Direct Labor Rate Variance

The direct labor rate variance is a standard costing measure that shows whether a business paid more or less per hour for direct labor than planned. It is calculated as the difference between the actual hourly rate and the standard hourly rate, multiplied by the actual number of hours worked. It answers the question: given the hours that were actually used, what did the difference in wage rates cost or save?

It is the price side of the total direct labor variance, alongside the direct labor efficiency variance, which measures the effect of using more or fewer hours than allowed. The rate variance is sometimes called the labor price variance, and it is the labor counterpart of the direct materials price variance.

A renovation company plans its jobs assuming carpenters cost $30 an hour. On one job, its regular carpenters are busy, so it brings in a more senior carpenter at $36 an hour. Even if the job takes exactly the planned number of hours, it costs more than expected, because each hour was more expensive.

The rate variance measures that difference. It looks only at the price of each hour, not at how many hours were used, so managers can see whether a cost overrun came from paying higher wages or from the work taking longer.

The variance is calculated as:

• $\text{AR}$ is the actual hourly rate paid, including any premiums charged to direct labor.
• $\text{SR}$ is the standard hourly rate.
• $\text{AH}$ is the actual direct labor hours worked.

A factory's standard rate is $24 an hour. In March its direct workers log 2,150 hours and are paid $50,525, an average of $23.50 an hour. The rate variance is $(23.50 - 24.00) \times 2{,}150 = -1{,}075$. Because the actual rate was lower than standard, this is a $1,075 favorable variance.

The same month's output was 1,000 units with a standard of 2 hours each, so 2,000 standard hours were allowed. The efficiency variance is $(2{,}150 - 2{,}000) \times 24 = 3{,}600$ unfavorable. Together the two give the total labor variance: actual cost of $50,525 minus standard cost of $48,000 equals $2,525 unfavorable, which is $3,600 unfavorable less $1,075 favorable.

In a standard cost system the rate variance is isolated when payroll is charged to production. Work-in-Process Inventory is debited at standard hours times standard rate. A favorable rate variance is recorded as a credit and an unfavorable one as a debit, with Wages Payable credited for the actual payroll. At period-end the variance accounts are normally closed to cost of goods sold, or, if large, spread across inventories and cost of goods sold.

• Skill mix. Using more senior, higher-paid workers than the standard assumes produces an unfavorable variance; using junior staff produces a favorable one.
• Overtime premiums. If overtime premiums are charged to direct labor rather than to overhead, rush periods raise the average rate.
• Wage changes. Pay rises, new union agreements or changes in payroll taxes and benefits included in the rate push actual cost away from standard.
• Labor market conditions. Shortages of skilled workers can force a business to pay more than planned or to hire temporary staff through agencies.
• Outdated standards. A standard rate that was not updated after a general pay increase will produce a variance that reflects the budget, not current decisions.

Responsibility often lies with production managers, who decide which workers are assigned to a job, or with human resources, which negotiates pay. A favorable rate variance is not automatically good news: using less experienced workers may save on wages but lead to longer hours, more scrap and an unfavorable efficiency variance.

Rate variances are most useful where direct labor is a significant and variable cost. In many modern factories, workers are paid a fixed salary regardless of output, and direct labor is small compared with overhead, so the variance carries less information. Like other variances, it also depends on standards being realistic and kept up to date; otherwise managers spend time explaining differences that simply reflect a stale budget. It is best read together with the efficiency variance and with the flexible budget as a whole, as part of the wider budget variance review.

• Institute of Management Accountants