Labor Efficiency Variance
Labor efficiency variance is the difference between the time we plan and the actual time spent in production. It is the difference between the actual hours spent and the budgeted hour that the company expects to take to produce a certain level of output. This variance does not consider the change of standard and actual rate. The actual time can be shorter or longer due to various reasons, so it will create a favorable and unfavorable variance. In the end, it will impact our bottom line.
Before production, the company needs to prepare the product standard cost. It is the predetermined cost of one unit of production. The standard cost usually includes variable costs such as direct material and direct labor. In order to make a proper estimate, management estimates the standard cost base on the unit of labor and material. It depends on the weight and time spent by workers. For example, one unit of cloth requires 0.1Kg of raw material and 1 hour of labor.
To arrive at the total cost per unit, we need to multiply the unit of material and labor with the standard rate. It is the estimated price of material and labor that a company need to pay to supplier and workers.
Labor efficiency variance happens when the price per direct labor remains the same but the time spends to produce one unit different from standard costing. Management makes the wrong estimate of the time spent in production or the actual time increase due to various reasons. When the actual time spends different from the estimation, it will lead to a difference of the actual cost and the standard cost. It can be both favorable (actual cost less than the estimate) or unfavorable, the actual is higher than estimate.
We may think that only unfavorable variance is required to solve as it impacts the profit at the end of the year. It is correct that we need to solve the unfavorable variance, however, the favorable variance also required to investigate too. Favorable variance means that the actual time is less than the budget, so we need to reassess our budgeting method. When we set the budget too high, it will impact the total cost as well as the selling price. As a result, we may lose some sales due to the high selling price.
The company does not want to see a significant variance even it is favorable or unfavorable.
Formula
Labor efficiency variance = (Actual hour * Standard rate) – (Standard hour * Standard rate)
Process of Calculation
| 1. Actual working hours | It is the total of actual working hours which already happen. For a huge company that produces different products at the same time, it may require the system to collect all the information. |
| 2. Standard cost of actual hour | It is the cost of actual hour, which is based on the standard rate. The company usually set standard cost at the beginning of the year. It is the actual working multiplied by the standard rate. |
| 3. Standard hour | It is the time which we expect to spend based on the units produce. |
| 4. Standard cost of standard hour | We take the standard hour in step 3 and multiply by the standard rate per hour. |
| 5. Variance | Compare the result from step 2 with step 4. |
Labor Efficiency Variance Example
Company A manufacture shirt, base on experience, the company set the standard cost as following:
- Direct labor: 5 hours per unit
- Direct labor rate: $ 10 per hour
During the year, the company spends 200,000 hours producing 35,000 of output. The actual payment to the worker is $ 10 per hour.
Standard hour = 35,000 unit * 5 hours = 175,000 hours
Labor efficiency variance = (190,000 hours * $ 10) – (200,000 hours * $ 10) = $ 250,000 unfavorable because the company spend more time than the expectation.
Based on the standard cost, company spends 5 hours per unit of production. However, they spend 5.71 hours per unit (200,000 hours /35,000 units) on the actual production. Due to the unexpected increase in actual cost, the company’s profit will decrease. Management needs to investigate and solve the issue by reducing the actual time spend or revising the standard cost.
Cause of Labor Efficiency Variance
| Main causes of labor efficiency variance | |
|---|---|
| Machine break down | The old and outdated machines will increase breakdown time, and it will increase production time as well. |
| Unskill worker | The new workers will not be able to perform the task as quick as the experienced workers. If the company has a high turnover, there will be more new workers which impact the working efficiency. |
| Ineffective process | The whole process itself may cause the idle time, the workers need to wait for tasks to finish. They should be doing something else during this time. |
| Unreasonable idle time | During the working hour, there may be some unusual idle time such as swift change, material movement, and so on. |
| Pressure from price deduction | The manager may under pressure to cut the price to compete in the market, so he keeps reducing the working time to the level which will never happen. |
How to Solve Unfavorable Variance?
| Solutions to unfavorable variance | |
|---|---|
| Repair Machine | The company should double-check the conditions of the machine. If they are too old, we should consider overhauling or replace them. The technical support should be standing by in order to fix in case of an unexpected breakdown. |
| Train Staffs | The staff should receive enough training to prevent any risk of error, which will increase the time spend. |
| Reduce non-value-added activities | Any unnecessary activities should be removed from the process as they will not contribute to the production. |
| Redesign process | The engineering needs to go through all the processes and if there is any inefficiency, they should consider redesigning it. |
| Use high-quality material | The low quality is cheaper but it may increase the time spent and wastage, which is more expensive than cost-saving. The company should consider using high-quality material and save time. |
| Reduce idle time | We should check the root cause of unusual idle time and minimize it. |
| Double-check our standard hour | If we have done all the steps above and there are still huge variances, we should get back to check our standard hour, which may set too low, and it is impossible to achieve. |