He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University. Mark P. Holtzman, PhD, CPA, is Chair of the Department of Accounting and Taxation at Seton Hall University. He has taught accounting at the college level for 17 years and runs the Accountinator website at , which gives practical accounting advice to entrepreneurs. Tracking this variance is only useful for operations that are conducted on a repetitive basis; there is little point in tracking it in situations where goods are only being produced a small number of times, or at long intervals. Daniel S. Welytok, JD, LLM, is a partner in the business practice group of Whyte Hirschboeck Dudek S.C., where he concentrates in the areas of taxation and business law.

United Airlines asked a
bankruptcy court to allow a one-time 4 percent pay cut for pilots,
flight attendants, mechanics, flight controllers, and ticket
agents. The pay cut was proposed to last as long as the company
remained in bankruptcy and was expected to provide savings of
approximately $620,000,000. How would this unforeseen pay cut
affect United’s direct labor rate variance? The
direct labor rate variance would likely be favorable, perhaps
totaling close to $620,000,000, depending on how much of these
savings management anticipated when the budget was first
established. Boulevard Blanks has decided to allocate overhead based on direct labor hours (DLH).

• A favorable labor efficiency variance indicates better productivity of direct labor during a period.
• This awareness helps managers make decisions that protect the financial health of their companies.
• By using standard cost against both the actual and expected quantity, we get the variance in dollars that is attributed to quantity only.
• Labor efficiency variance Usually, the company’s engineering department sets the standard amount of direct labor-hours needed to complete a product.
• If, however, the actual hours worked are greater than the standard hours at the actual production output level, the variance will be unfavorable.

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.

A direct labor variance is caused by differences in either wage rates or hours worked. As with direct materials variances, you can use either formulas or a diagram to compute direct labor variances. Typically, a favorable direct labor efficiency variance indicates that there is better productivity of labor used in the production. In contrast, an adverse or unfavorable variance shows the inefficiency or low productivity of the labor used in the production. First, we need to calculate the total actual labor hours as well as the standard labor hours. Direct labor rate variance measures the cost of the difference between the expected labor rate and the actual labor rate.

Which of these is most important for your financial advisor to have?

Errors and inefficiencies are never considered to be assets; therefore, the entire amount must be expensed immediately. In this simple example, this variance shows ADVERSE variance, because the labor took more hours per unit and cost more per unit than the standard or budgeted targets. The variance is unfavorable since more hours than the standard number of hours were required to complete the period’s production. Before we go on to explore the variances related to fixed indirect costs (fixed manufacturing overhead), check your understanding of the variable overhead efficiency variance. If the balance in the Direct Materials Price Variance account is a credit balance of $3,500 (instead of a debit balance) the procedure and discussion would be the same, except that the standard costs would be reduced instead of increased.

Labor efficiency variance happens when the price per direct labor remains the same but the time spends to produce one unit different from standard costing. Management makes the wrong estimate of the time spent in production or the actual time increase due to various reasons. When the actual time spends different from the estimation, it will lead to a difference of the actual cost and the standard cost. It can be both favorable (actual cost less than the estimate) or unfavorable, the actual is higher than estimate.

• Even though the answer is a negative number, the variance is favorable because employees worked more efficiently, saving the organization money.
• If the balance is considered insignificant in relation to the size of the business, then it can simply be transferred to the cost of goods sold account.
• This includes work performed by factory workers and machine operators that are directly related to the conversion of raw materials into finished products.
• Possible causes of an unfavorable efficiency
  variance include poorly trained workers, poor quality materials, faulty
  equipment, and poor supervision.

As mentioned earlier, the cause of one variance might influence another variance. For example, many of the explanations shown in Figure 10.7 “Possible Causes of Direct Labor Variances for Jerry’s Ice Cream” might also apply to the favorable materials quantity variance. The most common causes of labor variances are changes in employee skills, supervision, production methods capabilities and tools. An example is when a highly paid worker performs a low-level task, which influences labor efficiency variance.

Direct labor variance analysis

For this reason, labor efficiency variances are generally watched more closely than labor rate variances. The standard materials cost of any product is simply the standard quantity of materials that should be used multiplied by the standard price that should be paid for those materials. Actual costs may differ from standard costs for materials because the price paid for the materials and/or the quantity of materials used varied from the standard amounts management had set. These two factors are accounted for by isolating two variances for materials—a price variance and a usage variance. Like direct labor rate variance, this variance may be favorable or unfavorable.

This results in an unfavorable variance since the actual
rate was higher than the expected (budgeted) rate. The efficiency variance is the difference between the actual unit usage of something and the expected amount of it. The expected amount is usually the standard quantity of direct materials, direct labor, machine usage time, and so forth that is assigned to a product.

Direct Labor Variances

Suppose, for example, the standard time to manufacture a product is one hour but the product is completed in 1.15 hours, the variance in hours would be 0.15 hours – unfavorable. If the direct labor cost is $6.00 per hour, the variance in dollars encumbrance definition would be $0.90 (0.15 hours × $6.00). For proper financial measurement, the variance is normally expressed in dollars rather than hours. However, they spend 5.71 hours per unit (200,000 hours /35,000 units) on the actual production.

4 Direct Labor Variance Analysis

Figure 10.6 “Direct Labor Variance Analysis for Jerry’s Ice Cream” shows how to calculate the labor rate and efficiency variances given the actual results and standards information. Review this figure carefully before moving on to the next section where these calculations are explained in detail. Recall from Figure 10.1 that the standard rate for Jerry’s is
$13 per direct labor hour and the standard direct labor hours is
0.10 per unit. Figure 10.6 shows how to calculate the labor rate
and efficiency variances given the actual results and standards
information. Review this figure carefully before moving on to the
next section where these calculations are explained in detail.

Limitations of the direct labor efficiency variance analysis

Dan advises clients on strategic planning, federal and state tax issues, transactional matters, and employee benefits. He represents clients before the IRS and state taxing authorities concerning audits, tax controversies, and offers in compromise. He has served in various leadership roles in the American Bar Association and as Great Lakes Area liaison with the IRS. After filing for Chapter 11 bankruptcy in December 2002, United cut close to $5,000,000,000 in annual expenditures. As a result of these cost cuts, United was able to emerge from bankruptcy in 2006.

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The standard variable OH rate per DLH is $0.80 (calculated previously), and the actual variable overhead for the month was $1,395 for 2,325 actual direct labor hours, giving an actual rate of $0.60. If the direct labor is not efficient when producing the good output, there will be an unfavorable labor efficiency variance. That inefficiency will likely cause additional variable manufacturing overhead which will result in an unfavorable variable manufacturing overhead efficiency variance. If the inefficiencies are significant, the company might not be able to produce enough good output to absorb the planned fixed manufacturing overhead costs.

The direct labor or permanent workforce will be paid during the idle labor or machine hours, so the process efficiency in production will get affected adversely. Watch this video presenting an instructor walking through the steps involved in calculating direct labor variances to learn more. Hence, variance arises due to the difference between actual time worked and the total hours that should have been worked. Labor hours used directly upon raw materials to transform them into finished products is known as direct labor. This includes work performed by factory workers and machine operators that are directly related to the conversion of raw materials into finished products.

The direct labor efficiency variance is the difference between the standard or budget labor hours allocated and the actual labor hours consumed for the production. The amount by which actual cost differs from standard cost is called a variance. When actual costs are less than the standard cost, a cost variance is favorable. When actual costs exceed the standard costs, a cost variance is unfavorable.