Understanding Applied Labor and the Cost of Inefficiency in Manufacturing

This article breaks down a critical concept for manufacturers: applied labor or the cost of inefficiency. We define it, provide examples of its importance, show how to calculate it, and explain how to use it for continuous improvement.

What Is Applied Labor?

Applied labor is a concept that focuses on how much of the labor cost you’re paying employees is directly contributing to your production. Labor costs are typically one of the largest, if not the largest, expenses in manufacturing. Therefore, understanding how much of that cost is applied to production is vital.

Unfortunately, many manufacturers lack clarity on this. And ff you’re not measuring applied labor, you can’t manage it effectively. This means you’re missing the opportunity to identify and reduce the cost of inefficiency—the portion of labor costs that isn’t contributing to production.

Defining and Calculating Applied Labor

Definition: Applied labor refers to the portion of payroll expenses, including related benefits and taxes, for shop floor employees (direct labor) that’s absorbed into the cost of manufacturing. It excludes indirect costs like management, supervision, and quality control.

How to Calculate It:

  1. Use your payroll system to isolate the costs of direct employees—payroll, taxes, and benefits—separately from other employee costs. This can be done by creating clear distinctions in your financial chart of accounts.
  2. Record the labor cost applied to production using your manufacturing system. This is based on employees logging their time spent on production activities.

For example, if you pay $10,000 per week in direct labor and your manufacturing system records $9,000 of applied labor, the remaining $1,000—or 10%—is unapplied labor. This unapplied labor represents the cost of inefficiency.

Setting Labor Rates

Each manufacturing system has its own method for recording applied labor, but calculating the labor rate is straightforward. Estimate your planned payroll expense for a specific period (e.g., a month or quarter) and divide it by the estimated hours your employees are expected to work during that period.

You can use a single labor rate (e.g., $30/hour) or create more detailed rates based on factors like work center, department, or the complexity of the tasks. For example, tasks requiring more experienced employees may have higher rates. It’s essential to capture accurate direct costs and have a clear plan for the expected labor hours during the time period.

Using Applied Labor for Improvement

To effectively use applied labor data, start by setting a clear target—something many manufacturers fail to do. Share this target with management, production teams, and employees, and measure performance against it regularly.

Here are some practical steps:

  1. Visualize and Share Data: Use tools like Power BI to display applied labor percentages on large screens in shop floors, break rooms, or management dashboards. Show targets alongside current performance and highlight variances.
  2. Drill Down for Insights: Identify areas of inefficiency by analyzing data by work center, employee, or employee pool. This helps pinpoint variances and focus improvement efforts.
  3. Track Trends Over Time: Compare applied labor percentages month-by-month or against targets to identify trends. Charting the cost of inefficiency over time can reveal progress and areas needing attention.
  4. Drive Continuous Improvement: Chart the cost of inefficiency with the goal of reducing it to zero. This fosters discussions about why inefficiencies exist and encourages solutions that improve profitability.

Why It Matters

Manufacturers can increase profitability, improve job quoting accuracy, and set better pricing strategies by measuring and improving applied labor. Monitoring applied labor as a percentage of labor costs—or as the cost of inefficiency—can lead to significant operational improvements over time.

If you need help implementing this concept or would like guidance on improving your processes, feel free to reach out to Chortek. We’re here to help. If you found this article helpful, please like and share it. Thanks for reading!