to what Luke goes over with you. The concepts discussed this week will really assist you with this big project we are working on. As far as the project goes, I can’t really go into details at this point since we are really trying to keep this project under wraps for now. However, I can assure you that this project will be large and very time consuming.
Sally: I am excited to be working with Luke again. I have my pen and paper ready to take notes while I go over this week’s materials with Luke. I am very interested to see what this big project is all about and I will do my best to be prepared for when the project is ready to go under way.
Dominic: I’m glad to hear that and I love your enthusiasm. We are lucky to have you assist us with this project when it begins; you have accomplished so much during your stay with us! Now let’s now make our way back down to Luke’s office.
Dominic: Good morning Luke! I have brought Sally back to you for the week. I will need you to go over some more concepts related to direct labor. As I told you and the rest of the staff, we are looking to undertake a huge project and I need everyone to be on the same page.
Luke: I completely understand Dominic. I will make sure to get Sally up to speed with some other key concepts she may need to know.
Sally, I hope you’re ready for another great week together. I have so much for us to do!
Sally: It is my pleasure to be working with you again Luke! I am ready to get started and am truly excited to learn even more from you!
Dominic, I think I am in good hands and I will report back to you next week. Thanks again for helping me prepare for this upcoming project; I feel that at the end of this internship I can be a real asset to this project you have been discussing.
Dominic: Thanks again Luke and thank you Sally for being so flexible. Trust me, all of your hard work will pay off at the end. Good luck and I look forward to talking with you next week.
See you later everyone!
Luke: Well, here we are again Sally! This week we will be talking about direct labor costs and its effect on productions. Before we get started, can you tell me a little bit about what you know about labor costs and how the government would use this information?
Sally: Here is what I know thus far.
I recall that the government places many contracts for physical products which they refer to as supplies. I also know that federal acquisition regulations define these supplies as all the properties that are expecting land or have interest in land.
Luke: Great job! Let me add a couple more things for you though. Take notice that the modern definition of supplies refers to the entire range of physical products that the government buys, including raw materials, parts, and components. We also see that fundamentally, all products and equipment sold contain labor inputs of some kind and the government often does a price analysis by itself when buying these products.
Sally: I do have a question though; I keep hearing the term direct and indirect labor costs at meetings in the CEO’s Boardroom, what is the difference?
Luke: That is a fine question to ask. Direct labor costs refer to the cost of labor specifically identified with a particular contract that a company is doing. We see that it is general practice to refer to the following three types of labor costs as direct labor:
Labor directly associated with the work being produced;
Labor readily identifiable with a particular objective such as a contract; and
Labor important enough to warrant identifying and measuring so we can keep up with its cost.
Sally: I think I understand the components of direct labor now! What about indirect labor?
Luke: When it comes to indirect labor, this is different from direct labor because it is not specifically identifiable to a given job or contract. For example, a supervisor may spend more time on one contract than another, and hence it would be difficult to apportion their time and cost to individual contracts.
Sally: Oh, I see the difference now between the two. Thanks for clearing that up for me.
Luke: Not a problem at all. There is one more thing I would like to share with you.
Make a note that there are some types of labor that can be either direct labor or indirect labor. The government is normally quite happy to let companies charge up individual workers any way they please, with a couple of restrictions. The Cost Accounting Standards do not tell companies which type of employees should be direct labor and which should be indirect, except in very broad terms. The standards, if they apply to the company at all, require the company to tell the government how they categorize people as direct or indirect labor and require that the company let the government know if they want to make a change.
Sally: That is very interesting, and I am glad you shared this with me. I have jotted a few notes down about this. It seemed pretty important to keep in mind.
Luke: Now let’s talk about how to estimate labor costs and the various processes that are involved. Before we get started, could I get a temperature of your background knowledge on the subject of labor costs?
Sally: I think I have some valuable insight to offer on this subject. I know that companies routinely use systematic procedures to estimate labor costs. I also recall that prior to submitting a bid or proposal; competent contractors examine thoroughly the engineering drawings, schedules, specifications, and standards to determine exactly what is to be done. I don’t really remember what occurs after; could you fill in this blank for me so I can get back on track?
Luke: Sure thing! You were doing so well too. Once the standards are determined, the contractors will estimate the direct labor hours that they believe will be needed to do the work. In many instances, they may also perform a site visit to assess the impact of environment and terrain on their estimate. After determining the estimated labor hours, direct labor cost is calculated by multiplying each type of labor hour by an appropriate hourly rate. One of the most widely used methods to estimate labor cost is the work breakdown structure.
What do you recall about a work breakdown structure?
Sally: I recall that a work breakdown structure is often used to estimate direct labor hours for a proposed project. The resulting estimated hours can then be multiplied by anticipated labor rates to determine the estimated labor costs.
Luke: Good work, that is correct! To add to this, a work breakdown structure also breaks a project down into its major parts, and then each major part is broken down into its subparts, continuing until the entire project is broken down into the lowest level of detail. Finally, the entire project will then be divided into small enough segments to work with.
Sally: Aren’t phase diagrams another method used by contractors to estimate costs?
Luke: Yes they are! They are similar to the work breakdown structure approach, except that the details of the work are spread out over a time base.
Sally: So why do you think it is so important to analyze direct labor costs? We seem to spend a lot of time collecting this type of data and information.
Luke: Well in fixed-price contracts, the detailed analysis of direct labor cost is extremely important when these costs are a significant part of the total contract costs. There are two basic reasons for this which includes: finally agreed upon direct labor costs are one hundred percent allocable to the contract; and indirect costs are likely to be overstated if direct labor cost is too high.
Keep in mind that a highly precise analysis of direct labor costs is generally not feasible in cost-reimbursement contracting. Why do you think this is?
Sally: Would it be because the government is protected in cost reimbursement contracts because it will pay the actual cost of performance, not a pre-estimated amount?
Luke: This is correct Sally! Nevertheless, the government has a responsibility to examine proposed direct labor costs and to consider the following items:
Differences in labor rates;
Level of the proposer’s understanding of the work; and
Fees.
Make a note that federal acquisition regulations give the directions for preparing a contract pricing proposal. For issues concerning the submission of direct labor costs, the instructions are simple and straightforward by providing a time-phased breakdown of labor hours, rates and cost by appropriate categories, and the furnishing of bases for estimates.
Sally: That makes a lot of sense now, I have written down a couple of things to help me remember these main points.
Luke, I would now like to know how you project the wage rates in the future.
Luke: I would be happy to share this with you! There are several ways to determine average wage rates. A few firms use a plant-wide rate, which is a single hourly wage rate that applies to all manufacturing labor. Many firms also use departmental rates, which are average rates established for each separate manufacturing department. Which rate do you think is used more commonly?
Sally: I would think that the departmental rates would be used more commonly. I remember learning that these rates work well when the skill mix for your work is very similar to the skill mix used to determine the departmental rate. However, I recall that these rates will cause an overstatement of direct labor cost when your work gets a lower skill mix.
Luke: That is correct, great job Sally! Keep in mind that most firms with an engineering department use a labor category rate for that department. In manufacturing, rates by labor category are most commonly used to predict engineering direct labor costs because differences in wage rates are significant among draftsmen, project engineers, and project managers. All these labor categories, including project managers, are almost always direct costs. Sally, what can you tell me about individual labor rates?
Sally: Aren’t individual labor rates used in unusual circumstances? I believe these rates would be used when named individuals, generally highly paid, are used for contract efforts. I also know that when individual rates are used, the offer will name the individuals to be assigned, estimate the hours required, and state their wage rates.
Luke: Right you are, you hit the nail on the head with your response. As we move on, make note that none of the wage rate methods we discussed are precise. It is not our job, as cost analysts, to tell buyers what system to use. It is instead our job to assess the results of the system actually being used.
Sally: I think I got it and have written down this information in my notebook.
Luke: Great! Let’s move on.
Sally: In a meeting recently I heard Dominic talking about the historical cost method, what does this mean?
Luke: The historical cost method is used for estimating the direct labor hours based on using actual experiences when making the same or similar products. We see that most manufacturers maintain very precise historical data on the actual times used for each step when making their products.
Sally: Couldn’t these manufacturers estimate the hours needed to build products for a new proposal if they had previous data on how long it took to make the products before.
Luke: Yes, Sally, and this is indeed what most manufacturers do. To estimate these hours, manufacturers will simply adjust the previous times to the quantity needed for the current offer.
Sally: Wouldn’t this be where negotiated contracts come into play?
Luke: You read my mind! I was just going to cover this concept. Keep in mind that negotiated contracts are generally awarded to companies with prior experience in manufacturing the same or similar items because these companies will usually have complete historical data on labor costs for prior contracts. Do you think firms need to have experience making a specific product?
Sally: I would think that a firm doesn’t need to have experience in making an identical product. I feel that since many of the manufacturing steps for the other product will be the same or similar to those for the new product, experience may not be needed.
Luke: Nice response, you definitely have a good understanding on that contract type. One thing I would like for you to take note of is the fact that the historical cost method is commonly used to estimate labor costs, even with its disadvantages.
Sally: Thank you for sharing that with me. What is next for us to go over?
Luke: Not a problem at all. I would now like to cover with you the labor standards methods that we use at SolarCal. This is very important; Dominic may ask you some questions about this method.
Sally: Am all ears Luke!
Luke: To start off, the labor standards method is an objective method for estimating labor hours that does not rely on prior experiences. Make note that these labor standards are expressed as output standards or time standards. When using an output standard it states the production rate for a given unit for a specific manufacturing task. On the other hand, a time standard is the time it should take to complete one task. Keep in mind that the standard time for an operation consists of the basic time required to complete the task plus the leveled time, personal delay and fatigue allowed, and special allowance. Any questions so far?
Sally: Not right now, everything makes sense.
Luke: I am now going to talk about the concept of “learning curve.” Now I know you may have heard this phrase while in school but its meaning takes on a different meaning in the world of productions.
Sally: Yes, I have heard this phrase before but I am interested to see what it means when it involves the production line.
Luke: Here at SolarCal, we are continually performing repetitive tasks, but more importantly we are almost always looking for and finding faster ways to complete these tasks. The learning curve is simply a graph that shows how this improvement can be measured and utilized. This graph also provides a way to predict labor hours and costs based on our beginning hours and costs.
Sally: Couldn’t we use this curve to predict the labor hours and costs needed for specific units if we have the standard hours for a first or intermediate unit?
Luke: You are right and this is exactly what we do here. These learning curves are very beneficial to us!
Furthermore, early developers of the theory called it the learning curve because they believed that learning by using workers saved the company a lot of time. When we use these learning curves, we use percentages to express improvement factors. Keep in mind that you shouldn’t be misled about learning curves. They are not that simple. Proper applications are very complex and the concept is only useful when mixed with good judgment.
Sally: I can see learning curves are very important! Can you talk a little bit about the direct and indirect labor costs at SolarCal and the industry as a whole?
Luke: Sure thing! Like other manufacturers, we use direct and indirect labor to convert raw materials and purchased parts and components into finished goods. In order to accomplish this task we need to complete several physical operations including cutting, grinding, and drilling. When we use factory direct labor we are talking about the people who are actually making parts from raw materials, installing parts into components, or assembling finished items.
Sally: Wouldn’t some of these costs be on the borderline of direct and indirect?
Luke: Great question! Let me explain this a little more. We see that different companies have different practices for classifying labor costs. For example, some companies classify all foremen as indirect labor and others classify them as direct labor.
Sally: That makes a lot of sense!
Luke: There are a wide variety of processes and direct labor skills that are present in a factory at any given time. Make note that each process has the direct labor people needed to get the work done. However, the mere fact that one company has a higher set of wage rates than another does not necessarily make the higher wage rates unreasonable.
Sally: Luke, what kind of factors can affect the hourly rate? I only asked because I see several engineers on the production floor and I was unsure of how their rates differed.
Luke: Thanks for bringing up that topic. As you can see there are numerous factors that can affect the hourly rate. Just like you said before, there are quite a few engineers present in my department. In order to validate each engineer’s wage rate we are checked by audits or by completing a comparison based on the Department of Labor’s prevailing rates for each area.
Sally: I think I have enough written down now to give an accurate report to Dominic next time I see him. Thank you again for sharing with me all this great information.
Luke: Not a problem at all! I was glad I was of assistance throughout the week.
Before we get ready for our weekly review, I would like for you to go through a review activity I have prepared to help you better grasp some of the concepts we covered this week.
Luke: Direct labor cost is the cost of labor specifically identified with a particular contract that a company is doing. It is a general practice to refer to the following three types of labor costs as direct labor:
Labor directly associated with the work being produced;
Labor readily identifiable with a particular objective such as a contract; and
Labor important enough to warrant identifying and measuring so we can keep up with its cost.
Luke: When projecting wage rates there are several ways to determine average wage rates. We see that many firms may elect to use a plant-wide rate, which is a single hourly wage rate that applies to all manufacturing labor.
Luke: The Historical Cost Method is used for estimating direct labor hours and is based on using actual experience when making the same or similar products. Most manufacturers maintain very precise historical data on the actual times used for each step when making their products and this can assist with long term production goals.
Luke: Labor Standards are expressed as output standards or time standards. An output standard states a production rate for a given unit for a specific manufacturing operation, while a time standard is the time it should take to complete one operation.
Luke: Great work on the review materials. You did great and I think you really have a solid foundation for the concepts we discussed this week.
I would now like to summarize what we went over this week to fill in any gaps you may have had. Feel free to add on to anything I say as we go through.
Sally: Sounds great Luke! If you don’t mind, I would like to start off the review. We first, we defined direct labor cost, and I learned that the cost of labor is specifically identified with the particular contract a company is working on. We then noted that indirect labor is different from direct labor because it is not specifically identifiable to a given job or contract.
Luke: Excellent! I then showed you how many companies estimate direct labor costs. We saw that one of the most widely used methods to estimate labor cost is the work breakdown structure. We went on to define work breakdown structures and saw that they are often used to estimate direct labor hours for a proposed project.
Sally: Let’s not forget about phase diagrams. I remember taking notes on this concept and writing down that these diagrams are another method used by contractors to estimate costs. I recall that they are similar to the work breakdown structure approach, except that the details of the work are spread out over a time base.
Luke: I’m glad you were paying attention Sally. As we moved on, we discussed how a detailed analysis of direct labor costs in fixed-price contracts are very crucial, because finally agreed upon direct labor costs are one hundred percent allocable to the contract.
Sally: You also told me to take note of indirect costs likely being overstated when the direct labor cost is too high. I also recall that the highly precise analysis of direct labor costs is generally not feasible in cost-reimbursement contracting.
Luke: Thank you for including that in our review. Later we identified the general approaches to analyzing direct labor costs revolves around examining each element of the proposed cost.
Sally: We then talked about the historical cost method and saw that it is used for estimating direct labor hours using actual experiences when making the same or similar products. You also made note of negotiated contracts and how they are generally awarded to companies with prior experience in manufacturing the same or similar items.
Luke: You’re doing great thus far. I hope this is helping. Next, we took a closer look at the labor standards method. We learned that this is an objective method for estimating labor hours and saw that it doesn’t rely on prior experiences.
Sally: This is definitely helpful, it’s nice to look back at my notes and really reflect on the concepts we have covered. This now brings me to the next topic we addressed which was learning curves. I learned that these learning curves are graphs that show how performing an operation repeatedly helps complete it faster as well as showing how improvement can be measured and used.
Luke: I’m really glad to hear that! To close out the week we learned that manufacturers use direct and indirect labor to convert raw materials and purchased parts and components into finished goods.
Sally: Thank you again for the review Luke! I feel that I learned a lot this week and I think we really work well together. I’m excited to share my newfound knowledge with Dominic when I see him next week.
Jake: You are truly an asset to us here at SolarCal and I look forward to working with you again. I know Dominic will be very impressed when you report back to him next week.
Until we meet again, don’t forget to complete your weekly discussion questions based on the key concepts we covered this week.
Have a good rest of the day and I will see you soon!
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