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. However, the efficiency variance can also be applied to services. For example, an efficiency variance can be calculated for the number of hours required to complete an audit versus the budgeted amount.
The efficiency variance is usually calculated separately for each of the following costs:
Direct materials. This is called the material yield variance, and is calculated as: (Actual unit usage - Standard unit usage) x Standard cost per unit
Direct labor. This is called the labor efficiency variance, and is technically related more to material usage than to efficiency. It is calculated as: (Actual hours - Standard hours) x Standard rate
Overhead. This is known as the overhead efficiency variance, and is calculated as: (Actual hours - Standard hours) x Standard overhead rate
Another key component of any efficiency variance is the basis upon which the standard is set. For example, the number of units of direct material could assume the absence of scrap, when in fact a standard amount of scrap is normally realized, causing a continuing negative efficiency variance. This would be a theoretical standard, that can only be met if the circumstances are optimal. Or, a realistic standard could be used that incorporates reasonable inefficiency levels, and which comes close to actual results. Generally, the latter approach is preferable, if only to avoid a depressing series of negative efficiency variances.