Direct Labor Efficiency Variance

The direct labor efficiency variance is a measure used in standard costing that shows whether a business used more or fewer direct labor hours than it should have for the output it actually produced. It is calculated as the difference between the actual hours worked and the standard hours allowed, multiplied by the standard hourly rate. Because it is priced at the standard rate, it isolates the effect of how efficiently time was used, separate from what each hour cost.

It is one of two parts of the total direct labor variance. The other is the direct labor rate variance, which captures paying more or less per hour than planned. The efficiency variance is sometimes called the labor usage or labor quantity variance, and it is the labor counterpart of the direct materials usage variance.

Suppose a bakery expects a skilled baker to decorate a wedding cake in two hours. If this week's cakes took two and a half hours each, the bakery spent more labor time than planned, even if it paid the baker the normal wage. That extra time has a cost, and the efficiency variance puts a dollar figure on it.

If the cakes were finished faster than expected, the variance would be favorable: the bakery saved time. The point of the measure is to tell managers whether the work itself is going as planned, so they can find out why and act.

The variance is calculated as:

• $\text{AH}$ is the actual direct labor hours worked.
• $\text{SH}$ is the standard hours allowed for the actual output: actual units produced times the standard hours per unit.
• $\text{SR}$ is the standard labor rate per hour.

A factory sets a standard of 2 direct labor hours per unit at $24 an hour. In March it makes 1,000 units, so the standard hours allowed are 2,000. Workers actually log 2,150 hours. The variance is $(2{,}150 - 2{,}000) \times 24 = 3{,}600$. Because more hours were used than allowed, the $3,600 variance is unfavorable. Had the work taken only 1,900 hours, there would be a $2,400 favorable variance.

Note that the standard hours are based on actual output, not on the output originally budgeted. This follows the logic of a flexible budget: performance is judged against what the actual level of production should have required.

In a full standard cost system, Work-in-Process Inventory is charged with standard hours at the standard rate, and variances are recorded in separate accounts. Continuing the example, if the actual payroll was 2,150 hours at $23.50, or $50,525, the entry is:

• Debit Work-in-Process Inventory $48,000 (2,000 hours times $24).
• Debit Direct Labor Efficiency Variance $3,600.
• Credit Direct Labor Rate Variance $1,075 (2,150 hours times $0.50 below standard).
• Credit Wages Payable $50,525.

Unfavorable variances carry debit balances and favorable variances carry credit balances. At the end of the period, small variances are usually closed to cost of goods sold.

• Worker skill and experience. New or poorly trained staff usually take longer than the standard assumes.
• Materials quality. Defective or hard-to-work materials can slow production and cause rework.
• Equipment problems. Breakdowns, slow machines or poor maintenance waste labor time.
• Scheduling and supervision. Idle time waiting for parts, frequent changeovers or weak supervision raise hours.
• Unrealistic standards. If the standard itself is too tight or out of date, the variance reflects the standard rather than performance.

The variance is usually the responsibility of the production manager, but causes often cross departments. A purchasing decision to buy cheaper materials might produce a favorable price variance and an unfavorable labor efficiency variance at the same time, so the two should be read together.

An efficiency variance shows that hours differed from plan, not why. In highly automated plants, direct labor may be a small and largely fixed cost, so the variance says little about overall efficiency. Pressure to avoid unfavorable variances can also encourage rushing work, skipping quality checks or building unneeded inventory to keep hours productive. Many companies therefore combine labor variances with non-financial measures, such as defect rates and on-time delivery, in their management accounting reports.

• Institute of Management Accountants