Chapter 12

Human Resource Decisions

Building on accounting for operations, this chapter explains the components of labour costs and how those costs are applied to decisions affecting the production of goods or services. The relevant cost of labour for decision-making purposes is also explained.

Human resources and accounting

According to Armstrong (1995a, p. 28), ‘personnel management is essentially about the management of people in a way that improves organizational effectiveness.’ Personnel management – or human resources (HR) as it is more commonly called – is a function concerned with job design; recruitment, training and motivation; performance appraisal; industrial relations, employee participation and team work; remuneration; redundancy; health and safety; and employment policies and practices. It is through human resources, that is people, that the marketing and production of goods and services takes place. Historically, as Chapter 1 suggested, employment costs were a large element of the cost of manufacture. However, with improvements in manufacturing, information and communications technologies and the shift to service and knowledge-based industries in most Western economies, people costs have tended to decline in proportion to total costs.

Armstrong (1995b) argued that the tighter grip of accountants on business management and the diffusion of management accounting techniques were forces with which human resource managers had to contend. This was particularly the case where the HR function was devolved to divisionalized business units and under line management control.

Many non-accounting readers ask why the Statement of Financial Position of a business does not show the value of its human assets (what the HR literature refers to as human resource accounting). The knowledge, skills and abilities of people are a key resource in satisfying markets through the provision of goods and services. But people are not owned by a business. They are recruited, trained and developed, then motivated to accomplish tasks for which they are appraised and rewarded. People may leave the business for personal reasons or be made redundant when there is a business downturn. The value of people to the business is in the application of their knowledge, skills and abilities towards the provision of goods and services. Intellectual capital, which was described in Chapter 7, goes some way towards trying to report to shareholders and others the value of human, as well as organizational and customer, capital.

In accounting terms, people are treated as labour, a resource that is consumed – therefore an expense rather than an asset – either directly in producing goods or services or indirectly as a business overhead. This distinction between direct and indirect labour is an important concept that is considered in more detail in Chapter 13.

The cost of labour

The cost of labour can be considered either over the short term or long term. In the short term, the cost of labour is the total expense incurred in relation to that resource, which may, for direct labour, also be calculated as the cost per unit of production, for either goods or services. The cost of labour is the salary or wage cost paid through the payroll, plus the oncost. The labour oncost consists of the non-salary or wage costs that follow from the payment of salaries or wages. The most obvious of these in the UK are National Insurance contributions and pension (or superannuation) contributions made by the business. In other countries oncosts may include health insurance costs, payroll taxes or workers compensation insurance premiums. Virtually all oncosts are expressed as a percentage of salary. The total employment cost may include other forms of remuneration such as bonuses, profit shares and non-cash remuneration, for example share options, expense allowances, business-provided motor vehicles and so on.

A less visible but important element of the cost of labour is the period during which employees are paid but do not work, covering for example public holidays, annual leave and sick leave. A second element of the cost of labour is the time when people are at work but are unproductive, such as when they are on refreshment or toilet breaks, socializing, or during equipment downtimes. These unproductive times all increase the cost of labour in relation to the volume of production of goods or services. The actual at-work and productive time is an important calculation in determining the production capacity of the business (see Chapter 11).

The following example shows how the total employment cost may be calculated for an individual (the oncosts are indicative only as they can vary widely depending on the location and industry of the business):

Assuming a five-day week and 20 days’ annual leave, five days’ sick leave and eight public holidays per annum (the actual calculation will vary by location and industry), the actual days at work (the production capacity) can be calculated as:

The total employment cost per working day for this employee is therefore £174.89 (£39,700/227 days). Assuming that the employee works eight hours per day and the employee is productive for 80% of the time at work, then the cost per hour worked is £27.33 (£174.89/(8 × 80%)).

The employee, taking home £30,000 for a 40-hour week, may consider their cost of employment as £14.42 per hour (£30,000/52/40), even though they will not receive this amount as income tax has to be deducted. From the employer’s perspective, however, this example shows the total employment cost and the effect of the paid but unproductive time, which almost doubles the cost to the employer – what is £14.42 per hour to the employee is £27.33 per hour to the employer.

The cost per unit of production can be expressed either as the (total employment) cost per (productive) hour worked, in this case a labour cost per hour of £27.33, or as a cost per unit of production. If an employee during their productive hours completes four units of a product, the direct labour cost per unit of production is £6.83 (£27.33/4). If a service employee processes five transactions per hour, the direct labour cost per unit of production (a transaction is still a unit of production) is £5.47 (£27.33/5).

The calculation of the cost of labour is shown in Table 12.1.

Table 12.1 The cost of labour.

In the longer term, a business may want to take a broader view of the total cost of employment. Many costs are incurred over and above the salary and wages paid to employees, who must be recruited and trained before they can be productive. A longer term approach to the total cost of employment may include recruitment and training costs as additional costs of employment. In relation to short term and long term, an important issue arises as to whether the cost of labour is a fixed or variable cost, following the distinction made in Chapter 10. It is clear that materials used in production are a variable cost, as no materials are consumed if there is no production, but the situation for labour is more complex. Accountants have historically considered labour that is consumed in producing goods or services, i.e. direct labour, as a variable cost. This is because it is usually expressed as a cost per unit of production, which, in total, increases or decreases in line with business activity (but often ignores the cost of spare capacity, which was explained in Chapter 11). Changing legislation, the influence of trade unions and business HR policies have meant that in the very short term, all labour takes on the appearance of a fixed cost. The consultation process for redundancy takes time, and legislation such as Transfer of Undertakings Protection of Employment (TUPE) in the UK or the European Union Acquired Rights Directive secures the employment rights of labour that is transferred between organizations, a fairly common occurrence as a consequence of outsourcing arrangements or business mergers and acquisitions. Consequently, reflecting the underlying practicality, many businesses now account for direct labour as a fixed cost.

Relevant cost of labour

The distinction between fixed and variable costs is not sufficient for the purpose of making decisions about labour in the very short term as, in that short term, labour will still be paid irrespective of whether employees are fully utilized or have spare capacity. Therefore, in the short term, a business bidding for a special order should only take into account the relevant costs associated with that decision. As we saw in Chapter 11, the relevant cost is the future, incremental cash flow, i.e. the cost that will be affected by a particular decision to do (or not to do) something. As decision making is not concerned with the past, historical (or sunk) costs are irrelevant. The relevant cost may be an additional cash payment or an opportunity cost, i.e. the loss from an opportunity forgone. For example, in the case of full capacity, the relevant cost could be the additional labour costs (e.g. overtime or casual labour) that may have to be incurred, or the opportunity cost following from the inability to sell products/services (e.g. both the loss of income from a particular order and the wider potential loss of customer goodwill).

Costs that are the same irrespective of the alternative chosen are irrelevant for the purposes of a particular decision, as there is no financial benefit or loss as a result of either choice. The costs that are relevant may change over time and with changing circumstances. This is particularly so with the cost of labour, where full capacity in one week or month may be followed by surplus capacity in the following week or month.

Where there is spare capacity, with surplus labour that will be paid irrespective of whether a particular decision is taken or not, the labour cost is irrelevant to the decision, because there is no future incremental cash flow. Where there is casual labour or use of overtime and the decision causes that cost to increase (or decrease), the labour cost is relevant. Where labour is scarce and there is full capacity, so that labour has to be diverted from alternative work involving an opportunity cost, the opportunity loss is the relevant cost.

For example, Brown & Co. is a small management consulting firm that has been offered a market research project for a client. The estimated workloads and labour costs for the project are:

There is at present a shortage of work for partners, but this is a temporary situation. Managers are fully utilized and if they are used on this project, other clients will have to be turned away, which will involve the loss of revenue of €100 per hour. Support staff are paid on a casual basis and are only hired when needed. Fixed costs are €100,000 per annum.

The relevant cost of labour to be used when considering this project can be calculated by considering the future, incremental cash flows:

However, the accounting system would have recorded the cost of labour (based on timesheets and hourly labour costs) as:

While the accounting system records the historic cost, in this instance it does not take into account the opportunity cost of the lost revenue. Accounting costs are therefore a limited way in which to make management decisions. The relevant cost approach identifies the future, incremental cash flows associated with acceptance of the order. The relevant cost ignores the cost of partners as there is no future, incremental cash flow. The cost of managers is the opportunity cost – the lost revenue from the work to be turned away. The support staff cost is due to the need to employ more temporary staff. Fixed costs are irrelevant as they are unaffected by this project. In this case, Brown & Co. would be worse off by taking the market research project at a price less than €38,000. If it is unable to achieve a higher price, the existing clients should be retained at the €100 rate for managers.

Chapter 11 introduced outsourcing as a business strategy that has been in favour with many businesses to reduce the cost of labour. The following example illustrates the relevant costs of labour in an outsourcing decision.

Newgo Industries operates a telephone call centre as part of a larger company. The call centre employs 10 telephone operators at a total employment cost of $40,000 per annum each. Each operator is on a short-term employment contract which is cancellable with a month’s notice. Management salaries cost $50,000 per annum and the call centre is charged a rental and utilities cost by head office of $20,000 per annum. An offshore company has offered to undertake the call centre function for $325,000 per annum. If the call centre is outsourced, management salaries will continue unchanged and the head office charge cannot be avoided. Table 12.2 shows the total cost under each alternative. Table 12.3 shows the relevant costs for each alternative, by eliminating those costs which are unavoidable under both alternatives. Both Tables 12.2 and 12.3 show that the cost differential is $75,000 per annum and therefore, from a financial perspective, the outsourcing should proceed.

Table 12.2 Total costs of call centre and outsourcing.

Table 12.3 Relevant costs of call centre and outsourcing.

Note in this example that the salaries of telephone operators are a relevant cost as these costs can be avoided by giving a month’s notice. Management salaries are not a relevant cost as they are incurred irrespective of the decision to outsource. This example shows how it is important in any calculation of relevant costs to be sure about which costs involve future incremental cash flows, i.e. which costs are avoidable and which costs are unavoidable. However, it is also important to remember that financial information is only one element of a business decision such as outsourcing. Other factors that must be considered (but which are often difficult to quantify) include quality, customer service and reputation.

The following case studies illustrate how an understanding of labour costs and unused capacity can influence management decisions.

Case study 12.2: Trojan Sales – the cost of losing a customer

Trojan Sales is a business employing a number of sales representatives, each costing the business €40,000 per annum, a figure that includes salary, oncosts and motor vehicle running costs. Sales representatives also earn a commission of 1% on the orders placed by their customers. On average, each sales representative looks after 100 customers (one driver of activity) and each year, customers place an average of five orders, with an average order size of €2,500. Therefore, each representative generates sales of:

and earns commission of 1%, amounting to €12,500.

However, Trojan suffers from a loss to competitors of about 10% of its customer base each year. Consequently, only about 70% of each sales representative’s time is spent with existing customers, the other 30% being spent on winning replacement customers, with each representative needing to find 10 new customers each year (a second driver of activity). The business wants to undertake a campaign to prevent the loss of customers and has asked for a calculation of the cost of each lost customer.

A first step is to calculate the cost of the different functions carried out by each sales representative:

The cash cost of winning a new customer is €1,200. However, the opportunity cost provides a more meaningful cost. If there were no lost business and sales representatives could spend all of their time with existing customers, each representative could look after 142 customers (100 × 100/70) in the same time.

If each of the 142 customers placed the average five orders with an average order size of €2,500, each representative could generate income of €1,775,000 and earn commission of €17,750. The opportunity cost is the loss of the opportunity by the company to generate the extra income of €525,000 (€1,775,000 – €1,250,000) and the opportunity cost to the representative personally of €5,250 (commission of €17,750 – €12,500).

Each customer lost costs Trojan €1,200 in time taken by sales representatives to find a replacement customer. However, on an opportunity cost basis, each lost customer potentially costs the company €52,500 in lost sales and the sales representative €525 in lost commission.

For this kind of reason, businesses sometimes adopt a strategy of splitting their salesforce into those representatives who are good at new account prospecting and those who are better at account maintenance.

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Conclusion

This chapter has calculated the cost of labour and contrasted earnings from an employee’s perspective with the total cost of employment to an employer. We have also developed the idea of relevant costs (introduced in Chapter 11) with examples of the relevant cost of labour.

Unfortunately, one of the first business responses to a downturn in profits is frequently to make staff redundant. Although the redundancy payments will be recognized as a cost in the Income Statement, there is a substantial social cost, not reflected in the financial reports of a business. These social effects will be borne by the redundant employee, while the financial burden of unemployment benefits may be borne by the taxpayer (see Chapter 5 for a discussion). This short-term concern with reducing labour cost often ignores the potential for cost improvement that can arise from a better understanding of business processes. It also ignores the investment in human capital: the knowledge, skills and experience of employees made redundant and the long-term costs associated with recruitment and training that will have to be incurred again if business activity returns to higher levels.

References

Armstrong, M. (1995a). A Handbook of Personnel Management Practice (5th edn). London: Kogan Page.

Armstrong, P. (1995b). Accountancy and HRM. In J. Storey (Ed.), Human Resource Management: A Critical Text, London: International Thomson Business Press.

Questions

12.1 Grant & McKenzie is a firm of financial advisers that needs to calculate an hourly rate to charge customers for its services.

The average salary cost for its advisers is £40,000. National Insurance is 11% and the firm pays a pension contribution of 6%. Each adviser has four weeks’ annual holiday and there are 10 days per annum when the firm closes for bank holidays and Christmas. Each adviser is expected to do chargeable work for clients of 25 hours per week, the remainder of the time being administrative work. Calculate an hourly rate (to the nearest whole £) to cover the cost of each financial adviser.

12.2 Local Bank does not know how much of its cheque-processing costs are fixed and how much are variable. However, total costs have been estimated at €750,000 for processing of 1,000,000 transactions and €850,000 for processing of 1,200,000 transactions.

What are the variable costs per transaction?

What are the fixed costs?

12.3 Cardinal Co. needs 20,000 units of a certain part to use in one of its products. The following information is available in relation to the cost to Cardinal to make each part:

Raw materials	$4
Production labour	16
Variable manufacturing overhead	8
Fixed manufacturing overhead	10
Total	$38

The cost to buy the part from the Oriole Co. is $36. If Cardinal buys the part from Oriole instead of making it, Cardinal would have no use for the spare capacity. Additionally, 60% of the fixed manufacturing overheads would continue regardless of what decision is made. Cardinal decides that direct labour is an avoidable cost for the purposes of this decision.

Decide whether to make or buy the 20,000 parts, by comparing the relevant costs.

12.4 Cirrus Company has calculated that the cost to make a component is made up of raw materials £120, production labour £60, variable overhead £30 and fixed overhead of £25. Another company has offered to make the component for £140.

If the company has spare capacity and wishes to retain its skilled labour force, should it make or buy the component?

12.5 Bromide Partners provides three services: accounting, audit and tax. The total business overheads of €650,000 have been divided into two groups:

Partners	€200,000
Juniors	€450,000

Partner hours are a measure of complexity and junior hours define the duration of the work. The hours spent by each type of staff are:

Calculate the total cost of providing audit services.

12.6 Bendix Ltd is considering the alternatives of either purchasing component VX-1 from an outside supplier or producing the component itself. Production costs to Bendix are estimated at:

Production labour	$200
Raw materials	600
Variable overheads	100
Fixed overheads	300
Total	$1,200

An outside supplier, Cosmo Ltd, has quoted a price of $1,000 for each VX-1 for an order of 100 of these components. However, if Bendix accepts the quote from Cosmo, the company will need to give three months’ notice of redundancy to staff.

• Calculate the relevant costs of the alternative choices (show your workings) and make a recommendation to management as to which choice to accept.
• How would your recommendation differ if Bendix employees were on temporary contracts with no notice period?
• Explain the significance of a stock valuation of $1,300 for the VX-1 at the end of the last accounting period.

12.7 Victory Products Ltd manufactures high-technology products for the computer industry. Victory’s accountant has produced a profit report showing the profitability of each of its three main customers for last year (Table 12.9).

Table 12.9 Victory Products profit report.

Victory is operating at almost full capacity, but wishes to improve its profitability further. The accountant has reported that, based on the above figures, Franklin Industries is the least profitable customer and has recommended that prices be increased. If this is not possible, the accountant has suggested that Victory discontinues selling to Franklin and seeks more profitable business from Engineering Partners and Zeta.

Labour is the most significant limitation on capacity. It is highly specialized and is difficult to replace. Consequently, Victory does all it can to keep its workforce even where there are seasonal downturns in business. The company charges £100 per hour for all labour, which is readily transferable between each of the customer products.

You have been asked to comment on the accountant’s recommendations.

12.8 Seaford Group produces chocolate products including an exclusive range of chocolate Easter eggs, producing and selling a total of 100,000 eggs each year. The materials cost is $1.25 per egg and the labour cost is $0.70. Additional variable overhead costs are estimated at $0.20 per egg. Fixed overhead costs for Seaford Group total $150,000.

An international company has offered to produce the 100,000 Easter eggs to the same quality on behalf of Seaford for $2.50 per egg. If Seaford accepts this offer it can use its labour to produce other products and its fixed costs can be reduced by $50,000. However, there will be transportation costs that Seaford has to bear to bring the Easter eggs to its premises, amounting to $0.25 per egg.

Apply relevant cost principles to determine whether Seaford should continue to make the Easter eggs in-house or should subcontract to the international company.

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