Companies prepare budgets that plan how long it should take employees to produce a specific number of products. However, the actual result may not always be close to that forecast. Therefore, companies must calculate variance to understand why differences exist. One variance they might calculate is for direct labour efficiency.
What is the Direct Labor Efficiency Variance?
The direct labour efficiency variance is a critical component of variance analysis within cost accounting. Variance analysis involves comparing actual to expected or standard performance to understand the reasons behind deviations and take appropriate actions. The direct labour efficiency variance measures the difference between the actual hours of direct labour used in production and the standard hours based on the production level achieved.
The direct labour efficiency variance provides insights into the performance of direct labour employees. Similarly, it offers companies the opportunity to optimize their production processes, control costs, and enhance overall operational efficiency. Simply, it measures how efficiently a company utilizes its direct labour compared to the standard labour hours.
How to calculate the Direct Labor Efficiency Variance?
Companies can calculate the direct labour efficiency variance using the following formula.
Direct labor efficiency variance = (Actual hours – Standard hours) × Standard rate
The above formula for direct labour efficiency variance includes the following components.
- Actual hours: The actual number of hours worked by direct labour employees
- Standard hours: The number of hours that should have been used based on the standard production level and the standard time required to complete a unit of production
- Standard rate: The standard labour rate per hour
How to interpret the Direct Labor Efficiency Variance?
The above formula for direct labour efficiency variance may result in a positive or negative result. If it’s zero, it means no variance exists between the actual hours and standard hours for the specific activity level. However, that is rarely the case. Nonetheless, the interpretation of positive and negative results from the direct labour efficiency variance is below.
Positive Variance
If the direct labour efficiency variance is positive, it suggests that the actual hours worked were fewer than the standard hours. It can indicate that the employees are working more efficiently than expected. The positive variance is often seen as a favourable outcome, as it can lead to cost savings.
Negative Variance
If the direct labour efficiency variance is negative, it implies the actual hours worked are higher than the standard hours. It indicates that the employees are less efficient than expected. An unfavourable variance can lead to increased labour costs and prompts management to investigate the reasons behind the inefficiency.
Example
Red Co has established a standard of 2 hours to produce one product. The standard labour rate is $15 per hour. However, during the production of 1,000 units, the actual time taken by the direct labour employees was 2.2 hours per item, and the actual labour rate was $14 per hour.
Based on the above information, the direct labour efficiency variance for Red Co. will be as follows.
Direct labor efficiency variance = (Actual hours – Standard hours) × Standard rate
Direct labor efficiency variance = (2.2 hours – 2 hours) × $15 per hour
Direct labor efficiency variance = $3 per unit
Conclusion
Direct labour efficiency variance measures the difference between actual and standard hours worked for a specific activity level. It gauges how efficiently a company uses its labour to produce items. The formula for direct labour efficiency variance considers three components. Once they are available, companies can calculate this variance for any activity level.
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