Labor Rate Variance Overview
The labor rate variance measures the difference between the actual and expected cost of labor. It is calculated as the difference between the actual labor rate paid and the standard rate, multiplied by the number of actual hours worked. The formula is:
(Actual rate - Standard rate) x Actual hours worked = Labor rate variance
An unfavorable variance means that the cost of labor was more expensive than anticipated, while a favorable variance indicates that the cost of labor was less expensive than planned. This information can be used for planning purposes in the development of budgets for future periods, as well as a feedback loop back to those employees responsible for the direct labor component of a business. For example, the variance can be used to evaluate the performance of the company's bargaining staff in setting hourly rates with the company union for the next contract period.
There are a number of possible causes of a labor rate variance. For example:
- Incorrect standards. 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.
- Pay premiums. The actual amounts paid may include extra payments for shift differentials or overtime. For example, a rush order may require the payment of overtime in order to meet an aggressive delivery date.
- Staffing variances. 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. For example, the only person available to do the work may be very skilled, and therefore highly compensated, even though the underlying standard assumes that a lower-level person (at a lower pay rate) should be doing the work. Thus, this issue is caused by a scheduling problem.
- Component tradeoffs. The engineering staff may have decided to alter the components of a product that requires manual processing, thereby altering the amount of labor needed in the production process. For example, a business may use a subassembly that is provided by a supplier, rather than using in-house labor to assemble several components.
- Benefits changes. If the cost of labor includes benefits, and the cost of benefits has changed, then this impacts the variance. 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 standard labor rate is developed by the human resources and industrial engineering employees, and is based on such factors as:
- The expected mix of pay levels among the production staff
- The amount of overtime likely to be incurred
- The amount of new hiring at different pay rates
- The number of employees retiring
- The number of promotions into higher pay levels
- The outcome of contract negotiations with any unions representing the production staff
An error in these assumptions can lead to excessively high or low variances.
In situations where goods are produced in small volume or on a customized basis, there may be little point in tracking this variance, since the work environment makes it difficult to create standards or reduce labor costs.
Direct Labor Rate Variance Example
The human resources manager of Hodgson Industrial Design estimates that the average labor rate for the coming year for Hodgson's production staff will be $25/hour. This estimate is based on a standard mix of personnel at different pay rates, as well as a reasonable proportion of overtime hours worked.
During the first month of the new year, Hodgson has difficulty hiring a sufficient number of new employees, and so must have its higher-paid existing staff work overtime to complete a number of jobs. The result is an actual labor rate of $30/hour. Hodgson's production staff worked 10,000 hours during the month. Its direct labor rate variance for the month is:
($30/hr Actual rate - $25/hour Standard rate) x 10,000 hours
= $50,000 Direct labor rate variance