8 3 Compute and Evaluate Labor Variances Principles of Accounting, Volume 2: Managerial Accounting

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The direct labor efficiency variance may be computed either in hours or in dollars. 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 would be $0.90 (0.15 hours × $6.00).

Direct labor variance analysis

In order to keep the overall direct labor cost inline with standards while maintaining the output quality, it is much important to assign right tasks to right workers. Like direct labor rate variance, this variance may be favorable or unfavorable. If workers manufacture a certain number of units in an amount of time that is less than the amount of time allowed by standards for that number of units, the variance is known as favorable direct labor efficiency variance.

Causes of direct labor efficiency variance

It usually occurs when less-skilled laborers are employed (hence, cheaper wage rate). Hitech manufacturing company is highly labor intensive and uses standard costing system. The standard time to manufacture a product at Hitech is 2.5 direct labor hours. In other words, when actual number of hours worked differ from the standard number of hours allowed to manufacture a certain number of units, labor efficiency variance occurs. The total direct labor variance is also found by combining the direct labor rate variance and the direct labor time variance. By showing the total direct labor variance as the sum of the two components, management can better analyze the two variances and enhance decision-making.

How Are Standard Rates Created?

This includes work performed by factory workers and machine operators that are directly related to the conversion of raw materials into finished products. Hence, variance arises due to the difference between actual time worked and the total hours that should have been worked. Boulevard Blanks has set the standard cost for labor at $18 per hour. The labor standard may not reflect recent changes in the rates paid to employees. For example, the standard may not reflect the changes imposed by a new union contract. An example is when a highly paid worker performs a low-level task, which influences labor efficiency variance.

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For proper financial measurement, the variance is normally expressed in dollars rather than hours. Labor costs can be a significant expense in a manufacturing company. The Human Resources and Accounting departments will set a standard cost for labor, and the budget will be built on that. A direct labor cost variance occurs when a company pays a higher or lower price than the standard price set. To estimate how the combination of wages and hours affects total costs, compute the total direct labor variance.

Clearly, this is favorable since theactual hours worked was lower than the expected (budgeted)hours. Note that both approaches—direct labor rate variance calculationand the alternative calculation—yield the same result. An adverse labor rate variance indicates higher labor costs incurred during a period compared with the standard. The other two variances that are generally computed for direct labor cost are the direct labor efficiency variance and direct labor yield variance. Labor rate variance is the difference between the expected cost of labor and the actual cost of labor.

If a company brings in outside labor, such as temporary workers, this can create a favorable labor rate variance because the company is presumably not paying their benefits. The labor efficiency variance calculation presented previously shows that 18,900 in actual hours worked is lower than the 21,000 budgeted hours. Clearly, this is favorable since the actual hours worked was lower than the expected (budgeted) hours. Note that both approaches—direct labor rate variance calculation and the alternative calculation—yield the same result. The labor efficiency variance calculation presented previouslyshows that 18,900 in actual hours worked is lower than the 21,000budgeted hours.

If the actual hours worked are less than the standard hours at the actual production output level, the variance will be a favorable variance. A favorable outcome means you used fewer hours than anticipated to make the actual number of production units. If, however, the actual hours worked are greater than the standard hours at the actual production output level, the variance will be unfavorable.

The company used 39,500 direct labor hours and paid a total of $325,875. In this case, the actual hours worked are \(0.05\) per box, the standard hours are \(0.10\) per box, and the standard rate per hour is \(\$8.00\). During June 2022, Bright Company’s workers worked for 450 hours to manufacture 180 units of finished product.

How would this unforeseen pay cutaffect United’s direct labor rate variance? Thedirect labor rate variance would likely be favorable, perhapstotaling close to $620,000,000, depending on how much of thesesavings management anticipated when the budget was firstestablished. If customer orders for a product are not enough to keep the workers busy, the production managers will have to either build up excessive inventories or accept an unfavorable labor efficiency variance. The first option is not in line with just in time (JIT) principle which focuses on minimizing all types of inventories. Excessive inventories, particularly those that are still in process, are considered evil as they generally cause additional storage cost, high defect rates and spoil workers’ efficiency. Due to these reasons, managers need to be cautious in using this variance, particularly when the workers’ team is fixed in short run.

A labor standard may assume that a certain job classification will perform a designated task, when in fact a different position with a different pay rate may be performing the work. 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. Figure 10.7 contains some possible explanations for the laborrate variance (left panel) and labor efficiency variance (rightpanel).

In such situations, a better idea may be to dispense with direct labor efficiency variance – at least for the sake of workers’ motivation at factory floor. However, a positive value of direct labor rate variance may not always be good. When low skilled workers are recruited at a lower wage rate, the direct labor rate variance will be favorable however, such workers will likely be inefficient and will generate a poor direct labor efficiency variance. Direct labor rate variance must be analyzed in combination with direct labor efficiency variance. At first glance, the responsibility of any unfavorable direct labor efficiency variance lies with the production supervisors and/or foremen because they are generally the persons in charge of using direct labor force.

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. 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. 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.

Michelle was asked to find out why direct labor and direct materials costs were higher than budgeted, even after factoring in the 5 percent increase in sales over the initial budget. Lynn was surprised to learn that direct labor and direct materials costs were so high, particularly since actual materials used and actual direct labor hours worked were below budget. 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.

  1. Labor efficiency variance arises when the actual hours worked vary from standard, resulting in a higher or lower standard time recorded for a given output.
  2. Another element this company and others must consider is a direct labor time variance.
  3. In order to keep the overall direct labor cost inline with standards while maintaining the output quality, it is much important to assign right tasks to right workers.
  4. We have demonstrated how important it is for managers to be aware not only of the cost of labor, but also of the differences between budgeted labor costs and actual labor costs.
  5. The unfavorable will hit our bottom line which reduces the profit or cause the surprise loss for company.

Primarily, it reviews the differences between the expected costs of labor and the actual costs of labor. It can also aid the planning and development of new budgets and serve as a means of gaining information on company performance. We actually paid $46,500 for labor for which we expected to pay $41,850.

We have demonstrated how important it is for managers to be aware not only of the cost of labor, but also of the differences between budgeted labor costs and actual labor costs. This awareness helps managers make decisions that protect the financial health of their companies. Jerry (president and owner), Tom (sales manager), Lynn(production manager), and Michelle (treasurer and controller) wereat the meeting described at the opening of this chapter. Michellewas asked to find out why direct labor and direct materials costswere higher than budgeted, even after factoring in the 5 percentincrease in sales over the initial budget.

So as we discussed, we can analyze the variance for labor efficiency by using the standard cost variance analysis chart on 10.3. The actual hours used can differ from the standard hours because of improved efficiencies in production, carelessness or inefficiencies in production, or poor estimation when creating the standard usage. Reporting the absolute value of the number (without regard to the negative sign) and an Unfavorable label makes this easier for management to read. We can also see that this is an unfavorable variance just based on the fact that we paid $20 per hour instead of the $18 that we used when building our budget.

In this case, the actual rate per hour is $9.50, the standard rate per hour is $8.00, and the actual hours worked per box are 0.10 hours. This is an unfavorable outcome because the actual rate per hour was more than the standard rate per hour. As a result of this unfavorable outcome information, the company may consider using cheaper labor, changing the production process to be more efficient, or increasing prices to cover labor costs. In this case, the actual rate per hour is \(\$9.50\), the standard rate per hour is \(\$8.00\), and the actual hours worked per box are \(0.10\) hours. Standard costs are used to establish theflexible budget for direct labor. The flexible budget is comparedto actual costs, and the difference is shown in the form of twovariances.

A positive DLRV would be unfavorable whereas a negative DLRV would be favorable. Commonly used direct labor variance formulas include the direct labor rate variance and the direct labor efficiency variance. Doctors, for example, have a time allotment for a physical exam and base their fee on the expected time. Insurance companies pay doctors according to a set schedule, so they set the labor standard. They pay a set rate for a physical exam, no matter how long it takes. If the exam takes longer than expected, the doctor is not compensated for that extra time.

Managers can better address this situation if they have a breakdown of the variances between quantity and rate. Specifically, knowing the amount and direction of the difference for each can help them take targeted measures forimprovement. As mentioned earlier, the cause of one variance might influenceanother variance. For example, many of the explanations shown inFigure 10.7 might also apply to the favorable materials quantityvariance. Note that in contrast to direct labor, indirect labor consists of work that is not directly related to transforming the materials into finished goods. Examples include salaries of supervisors, janitors, and security guards.

This math results in a favorable variance of $4,800, indicating that the company saves $4,800 in expenses because its employees work 400 fewer hours than expected. The difference between the standard cost of direct labor and the actual hours of direct labor at standard rate equals the direct labor quantity variance. The DL rate variance is unfavorable if the actual rate per hour is higher than the standard rate.

When a company makes a product and compares the actual labor cost to the standard labor cost, the result is the total direct labor variance. In this case, the actual hours worked are 0.05 per box, the standard hours are 0.10 per box, and the standard rate per hour is $8.00. This is a favorable outcome because the actual hours worked were less than the standard hours expected. If the actual rate of pay per hour is less than the standard rate of pay per hour, the variance will be a favorable variance. If, however, the actual rate of pay per hour is greater than the standard rate of pay per hour, the variance will be unfavorable.

Doctors know the standard and try to schedule accordingly so a variance does not exist. If anything, they try to produce a favorable variance by seeing more patients product owner vs product manager in a quicker time frame to maximize their compensation potential. The combination of the two variances can produce one overall total direct labor cost variance.

Standard rates are developed by the companies’ human resources and engineering departments and are based on several factors. There are a number of possible causes of a labor rate variance, which are noted below. Direct labor efficiency variance pertain to the difference arising from employing more labor hours than planned. Labor hours used directly upon raw materials to transform them into finished products is known as direct labor.

The 21,000 standard hours are the hours allowed given actualproduction. For Jerry’s Ice Cream, the standard allows for 0.10labor hours per unit of production. Thus the 21,000 standard hours(SH) is 0.10 hours per unit × 210,000 units produced. If we compute for the actual rate per hour used (which will be useful for further analysis later), we would get $8.25; i.e. $325,875 divided by 39,500 hours. The direct labor (DL) variance is the difference between the total actual direct labor cost and the total standard cost.

As with direct materials variances, all positive variances are unfavorable, and all negative variances are favorable. The labor rate variance calculation presented previously shows the actual rate paid for labor was $15 per hour and the standard rate was $13. This results in an https://www.bookkeeping-reviews.com/ unfavorable variance since the actual rate was higher than the expected (budgeted) rate. The difference column shows that 100 extra hours were used vs. what was expected (unfavorable). It also shows that the actual rate per hour was $0.50 lower than standard cost (favorable).

An overview of these two types of labor efficiency variance is given below. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. An error in these assumptions can lead to excessively high or low variances. 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.

In this case, the actual rate per hour is $7.50, the standard rate per hour is $8.00, and the actual hour worked is 0.10 hours per box. This is a favorable outcome because the actual rate of pay was less than the standard rate of pay. As a result of this favorable outcome information, the company may consider continuing operations as they exist, or could change future budget projections to reflect higher profit margins, among other things. To compute the direct labor quantity variance, subtract the standard cost of direct labor ($48,000) from the actual hours of direct labor at standard rate ($43,200).

The difference due to actual amount paid and the standard rate per hour while the time spends during production remains the same. As stated earlier, variance analysis is the control phase of budgeting. This information gives the management a way to monitor and control production costs.

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