Usually, the company’s engineering department sets the standard amount of direct labor-hours needed to complete a product. Engineers may base the direct labor-hours standard on time and motion studies or on bargaining with the employees’ union. The Direct Labor Efficiency Variance occurs when employees use more or less than the standard amount of direct labor-hours to produce a product or complete a process. The direct labor efficiency variance is similar to the direct materials usage variance. In fact, the basic formula is the same, except we use actual direct labor-hours worked for Actual Quantity (AQ), standard direct labor-hours allowed for Standard Quantity (SQ), and the standard direct labor-hour rate per hour for Standard Cost (SC):

Direct Labor Efficiency Variance = (AQ – SQ) x SC

Alternatively, the Direct Labor Efficiency Variance could be calculated by multiplying Actual Quantity of labor hours (AQ) by the Standard Cost (SC) which would give the total cost of labor without regard to the price variance, and from that subtracting from that the product of the Standard Quantity of labor hours (AQ) and the Standard Cost (SC) which would give the total expected cost of labor if the process used those labor hours exactly as expected.

(AQ x SC) – (SQ x SC)

From the payroll records of Boulevard Blanks, we find that line workers (production employees) put in 2,325 hours to make 1,620 bodies, and we see that the total cost of direct labor was $46,500. Based on the time standard of 1.5 hours of labor per body, we expected labor hours to be 2,430 (1,620 bodies x 1.5 hours).

We can already see that we have a favorable variance. It took our workers 2,325 hours to do what we expected them to do in 2,430 hours. Let’s do the calculation:

(AQ – SQ) x SC

(2,325 – 2,430) x $18.00 = -$1,890.00

Alternatively:

(AQ * SC) – (SQ * SC) = (2,325 * $18.00) – (2,430 * $18.00) = $41,850 – $43,740= -$1,890.00

Even though the answer is a negative number, the variance is favorable because employees worked more efficiently, saving the organization money. Notice that using the standard labor rate of $18 per hour and assuming 1,620 bodies produced, we would have expected to pay $43,740 for labor, but because our employees were more efficient than expected, we only paid $41,850 (based on standard cost, not actual). What we have done is to isolate the cost savings from our employees working swiftly from the effects of paying them more or less than expected.

Typically, the hours of labor employed are more likely to be under management’s control than the rates that are paid. For this reason, labor efficiency variances are generally watched more closely than labor rate variances.

Let’s look at the two variances together:

And relate them back to the budget v. actual report:

We can double-check our work by reconciling the two variances to the overall variance in the budget:

(actual quantity x actual cost) – (standard quantity x standard cost)

Again, in reporting to our internal users, we would omit the parentheses that we use in accounting to show a negative amount, since that may confuse non-financial managers who are relying on the report. We would show the variances as follows:

This shows that our labor costs are over budget, but that our employees are working faster than we expected. Remember that the direct labor efficiency variance in this case was negative, showing that if wages had been exactly as we predicted, our labor costs would have come in $1,890 under budget, making it a favorable variance, despite the fact it computes as a negative number.

Before we go on to explore the variances related to indirect costs (manufacturing overhead), check your understanding of the direct labor efficiency variance.