A labor variance arises when the actual expense associated with a labor activity varies (either better or worse) from the expected amount. The expected amount is typically a budgeted or standard amount. The labor variance concept is most commonly used in the production area, where it is called a direct labor variance. This variance can be subdivided into two additional variances, which are:
- Labor efficiency variance. Measures the difference between actual and expected hours worked, multiplied by the standard hourly rate.
- Labor rate variance. Measures the difference between the actual and expected cost per hour, multiplied by the actual hours incurred.
The labor variance can be used in any part of a business, as long as there is some compensation expense to be compared to a standard amount. It can also include a range of expenses, beginning with just the base compensation paid, and potentially also including payroll taxes, bonuses, the cost of stock grants, and even benefits paid.
The use of the labor variance is questionable in a production environment, for two reasons:
- Other costs usually comprise by far the largest part of manufacturing expenses, rendering labor immaterial.
- Direct labor costs have proven to be considerably less than variable, and therefore less subject to change than might be expected, which leaves one to wonder why the variance is being calculated for what is essentially a fixed cost.
The labor variance is particularly suspect when the budget or standard upon which it is based has no resemblance to actual costs being incurred. For example, the engineering department may set labor standards at the theoretically attainable level, which means that actual results will almost never be as good, resulting in an ongoing series of very large unfavorable variances. Alternatively, a manager might use political pressure to artificially increase labor standards; this makes it easy to improve upon the standards, resulting in perpetually favorable variances that artificially enhance the performance of the manager.