Labor Rate Variance
Labor rate variance is the difference between actual cost of direct labor and its standard cost. The difference due to actual amount paid and the standard rate per hour while the time spends during production remains the same.
The variance can be favorable and unfavorable. Favorable when the actual labor cost per hour is lower than standard rate. It means the direct labor cost lower than expected. On the other hand, unfavorable mean the actual labor cost is higher than expected.
Both favorable and unfavorable must be investigated and solved. The unfavorable will hit our bottom line which reduces the profit or cause the surprise loss for company. The favorable will increase profit for company, but we may lose some customers due to high selling price which cause by overestimating the labor standard rate. However, we do not need to investigate if the variance is too small which will not significantly impact the decision making.
This variance occurs when the time spends in production is the same between budget and actual while the cost per hour change. We assume that the actual hour per unit equal to the standard hour but we need to pay higher or lower due to various reasons.
Formula
Process of Labor Rate Variance Calculation
| 1. Calculate actual cost | The company can get this figure from their actual payment to the workers. It is the actual hour multiply by actual rate. |
| 2. Calculate the standard cost of the actual hour | We calculate this by using the actual hour at the standard rate per hour. The standard rate is the cost which we expect to pay to the workers per hour. |
| 3. Calculate variance | We can get a difference by comparing both figures above. It can be favorable or unfavorable (adverse).
|
Example
The company A manufacture shirt, the standard cost shows that one unit of production requires 2 hours of direct labor at $5 per hour.
During the year, company paid $ 200,000 for 80,000 working hours.
The company produces 170,000 units of shirts.
Solution
Actual labor rate = $ 200,000 / 80,000 hours = $ 2.5 per hour
Labor rate variance = (80,000 hour *$ 2.5) – (80,000 hour * $ 2) = $ 40,000 unfavorable.
The company pays $ 40,000 more than expected.
What are the causes of unfavorable labor rate variance?
| Cause of unfavorable labor rate variance | |
|---|---|
| Overtime | In some cases, the company may want to complete the order in a short time to satisfy the customers, so they require the workers to work overtime. The overtime rate is higher than normal rate (1.5 times for the US). |
| Law requirement | The government may raise the minimum rate, which will impact our rate if we use the lowest rate. |
| High Skill worker | The company may hire high skill workers who will not accept the low rate. However, it will have a positive impact on the efficiency variance. |
| Pressure from labor union | The workers in company usually have labor union representative which seeking for the additional benefit for the workers. They can put pressure on company and require a higher wage. |
| Decrease of labor supply in market | A huge increase in foreign investments will require a lot of workers and they will provide high wages to attract the workers. The workers are highly likely to move for a better rate, so the company needs to increase the existing rate too. |
How to solve unfavorable labor rate variance?
| Solutions to unfavorable labor rate variance | |
|---|---|
| Reduce overtime | Manager needs to minimize the overtime by making proper production plan and reserve some stock for the unexpected order. However, we can’t eliminate the overtime as it may impact our customers, but we need to manage it. |
| Low wage countries | In recent years, most of the giant companies have moved their factories to third world countries where the labor cost is very low. |
| Staff training | We can have skillful workers with reasonable wage by providing training to the unskilled workers. However, there is also a risk when they move to other company. |