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Labor Efficiency Variance

Labor Efficiency Variance

The labor efficiency variance is an important metric in accounting. The labor efficiency variance measures the efficiency of production at utilizing the labor in accordance with expectations. This helps in highlighting the areas in production which should take the focus of productivity-improving measures. The components that utilize more labor hours than other components are optimized first and then the effort is sequentially moved to other components. This labor efficiency variance can be calculated as the difference between the actual labor hours consumed in producing an item and the standard amount/expected amount that should have been utilized for the product, multiplied by the standard labor rate. If the labor efficiency variance comes out to be unsatisfactory, a review of the process is done by industrial and production engineers. Many a times, whole lines are overhauled in order to ensure a particular minimum variance.

Such reviews might result in one or all of the following:

  • Increased automation driving up the efficiency
  • Changes in product design in order to consume less labor hours
  • An improvement in the amount of wastage, leakage, or scrap in the process.
  • Modifying the process or the work-flow.

The review might also reflect a flaw in the expected value of labor efficiency variance and therefore might highlight the need to increase it to more realistic values.

Following is the formula for calculating the labor efficiency variance:

(Actual labor hours - Standard/expected labor hours) x Standard rate = Labor efficiency variance

An unfavorable variance means that labor efficiency has worsened, and a favorable variance means that labor efficiency has increased.

The standard number of hours is an estimate given by industrial engineers regarding the optimal speed at which the production staff can manufacture goods. This figure can vary considerably among similar production processes and is contingent on setup time of a production run, availability of materials and machine capacity, labor skill levels, the duration of a production run, and other factors. Since it involves a large no. of variables to determine the labor efficiency variance, it is a complex problem to determine the standard number of hours required to complete a task.

Moreover, a low labor efficiency variance might arise from a number of different reasons. Therefore a robust diagnostic mechanism needs to be in place.

  • Communication: The labor may not have been properly communicated about the work. This might include training, expectations and other information.
  • Skill Set: The standard labor hour required is calculated based on assumptions about the skill levels of the employees. In a realistic scenario, employees exhibit a wide range of skills, capability and motivations on different tasks and at different time.
  • Process design: The process itself might be improperly designed and might be different from the assumptions taken while calculating the standard.

Labor Efficiency Variance Example

Let's say the industrial engineers of a company, XYZ, calculated the standard amount of time required to produce a product is 40 minutes. This is based on certain assumptions about the efficiency of XYZ's production staff, the availability of materials, capacity availability etc. Due to lack of supply, so XYZ had to pay employees even when the production was slower than usual. The average production rate increased to 50 mins. A total of 800 units were produced. The standard cost per labor hour is $15. To calculate the labor efficiency variance:

(666.7 Actual hours - 533.3 Standard hours) x $15 Standard rate = $2000.5 Labor efficiency variance

Difficulties Encountered In Labor Efficiency Variance

Most of the times, students commit the mistake of considering the hourly rate in the formula instead of the total no. of hours. In the above example, if we take 40 and 50 mins as the total time, we get erroneous solution. Students must always keep the correct formula in mind. This becomes easy once the student understands the concept in detail and becomes comfortable with it.

Secondly, students struggle to interpret the Variance. A large value might indicate a lot of things and according the problem, a student should be able to identify the right place to look for correction. This could be the product, the process or the standard itself. Student must investigate the issue, eliminating the causes that are surely not the root cause and short listing the possible to causes for further in-depth examination.

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