Managers, accountants, suppliers, and others will avoid many problems if they clearly define, understand, and agree on how costs are measured when they engage with each other. Consider the classification of programming labor payroll fringe costs, which include employer payments for employee benefits such as Social Security, life insurance, health insurance, and pensions. Consider, for example, a software programmer who is paid a wage of $80 an hour with fringe benefits totaling, say, $20 per hour. Some companies classify the $80 as a direct programming labor cost of the product for which the software is being written and the $20 as overhead cost. Other companies classify the entire $100 as direct programming labor cost.
In every situation, it is important for managers and management accountants to clearly define what direct labor includes and what direct labor excludes. This clarity will help prevent disputes regarding cost-reimbursement contracts, income tax payments, and labor union matters, which often can take a substantial amount of time for managers to resolve. Consider that some countries, such as Costa Rica and Mauritius, offer substantial income tax savings to foreign companies that generate employment within their borders. In some cases, to qualify for the tax benefits, the direct labor costs must at least equal a specified percentage of a company’s total costs.
When managers do not precisely define direct labor costs, disputes can arise about whether payroll fringe costs should be included as part of direct labor costs when calculating the direct labor percentage for qualifying for such tax benefits. Companies have sought to classify payroll fringe costs as part of direct labor costs to make direct labor costs a higher percentage of total costs. Tax authorities have argued that payroll fringe costs are part of overhead. In addition to payroll fringe costs, other debated items are compensation for training time, idle time, vacations, sick leave, and overtime premium. To prevent disputes, contracts and laws should be as specific as possible about accounting definitions and measurements.