Importance and limitation of Direct Labor Rate Variance

Direct Labor Rate Variance:

A direct labor rate variance compares the difference between the actual cost and the standard cost of hours utilized by the direct labor. It is calculated as follows:

(Actual rate – Standard rate) * Actual hours worked = Direct Labor Rate Variance

A variance in cost and management accounting is defined as the difference between budgeted cost/revenue and actual cost/revenue.

This process of variance analysis is performed on all production costs estimated by the production department.

Similarly, at the end of the forecasted year the rate at which direct labor was purchased is compared with the rate the production department estimated would cost them.

Analysis:

A direct labor rate variance can be favorable or unfavorable/adverse. A favorable labor rate variance indicates that the company managed to hire labor at a lower rate than what was budgeted.

This results in reduced manufacturing costs affecting the financial statements positively.

An adverse or unfavorable direct labor rate variance exists when the actual rate paid for direct labor is more than the budgeted rate resulting in a higher manufacturing expense than expected.

An unfavorable direct labor rate variance has an adverse effect on the financial statements of the company.

Importance of Direct Labor Rate Variance:

  • It helps us recognize the causes of a deviation in the labor rate which could be due to various reasons as below:
  • Increase or decrease in the minimum wage rate.
  • Hiring of either skilled labor or unskilled labor which would result in an unfavorable and favorable rate variance respectively.
  • A too high or low rate due to inappropriate planning.
  • Too much pressure of labor union to increase the wage rate.
  • Labor strikes to increase the wage rate.
  • Overtime work performed by labors due to excess demand.
  • A higher outstanding balance of liabilities on the face of financial statements gives a bad impact to the reader. By doing a variance analysis of direct labor rate we can increase our liquidity as per the budget to pay wages and salaries in time and minimize our current liabilities balance.
  • A favorable direct labor variance means more direct labor hours can be utilized within our budget. Hence we can manage our resources better and increase our revenue by efficient utilization of labor.
  • An accurate labor rate variance helps us reduce the costs to a minimum and keep it under budget.
  • A direct labor rate variance can assist in recognizing the trends and changes in the wage rate which would be a plus point for the managers since it gives a better idea of planning and budgeting.
See also  Direct Material Price Variance: Definition, Formula Explanation, Analysis, And Example

Limitations of direct labor rate variance:

  • One of the major cons of the direct labor variance is that it isn’t self-explanatory. After calculation of the difference in labor rate variance the management also needs to analyze the reason behind this deviation which could be a tiresome task in a huge business.
  • There is no defined threshold of materiality of the variance which could make it strenuous to decide whether an action must be taken against reducing or increasing the rate of labor or the number of labor hired.
  • A lot of judgment is involved in the entire process which could lead to several miscalculations and wrong decisions.
  • Variance analysis usually focuses on the past rather than the future. And a direct labor rate variance accounts for the past budget done by the company and may become a hurdle in future progress and plans if the managers kept on “wishing” on making the right decision in the past because the labor could have been managed more efficiently.
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