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

May 16, 2023 –
From Ukombozi Review (Kenya)

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Jerry (president and owner), Tom (sales manager), Lynn
(production manager), and Michelle (treasurer and controller) were
at the meeting described at the opening of this chapter. 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. 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. The labor efficiency variance calculation presented previously
shows that 18,900 in actual hours worked is lower than the 21,000
budgeted 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. An unfavorable outcome means you used more hours than anticipated to make the actual number of production units.

Additionally full details of the journal entry required to post the variance, standard cost and actual cost can be found in our direct labor variance journal tutorial. Direct labour efficiency variance measures the difference between actual and standard hours worked for a specific activity level. The formula for direct labour efficiency variance considers three components. Once they are available, companies can calculate this variance for any activity level.

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Four hours are needed to complete a finished product and the company has established a standard rate of $8 per hour. 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).

With either of these formulas, the actual rate per hour refers to the actual rate of pay for workers to create one unit of product.
Because of the cost principle, the financial statements for DenimWorks report the company’s actual cost.
This lesser quality denim causes the production to be a bit slower as workers spend additional time working around flaws in the material.
There is a favorable direct labor efficiency variance when the actual hours used is less than the anticipated or standard hours.

Nearshoring, the process of relocating operations closer to home, has emerged as an explosive opportunity for American and Mexican companies to collaborate like never before. An unfavorable variance means that labor efficiency has worsened, and a favorable variance means that labor efficiency has increased. Figure 10.7 contains some possible explanations for the labor
rate variance (left panel) and what is days inventory outstanding labor efficiency variance (right
panel). Let’s assume further that instead of the actual hours per unit of 0.4, Techno Blue manufactures was able to produce at 0.25 actual hours per unit. The most common causes of labor variances are changes in employee skills, supervision, production methods capabilities and tools. As mentioned earlier, the cause of one variance might influence another variance.

The direct labor efficiency variance can also be expressed as a percentage of the standard labor cost, to facilitate comparison and benchmarking. In this case, the actual hours worked per box are 0.20, the standard hours per box are 0.10, and the standard rate per hour is $8.00. This is an unfavorable outcome because the actual hours worked were more than the standard hours expected per box.

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. Let’s also assume that the quality of the low-cost denim ends up being slightly lower than the quality to which your company is accustomed. This lesser quality denim causes the production to be a bit slower as workers spend additional time working around flaws in the material. In addition to this decline in productivity, you also find that some of the denim is of such poor quality that it has to be discarded. Further, some of the finished aprons don’t pass the final inspection due to occasional defects not detected as the aprons were made. In the wake of the COVID-19 pandemic and escalating tensions with China, American companies are actively seeking alternatives to mitigate their supply chain risks and reduce dependence on Chinese manufacturing.

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This includes work performed by factory workers and machine operators that are directly related to the conversion of raw materials into finished products. 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. Based on the above information, the direct labour efficiency variance for Red Co. will be as follows.

The first question to ask is “Why do we have this unfavorable variance of $2,000?” If it was caused by errors and/or inefficiencies, it cannot be assigned to the inventory. Errors and inefficiencies are never considered to be assets; therefore, the entire amount must be expensed immediately. 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. An example is when a highly paid worker performs a low-level task, which influences labor efficiency variance. Hence, variance arises due to the difference between actual time worked and the total hours that should have been worked. Watch this video presenting an instructor walking through the steps involved in calculating direct labor variances to learn more.

Labor Costs in Service Industries

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. Note that in contrast to direct labor, indirect labor consists of work that is not directly related to transforming the materials into finished goods. If this cannot be done, then the standard number of hours required to produce an item is increased to more closely reflect the actual level of efficiency.

What is the Direct Labor Efficiency Variance?

If there is no difference between the standard rate and the actual rate, the outcome will be zero, and no variance exists. This shows that our labor costs are over budget, but that our employees are working faster than we expected. Even though the answer is a negative number, the variance is favorable because employees worked more efficiently, saving the organization money.

The direct labor variance measures how efficiently the company uses labor as well as how effective it is at pricing labor. There are two components to a labor variance, the direct labor rate variance and the direct labor time variance. Jerry (president and owner), Tom (sales manager), Lynn (production manager), and Michelle (treasurer and controller) were at the meeting described at the opening of this chapter. 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. For Jerry’s Ice Cream, the standard allows for 0.10 labor hours per unit of production.

As a result of these cost cuts, United was
able to emerge from bankruptcy in 2006.

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. 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?

Let’s assume that the Direct Materials Usage Variance account has a debit balance of $2,000 at the end of the accounting year. A debit balance is an unfavorable balance resulting from more direct materials being used than the standard amount allowed for the good output. The labor efficiency in hours is the difference between the total actual hours and standard hours. The total labor actual and standard hours were calculated as per step 1 and step 2 above.

How to interpret the Direct Labor Efficiency Variance?

If the outcome is unfavorable, the actual costs related to labor were more than the expected (standard) costs. If the outcome is favorable, the actual costs related to labor are less than the expected (standard) costs. Companies can calculate the direct labour efficiency variance using the following formula. If $2,000 is an insignificant amount relative to a company’s net income, the entire $2,000 unfavorable variance can be added to the cost of goods sold. Accounting professionals have a materiality guideline which allows a company to make an exception to an accounting principle if the amount in question is insignificant.

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