Labor variance is an accounting measure used to analyze cost rates and efficiencies connected with the compensation expense of employing staff. It's most often used in manufacturing, where it's referred to as direct labor variance and most frequently calculated using the staff directly responsible for turning raw materials into finished goods.
There are two ways to look at labor variance, either as a difference between the expected and actual cost in dollars, called the labor rate variance, or as a difference between the expected and actual hours worked, called the labor efficiency variance.
Labor Rate Variance = Actual Cost per Hour - Expected Cost per Hour × Current Hours Incurred
Labor Efficiency Variance = Actual Hours Worked - Expected Hours Worked × Standard Hourly Rate
Though it is most commonly used in manufacturing production, labor variance may be applied to any part of a business in which there's a compensation expense that can be compared to some baseline, such as a budget target or previous performance. For short-period reporting, such as weekly or monthly, base compensation costs are usually used to calculate labor expense, but this could also include payroll taxes, bonuses, benefits and even the cost of incentives, such as stock options plans.
Labor rate variance is a costing analysis. As such, it has factors that influence the labor expense for the part of the business for which it is calculated. Any factor that changes the cost per hour can potentially create a labor rate variance. These factors may be internal or external to the company. Internal factors include:
- Amount of overtime paid
- Shift premiums
- Excess staff wages, both from over-staffing and idle hours
- Production downtime
External influences on labor rate variances may be factors such as:
- Fluctuations in worker availability that affect hourly rates
- Local job market conditions
- Labor union influences
- Legislative factors, such as minimum wage changes
Labor efficiency variance downplays the influence of external factors on labor analysis because it uses a standard hourly rate as part of its calculation. A production department may have little ability to control external factors, so labor efficiency variance is an ideal way to analyze changes to labor usage based on factors the department can control. In theory, maximizing production efficiency takes care of itself in the larger picture of overall profitability. In practice, each company can devise its own standard hourly rate, which may not reflect labor levels beyond the scope of internal efficiency.
Factors that typically create labor efficiency variances include:
- Overstaffing and understaffing
- Hours of overtime
- Productivity changes resulting in more or fewer hours used per production unit
Some production environments report labor over short-term periods by way of a balance sheet that includes total direct labor hours and an estimate of cost, using a standard hourly rate. Rather than formally calculating labor variance, it's inferred by changes to these amounts compared to a budget and past performance.