The direct labor efficiency variance is one of the main standard costing variances, and results from the difference between the standard quantity and the actual quantity of labor used by a business during production. The variance is sometimes referred to as the direct labor usage variance or the direct labor quantity variance.
Together with the price variance, the efficiency variance forms part of the total direct labor variance.
The variance is calculated using the direct labor efficiency variance formula, which takes the difference between the standard quantity and the actual quantity of labor used, and multiplies this by the standard price per unit of labor, often referred to as the standard rate.
Example of Direct Labor Efficiency Variance
Suppose, for example, a manufacturer sets the standard labor rate at 15.00 per hour, and the standard quantity of labor needed to manufacture one item at 0.50 hours.
On a production run, they manufacture 500 items and find they have used 230 hours of labor. The direct labor efficiency variance is given as follows:
Direct labor efficiency variance = (Standard quantity - Actual quantity) x Standard rate. Direct labor efficiency variance = (500 x 0.50 - 230) x 15.00 Direct labor efficiency variance = 300
This is summarized in the table below:
In this example, the direct labor efficiency variance is positive (favorable), as the actual amount of labor used (230) was less than the standard amount of labor (250), and therefore it cost the business less to produce the 500 items for than it should have done. This variance would be posted as a credit to the direct labor efficiency variance account. Full details of the journal entry required to post the variance, standard cost and actual cost can be found in our direct labor variance journal tutorial.
Clearing the Direct Labor Efficiency Variance Account
The financial statements of the business must ultimately show the actual costs incurred by the business, and at the end of an accounting period, having investigated the direct labor efficiency variances using the variance report, the balance on the direct labor efficiency variance account needs to be cleared using the rules discussed in our standard costing and variance analysis tutorial and are available for download in PDF format here. These rules can be summarized as follows:
- For small, insignificant direct labor efficiency variances it is not worth the time and effort apportioning the balance, so it is simply transferred to the cost of goods sold account.
- Larger unfavorable variances (debit balances) which have resulted from errors and inefficiencies in the business, are also transferred to the cost of goods sold account, as apportioning them to an inventory account would incorrectly increase the value of the inventory.
- All other significant direct labor efficiency variances (debit or credit balances) are split between inventory accounts and the cost of goods sold account in proportion to the amount of standard labor cost remaining on that account.
Variance Apportionment Example
In the example used above the direct labor efficiency variance was favorable leaving a credit balance of 300 on the variance account. Assume for simplicity that this was the only direct labor efficiency variance for the year.
If the balance is considered insignificant in relation to the size of the business, then it can simply be transferred to the cost of goods sold account.
|Direct labor efficiency variance||300|
|Cost of goods sold||300|
If however, it is considered to be significant in relation to the size of the business, then the variance needs to be analyzed between the inventory accounts (work in process, and finished goods) and the cost of goods sold account.
Suppose for example, 40% of the standard labor cost remained in the work in process inventory, and 60% had been used in production and the items sold, then the direct labor efficiency variance account balance needs to be split as follows:
|Work in process inventory||40%||120|
|Cost of goods sold||60%||180|
And the bookkeeping journal to post the transaction to clear the direct labor variance account would be as follows:
|Direct labor efficiency variance||300|
|Work in process inventory inventory||120|
|Cost of goods sold account||180|
The credit balance on the direct labor efficiency variance account (300) has now been split between the work in process inventory account (120), and the cost of goods sold account (180), reducing both accounts by the appropriate amount, and clearing the variance account balance.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.