What are the pros and cons of using direct labor hours as a cost driver?

1 Pros of direct labor hours

One of the main benefits of using direct labor hours as a cost driver is that it is simple and easy to implement. Direct labor hours are readily available from payroll records or timesheets, and do not require complex calculations or estimations. Moreover, direct labor hours can reflect the relative size and complexity of different projects, as more labor-intensive projects tend to require more hours of work. Using direct labor hours as a cost driver can also encourage project managers and staff to be more efficient and productive, as they know that their hours will affect the project's profitability and performance.

2 Cons of direct labor hours

However, using direct labor hours as a cost driver also has some drawbacks. One of the main limitations is that it assumes a linear and proportional relationship between labor hours and overhead costs, which may not always be true. For example, some projects may incur more overhead costs due to factors such as travel, equipment, materials, or subcontractors, regardless of the labor hours involved. Conversely, some projects may have lower overhead costs due to economies of scale, automation, or reuse of resources, even if they have more labor hours. Using direct labor hours as a cost driver can also create distortions or incentives for manipulation, as project staff may overstate or understate their hours to influence the project's cost allocation and profitability.

3 Alternatives to direct labor hours

Project accountants may consider alternatives to direct labor hours when allocating overhead costs. Machine hours, which measure the number of hours that machines or equipment are used for each project, can be a more appropriate cost driver for projects that rely heavily on machinery or technology. Direct costs, which capture the sum of all direct costs incurred for each project, may be a more comprehensive and realistic measure of resource consumption and complexity. Activity-based costing is a more sophisticated approach which assigns overhead costs based on specific activities performed, such as design, testing, quality control, or customer service. This method can be more accurate and fair, as it reflects the actual drivers and causes of overhead costs.

4 How to choose a cost driver

The choice of a cost driver for project accounting depends on several factors, such as the nature and scope of the projects, the availability and reliability of data, the cost and complexity of the allocation process, and the objectives and expectations of the stakeholders. There is no one-size-fits-all solution, and project accountants need to weigh the pros and cons of each option and select the one that best suits their situation and needs. The key is to ensure that the cost driver is relevant, consistent, and verifiable, and that it provides useful and meaningful information for decision making and evaluation.

5 How to improve project accounting

Project accounting can be improved by following some best practices, such as establishing clear and realistic budgets and baselines for each project, tracking and recording all costs and revenues associated with each project, and comparing the actual results with the planned or expected outcomes. It is also important to analyze and explain any variances or deviations, report and communicate the financial performance of each project to relevant stakeholders, and identify and implement corrective actions or improvements as needed.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?