Labour Turnover and Payroll Accounting

Two practical questions follow from how labour is paid. How many of the people you hired are staying, and what does it cost when they leave? And how does a month’s pay become entries in the books, once tax, pension and other deductions have been taken out? The first is a question of labour turnover. The second is payroll accounting.

This topic gives the turnover formulas, the causes and the costs of turnover, and ways of managing it. It then shows the two journals that record a payroll and how the wages cost is spread over production and overheads. Exam questions usually ask for a turnover percentage with a comment, or for payroll journals from a table of deductions.

Labour turnover

Labour turnover is the number of employees who leave during a period, compared with the number employed. People leave for many reasons: resignation, retirement, retrenchment, ill health, pregnancy, death and others. The labour turnover rate measures how fast employees leave and have to be replaced.

Causes of labour turnover

A high rate may point to weak pay, poor engagement or poor management. A low rate usually suggests a stable, engaged workforce.

Measuring the rate

The average-based version smooths out changes in the size of the workforce over the period. The alternative counts everyone who was on the payroll at any time, which gives a wider view where there is a lot of hiring.

Worked calculation. A firm has 1,500 employees at the start of the year and 1,540 at the end. During the year 240 left and 270 were recruited.

• Average employees.
  (1,500 + 1,540) ÷ 2 = 1,520.
• Rate (average-based)
  240 ÷ 1,520 × 100 = 15.8%.
• Total employed in the year.
  1,500 opening + 270 recruited = 1,770.
• Rate (alternative)
  240 ÷ 1,770 × 100 = 13.6%.

The two methods give different percentages. In an exam, use the method the question asks for, or the average-based one if no method is named, and state the formula.

Implications of high and low turnover

Managing labour turnover

• Build engagement through involvement in decisions and regular feedback.
• Offer pay and benefits that match the market and the value of the job.
• Create clear career paths and invest in developing skills.
• Build an inclusive culture in which people feel safe and well.
• Use structured exit interviews to learn why people leave and to find problems in the organisation.

The cost of labour turnover

Background: the syllabus mentions the cost headings above but does not set out a costing method. Earlier papers asked for the cost of labour turnover, so this is a useful extension. The costs fall into two groups.

Replacement costs arise when someone leaves and a new person is found: advertising, interviewing and selection, induction, training, the lower output of a new starter, higher scrap, and the pay of the leaver’s notice period or of overtime to cover. Preventive costs are spent to keep people: welfare and social facilities, better pay and conditions, and training.

To estimate the annual cost of turnover, multiply the number of leavers by the average replacement cost per leaver. For example, if 240 people leave and each costs ₦85,000 to replace, the annual cost is 240 × ₦85,000 = ₦20,400,000.

Payroll accounting

Employers cannot pay staff the whole of their gross pay. They must deduct tax, pension contributions and other items and pay these amounts over to the right organisations. The accounts show this using two journals.

• Journal 1 records the payroll expense and the amounts the employer now owes: debit wages and salaries for the gross pay, and credit each deduction as a creditor (the tax authority, the pension administrator and so on), with the balance credited as net pay due to employees, or paid out of the bank.
• Journal 2 records the payment of what is owed to each creditor: debit each creditor account and credit bank.

Worked example

Zenith Mills Ltd employs 18 people. For one month the gross pay is ₦3,200,000. Deductions are PAYE tax ₦210,000, employees’ pension ₦256,000, National Housing Fund ₦80,000 and union dues ₦24,000. Total deductions = ₦210,000 + ₦256,000 + ₦80,000 + ₦24,000 = ₦570,000. Net pay = ₦3,200,000 − ₦570,000 = ₦2,630,000.

Each journal balances: debits equal credits (₦3,200,000 in the first, ₦570,000 in the second). The deductions are not an extra cost to the employer. They are part of the gross pay that the employer has agreed to pay and then passes on. Employer’s own contributions, such as the employer’s share of pension, are an additional expense and a further amount payable.

Charging wages to cost centres and cost units

Once payroll is recorded, the wages cost is analysed using the payroll and time records and charged to where it belongs. In a cost ledger kept on double entry, a common treatment is to debit work-in-progress with direct labour, and production overhead with indirect production labour, idle time and overtime premium, and administration and selling overheads with the pay of those departments, crediting a wages control account with the total.

The ideas in more depth

Why the turnover rate needs a comment

A number alone is not an answer. 15.8% may be normal in a hotel and alarming in a skilled engineering firm. A good answer compares the rate with previous years, with similar firms and with the firm’s target, asks who is leaving (skilled and experienced staff matter more), asks why (exit interviews), and links the rate to the costs of replacement.

Some turnover is healthy

A very low rate is not always good. If no one leaves, new ideas may be scarce and under-performers may stay. Management wants to keep its good people while renewing others.

Payroll control

Payroll is a high-risk area for errors and fraud, such as paying people who have left (ghost workers). Good practice is to separate those who authorise changes, those who prepare pay and those who pay it, and to reconcile the payroll total to the bank and to the cost ledger each month.

Linking to the cost of idle time and overtime

The payroll analysis relies on the direct and indirect classification from the previous topic. If idle time and overtime premium are not recorded separately on time sheets, the split between work-in-progress and overhead cannot be made accurately.

Worked example: a turnover calculation and a comment

1. Average employees.
   (800 + 760) ÷ 2 = 780.
2. Rate (average-based).
   96 ÷ 780 × 100 = 12.3%.
3. Total employed.
   800 + 56 = 856.
   Rate = 96 ÷ 856 × 100 = 11.2%.
4. Comment. The rate is up from 7%, an increase of about five percentage points. The workforce has also shrunk, because only 56 of the 96 leavers were replaced. Management should find out whether the leavers are mainly skilled staff, whether pay or conditions are the cause (exit interviews), and what the replacement costs are. If the trend continues, recruitment, induction and training costs will rise and productivity may fall.

Controlling and reducing labour cost

Labour is often the largest controllable cost, so managers look for ways to hold it down without damaging output or morale. The syllabus points to the following levers, which tie together the last two topics.

A useful test is cost per unit, not total cost. A scheme that raises the wage bill but raises output faster still lowers the labour cost of each unit.

Employer’s own contributions in the payroll

The journals above deal with deductions from the employee’s pay. The employer may also have to pay its own share of pension and similar schemes on top of the gross pay. This is an extra expense, so it is recorded separately and increases total labour cost.

1. Employer’s contribution.
   10% × ₦3,200,000 = ₦320,000.
2. The entry is: Dr Employer’s pension expense ₦320,000; Cr Pension payable ₦320,000.
3. The total owed to the pension administrator is the employee’s ₦256,000 plus the employer’s ₦320,000 = ₦576,000.

The total cost of employing the 18 staff is then the gross pay of ₦3,200,000 plus the employer’s contribution of ₦320,000 = ₦3,520,000, even though the employees’ net pay is only ₦2,630,000. This is why the labour cost in the cost accounts is larger than what appears in employees’ pay slips.

A second turnover example, with cost

A call centre has 400 staff at the start of the year and 380 at the end. During the year 72 left, and 52 were recruited to replace some of them. Average staff = (400 + 380) ÷ 2 = 390, so the rate is 72 ÷ 390 × 100 = 18.5%. Suppose the cost of replacing one employee is ₦90,000 (advertising ₦20,000, interviews and checks ₦15,000, induction and training ₦45,000, and lower output while the new person learns ₦10,000).

Treating each leaver as costing about the same to replace, the annual cost of turnover is 72 × ₦90,000 = ₦6,480,000. If the rate could be cut to 12%, leavers would fall to 12% × 390 = about 47. The saving would be (72 − 47) × ₦90,000 = ₦2,250,000 a year, which can be set against the cost of any retention measures such as better pay or training. Background: the costing of turnover is an extension to the syllabus.

Other turnover measures

Background: the syllabus gives the leaver-based rate. Two other measures are used in practice.

• Flux rate.
  (joiners + leavers) ÷ average employees × 100.
  It shows total movement in the workforce.
  With 270 joiners, 240 leavers and an average of 1,520, flux = (270 + 240) ÷ 1,520 = 33.6%.
  It is a better guide to instability than the leaver rate alone.
• Replacement rate.
  replacements ÷ average employees × 100.
  If only 200 of the 270 joiners filled vacancies left by leavers (the rest were new posts), the replacement rate is 200 ÷ 1,520 = 13.2%.
  It focuses on the recruitment and training cost, since replacements are the ones that cost money to find and train.

The leaver rate says how fast people go, the replacement rate how much rehiring is needed, and the flux rate how unsettled the workforce is.

Avoidable and unavoidable turnover

Not all leaving can be prevented. Unavoidable reasons include retirement, death, ill health, a spouse relocating and pregnancy leave in some cases. Avoidable reasons include pay, poor management, lack of promotion, bad working conditions and better offers elsewhere. Management should concentrate on the avoidable group, and a good exit interview helps to split the two.

If most leavers cite the same cause, such as a competitor paying more for a skill, the remedy is specific and measurable.

The payroll process step by step

Typical deductions explained

The deductions in payroll questions depend on the figures given. Commonly:

• PAYE tax is income tax withheld from pay and paid to the tax authority, calculated on taxable income after allowable reliefs.
• Employee pension contribution is a percentage of pensionable earnings paid into the employee’s retirement savings account. The employer also contributes a share, which is an additional cost to the employer. (Rates are set by law and may change, so always use those stated in the question.)
• National Housing Fund contribution is a percentage of basic salary for the housing scheme.
• Union dues, cooperative savings and loan repayments are deducted at the employee’s request or under agreement and paid to the relevant body.

All are credited to payable accounts, and cleared when paid over.

The wages control account

A wages control account brings the whole payroll together. Using the Zenith Mills figures (gross ₦3,200,000; deductions ₦570,000; net pay ₦2,630,000):

The account balances to nil. If it does not, there is an error: pay not analysed, an employee analysed twice, or a deduction omitted. Investigating a balance on the wages control account is a standard control in cost accounting.

Turnover and the other cost elements

High turnover affects other topics too. New starters waste more material, so materials usage variances rise. They work more slowly, so labour efficiency variances turn adverse. Training takes experienced staff away from production, creating idle time and overtime premium. A firm that sees these variances together should look at its turnover figures.

In a budget, a stable workforce is easier to plan: recruitment, training and induction costs can be forecast, and the labour cost per unit stays close to the standard.

Common mistakes in the exam

• Dividing by the opening or closing number of employees instead of the average.
• Using the number recruited instead of the number who left as the numerator.
• Giving the percentage with no comment.
• Listing only the costs of recruitment and forgetting lost output and the effects on morale.
• In payroll journals, crediting the deductions to expense instead of to creditors.
• Treating deductions from the employee’s pay as an additional cost to the employer.
• Journals that do not balance. Always add each side.

Quick revision

• Turnover rate = leavers ÷ average employees × 100. Average = (opening + closing) ÷ 2. Alternative: leavers ÷ total employed in the period.
• Voluntary causes: career moves, retirement. Involuntary: retrenchment, dismissal.
• High turnover: recruitment, induction and training costs, lost productivity and morale. Control: engagement, fair pay, careers, culture, exit interviews.
• Journal 1: Dr wages (gross); Cr each deduction payable; Cr net pay. Journal 2: Dr each payable; Cr bank.
• Wages control is cleared by charging direct labour to work in progress (WIP) and the rest to overheads.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer.

Section A style: multiple choice

Section B style: written questions

A further written question

Model answers

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