The direct labor price variance sometimes referred to as the direct labor rate variance, is one of the main standard costing variances, and results from the difference between the standard cost and the actual cost of labor used by a business.
The variance is calculated using the direct labor price variance formula which takes the difference between the standard labor price per unit (standard rate) and the actual labor price per unit (actual rate), and multiplies this by the quantity of units of labor used.
Example of Direct Labor Price Variance
Suppose, for example, a manufacturer sets the standard labor rate at 15.00 per hour.
On a production run they find they have used 230 hours of labor at an actual labor rate of 18.00 per hour. The direct labor price variance for the production run is given as follows:
Direct labor price variance = (15.00 – 18.00) x 230
Direct labor price variance = -690
This is summarized in the table below:
In this example, the direct labor variance is negative (unfavorable), as the actual price per labor hour (18.00) was higher than the standard price (15.00), and therefore the business paid more for the labor than it expected to. This variance would be posted as a debit to the direct labor price 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.
Reasons for the Direct Labor Price Variance
Any major direct labor price variance needs to be investigated by the business in order to find the specific reason for the variation from the expected standard cost, the most common causes include the following:
- The standard labor rate has not been altered to reflect agreed labor rate changes.
- Bonuses, overtime premiums and additional charges have not been included in the standard rate.
- The employees manufacturing the items are on a different pay rate than those on which the standard rate was based.
- An incorrect actual price per hour has been used in the variance calculation
Clearing the Direct Labor Price 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 price variances using the variance report, the balance on the direct labor price 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 price 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 price variances (debit or credit balances) are split between inventory accounts and the cost of goods sold account in proportion to the amount of the standard labor cost remaining on that account.
Variance Apportionment Example
In the example used above the direct labor price variance was unfavorable leaving a debit balance of 690 on the variance account. Assume for simplicity that this was the only direct labor price 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 price variance||690|
|Cost of goods sold||690|
If however, it is considered to be significant in relation to the size of the business, then the direct labor price 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 price variance account balance needs to be split as follows:
|Work in process inventory||40%||276|
|Cost of goods sold||60%||414|
And the bookkeeping journal to post the transaction to clear the direct labor variance account would be as follows:
|Direct labor price variance||690|
|Work in process inventory||276|
|Cost of goods sold account||414|
The debit balance on the direct labor price variance account (690) has now been split between the work in process inventory account (276) and the cost of goods sold account (414) increasing 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 Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years in 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.