Labor Efficiency Variance
The labor efficiency variance measures the ability to utilize labor in accordance with expectations. The variance is useful for spotlighting those areas in the production process that are using more labor hours than anticipated. This variance is calculated as the difference between the actual labor hours used to produce an item and the standard amount that should have been used, multiplied by the standard labor rate. If the variance outcome is unfavorable, there will likely to be a review by industrial engineers to see if the underlying process can be improved to reduce the number of production hours required, using such means as:
- A simplified product design to reduce assembly time
- A reduction in the amount of scrap produced by the process
- Increasing the amount of automation
- Altering the work flow
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.
The formula is:
(Actual hours - Standard hours) x Standard rate = Labor efficiency variance
An unfavorable variance means that labor efficiency has worsened, and a favorable variance means that labor efficiency has increased.
The standard number of hours represents the best estimate of a company's industrial engineers regarding the optimal speed at which the production staff can manufacture goods. This figure can vary considerably, based on assumptions regarding the setup time of a production run, the availability of materials and machine capacity, employee skill levels, the duration of a production run, and other factors. Thus, the multitude of variables involved makes it especially difficult to create a standard that you can meaningfully compare to actual results.
There are a number of possible causes of a labor efficiency variance. For example:
- Instructions. The employees may not have received written work instructions.
- Mix. The standard assumes a certain mix of employees involving different skill levels, which does not match the actual staffing.
- Training. The standard may be based on an assumption of a minimum amount of training that employees have not received.
- Work station configuration. A work center may have been reconfigured since the standard was created, so the standard is now incorrect.
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.
Labor Efficiency Variance Example
During the development of its annual budget, the industrial engineers of Hodgson Industrial Design decide that the standard amount of time required to produce a green widget should be 30 minutes, which is based on certain assumptions about the efficiency of Hodgson's production staff, the availability of materials, capacity availability, and so forth. During the month, widget materials were in short supply, so Hodgson had to pay production staff even when there was no material to work on, resulting in an average production time per unit of 45 minutes. The company produced 1,000 widgets during the month. The standard cost per labor hour is $20, so the calculation of its labor efficiency variance is:
(750 Actual hours - 500 Standard hours) x $20 Standard rate = $5,000 Labor efficiency variance
Episode 111 of the Accounting Best Practices podcast discusses variance analysis. Listen now.
The labor efficiency variance is also known as the direct labor efficiency variance, and may sometimes be called (though less accurately) the labor variance.