Employees are normally paid at a basic rate for an agreed number of hours each week. Any hours above this agreed number are usually paid at an overtime rate. The difference between the overtime rate and the basic rate is referred to as the overtime premium rate.
For example if an employee has a basic hourly rate of pay of 10.50 and overtime is paid at a rate of 15.75, then the overtime premium calculation is as follows.
Basic rate = 10.50 Overtime rate = 15.75 Overtime premium rate = Overtime rate - Basic rate Overtime premium rate = 15.75 - 10.50 = 5.25
In this example the premium rate is 5.25 an hour.
Overtime Premium Example
Suppose a business pays its employees a basic rate of 10.40 for the first 35 hours of each week and an overtime rate of 15.60 for hours worked above the agreed 35 hours.
Labor Cost Calculation
At the end of the week the employee has worked on a job for 40 hours and the labor cost is calculated as follows.
The employee has worked for 40 hours in total and is paid for 35 hours at the basic rate of 10.40 and for the additional 5 hours at the overtime rate of 15.60, giving a total labor cost of 442.
Overtime Premium Calculation
The problem with the method of presentation shown above is that while it shows the total labor cost it does not show the overtime premium pay.
The premium calculation is as follows.
Basic rate = 10.40 Overtime rate = 15.60 Overtime premium rate = Overtime rate - Basic rate Overtime premium rate = 15.60 - 10.40 = 5.20
In this example the premium rate is 5.20 an hour.
Using this rate the total labor cost can now be presented as follows.
As expected the total labor cost remains the same at 442; however, the above presentation demonstrates that from a job costing point of view the labor cost is 40 hours at the basic rate of 10.40 which includes 5 hours at the overtime premium rate of 5.20.
Overtime Premium in Cost Accounting
The importance of separating out the overtime premium is that in job costing terms the basic labor cost is allocated directly to the job whereas the overtime premium is indirectly allocated across all jobs using an appropriate method. In the above example, the basic labor cost of 416 is allocated directly to the job whereas the overtime premium of 26 is allocated indirectly across all jobs.
If the overtime premium was directly allocated to a job then for identical jobs the cost and therefore the selling price or profit for the job would vary depending on whether or not it was produced at a time when overtime rates were being incurred.
Job Costing Example
Suppose for example an employee had already worked 25 hours and is assigned a new job which requires 10 hours of labor. The employee completes the job and the additional 10 hours takes their total working hours for the week to 35 which is paid at basic rate.
The labor cost for the job is calculated as follows.
Now suppose the identical job was undertaken by the same employee at a point where they had already worked 30 hours that week. In this instance the employee completes the job in 10 hours but has now worked 5 (35-30) hours at the basic rate and an additional 5 hours at the overtime premium rate.
The labor cost is now calculated as follows.
The total labor cost for the identical job is now 130 simply because the employee started the job at a different point during the week.
In order to avoid this problem the basic labor cost of 104, which is the same in both instances, is allocated directly to the job, and the overtime premium of 26 is allocated indirectly across all jobs. Since the jobs in this example are identical a similar proportion of the overtime premium would be allocated to each job resulting in an identical total labor cost for each job.
Rush Jobs Exception
While in general the overtime premium is allocated indirectly across all jobs there are occasions when this is not appropriate.
If a customer has approached a business with a specific order which requires the job to be completed quickly at overtime rates, then it is appropriate for the overtime premium to be allocated directly to the job.
For example suppose a customer places a rush job estimated to take 10 labor hours. The business completes the job but due to the time constraints had to work 8 of the 10 hours at overtime rates.
If the business has a basic rate of pay of 10.00 and an overtime rate of pay of 15.00 the labor cost is calculated as follows.
The total labor cost is 140. Since the job is a rush job specific to the customer the total cost including the overtime premium is allocated directly to the job itself and is charged to the customer.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.