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Principles of Accounting, Volume 2: Managerial Accounting

8.3 Compute and Evaluate Labor Variances

Principles of Accounting, Volume 2: Managerial Accounting8.3 Compute and Evaluate Labor Variances
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  1. Preface
  2. 1 Accounting as a Tool for Managers
    1. Why It Matters
    2. 1.1 Define Managerial Accounting and Identify the Three Primary Responsibilities of Management
    3. 1.2 Distinguish between Financial and Managerial Accounting
    4. 1.3 Explain the Primary Roles and Skills Required of Managerial Accountants
    5. 1.4 Describe the Role of the Institute of Management Accountants and the Use of Ethical Standards
    6. 1.5 Describe Trends in Today’s Business Environment and Analyze Their Impact on Accounting
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Thought Provokers
  3. 2 Building Blocks of Managerial Accounting
    1. Why It Matters
    2. 2.1 Distinguish between Merchandising, Manufacturing, and Service Organizations
    3. 2.2 Identify and Apply Basic Cost Behavior Patterns
    4. 2.3 Estimate a Variable and Fixed Cost Equation and Predict Future Costs
    5. Key Terms
    6. Summary
    7. Multiple Choice
    8. Questions
    9. Exercise Set A
    10. Exercise Set B
    11. Problem Set A
    12. Problem Set B
    13. Thought Provokers
  4. 3 Cost-Volume-Profit Analysis
    1. Why It Matters
    2. 3.1 Explain Contribution Margin and Calculate Contribution Margin per Unit, Contribution Margin Ratio, and Total Contribution Margin
    3. 3.2 Calculate a Break-Even Point in Units and Dollars
    4. 3.3 Perform Break-Even Sensitivity Analysis for a Single Product Under Changing Business Situations
    5. 3.4 Perform Break-Even Sensitivity Analysis for a Multi-Product Environment Under Changing Business Situations
    6. 3.5 Calculate and Interpret a Company’s Margin of Safety and Operating Leverage
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  5. 4 Job Order Costing
    1. Why It Matters
    2. 4.1 Distinguish between Job Order Costing and Process Costing
    3. 4.2 Describe and Identify the Three Major Components of Product Costs under Job Order Costing
    4. 4.3 Use the Job Order Costing Method to Trace the Flow of Product Costs through the Inventory Accounts
    5. 4.4 Compute a Predetermined Overhead Rate and Apply Overhead to Production
    6. 4.5 Compute the Cost of a Job Using Job Order Costing
    7. 4.6 Determine and Dispose of Underapplied or Overapplied Overhead
    8. 4.7 Prepare Journal Entries for a Job Order Cost System
    9. 4.8 Explain How a Job Order Cost System Applies to a Nonmanufacturing Environment
    10. Key Terms
    11. Summary
    12. Multiple Choice
    13. Questions
    14. Exercise Set A
    15. Exercise Set B
    16. Problem Set A
    17. Problem Set B
    18. Thought Provokers
  6. 5 Process Costing
    1. Why It Matters
    2. 5.1 Compare and Contrast Job Order Costing and Process Costing
    3. 5.2 Explain and Identify Conversion Costs
    4. 5.3 Explain and Compute Equivalent Units and Total Cost of Production in an Initial Processing Stage
    5. 5.4 Explain and Compute Equivalent Units and Total Cost of Production in a Subsequent Processing Stage
    6. 5.5 Prepare Journal Entries for a Process Costing System
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  7. 6 Activity-Based, Variable, and Absorption Costing
    1. Why It Matters
    2. 6.1 Calculate Predetermined Overhead and Total Cost under the Traditional Allocation Method
    3. 6.2 Describe and Identify Cost Drivers
    4. 6.3 Calculate Activity-Based Product Costs
    5. 6.4 Compare and Contrast Traditional and Activity-Based Costing Systems
    6. 6.5 Compare and Contrast Variable and Absorption Costing
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  8. 7 Budgeting
    1. Why It Matters
    2. 7.1 Describe How and Why Managers Use Budgets
    3. 7.2 Prepare Operating Budgets
    4. 7.3 Prepare Financial Budgets
    5. 7.4 Prepare Flexible Budgets
    6. 7.5 Explain How Budgets Are Used to Evaluate Goals
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  9. 8 Standard Costs and Variances
    1. Why It Matters
    2. 8.1 Explain How and Why a Standard Cost Is Developed
    3. 8.2 Compute and Evaluate Materials Variances
    4. 8.3 Compute and Evaluate Labor Variances
    5. 8.4 Compute and Evaluate Overhead Variances
    6. 8.5 Describe How Companies Use Variance Analysis
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  10. 9 Responsibility Accounting and Decentralization
    1. Why It Matters
    2. 9.1 Differentiate between Centralized and Decentralized Management
    3. 9.2 Describe How Decision-Making Differs between Centralized and Decentralized Environments
    4. 9.3 Describe the Types of Responsibility Centers
    5. 9.4 Describe the Effects of Various Decisions on Performance Evaluation of Responsibility Centers
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  11. 10 Short-Term Decision Making
    1. Why It Matters
    2. 10.1 Identify Relevant Information for Decision-Making
    3. 10.2 Evaluate and Determine Whether to Accept or Reject a Special Order
    4. 10.3 Evaluate and Determine Whether to Make or Buy a Component
    5. 10.4 Evaluate and Determine Whether to Keep or Discontinue a Segment or Product
    6. 10.5 Evaluate and Determine Whether to Sell or Process Further
    7. 10.6 Evaluate and Determine How to Make Decisions When Resources Are Constrained
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  12. 11 Capital Budgeting Decisions
    1. Why It Matters
    2. 11.1 Describe Capital Investment Decisions and How They Are Applied
    3. 11.2 Evaluate the Payback and Accounting Rate of Return in Capital Investment Decisions
    4. 11.3 Explain the Time Value of Money and Calculate Present and Future Values of Lump Sums and Annuities
    5. 11.4 Use Discounted Cash Flow Models to Make Capital Investment Decisions
    6. 11.5 Compare and Contrast Non-Time Value-Based Methods and Time Value-Based Methods in Capital Investment Decisions
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  13. 12 Balanced Scorecard and Other Performance Measures
    1. Why It Matters
    2. 12.1 Explain the Importance of Performance Measurement
    3. 12.2 Identify the Characteristics of an Effective Performance Measure
    4. 12.3 Evaluate an Operating Segment or a Project Using Return on Investment, Residual Income, and Economic Value Added
    5. 12.4 Describe the Balanced Scorecard and Explain How It Is Used
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  14. 13 Sustainability Reporting
    1. Why It Matters
    2. 13.1 Describe Sustainability and the Way It Creates Business Value
    3. 13.2 Identify User Needs for Information
    4. 13.3 Discuss Examples of Major Sustainability Initiatives
    5. 13.4 Future Issues in Sustainability
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Thought Provokers
  15. Financial Statement Analysis
  16. Time Value of Money
  17. Suggested Resources
  18. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
  19. Index

In addition to evaluating materials usage, companies must assess how efficiently and effectively they are using labor in the production of their products. Direct labor is a cost associated with workers working directly in the production process. The company must look at both the quantity of hours used and the rate of the labor and compare outcomes to standard costs. Determining efficiency and effectiveness of labor leads to individual labor variances. A company can compute these labor variances and make informed decisions about labor operations based on these differences.

Fundamentals of Direct Labor Variances

The direct labor variance measures how efficiently the company uses labor as well as how effective it is at pricing labor. There are two components to a labor variance, the direct labor rate variance and the direct labor time variance.

Direct Labor Rate Variance

The direct labor rate variance compares the actual rate per hour of direct labor to the standard rate per hour of labor for the hours worked. The direct labor rate variance is calculated using this formula:

Direct Labor Rate Variance equals (Actual Hours Worked times Actual Rate per Hour) minus (Actual Hours Worked times Standard Rate per Hour).

Factoring out the actual hours worked from both components of the formula, it can be rewritten as

Direct Labor Rate Variance equals (Actual Rate per Hour minus Standard Rate per Hour) times Actual Hours Worked.

With either of these formulas, the actual rate per hour refers to the actual rate of pay for workers to create one unit of product. The standard rate per hour is the expected rate of pay for workers to create one unit of product. The actual hours worked are the actual number of hours worked to create one unit of product. If there is no difference between the standard rate and the actual rate, the outcome will be zero, and no variance exists.

If the actual rate of pay per hour is less than the standard rate of pay per hour, the variance will be a favorable variance. A favorable outcome means you paid workers less than anticipated. If, however, the actual rate of pay per hour is greater than the standard rate of pay per hour, the variance will be unfavorable. An unfavorable outcome means you paid workers more than anticipated.

The actual rate can differ from the standard or expected rate because of supply and demand of the workers, increased labor costs due to economic changes or union contracts, or the ability to hire employees at a different skill level. Once the manufacturer makes the products, the labor costs will follow the goods through production, so the company should evaluate how the difference between what it expected to happen and what actually happened will affect all the goods produced using these particular labor rates.

Let us again consider Connie’s Candy Company with respect to labor. Connie’s Candy establishes a standard rate per hour for labor of $8.00. Each box of candy is expected to require 0.10 hours of labor (6 minutes). Connie’s Candy found that the actual rate of pay per hour for labor was $7.50. They still actually required 0.10 hours of labor to make each box. The direct labor rate variance computes as:

Direct Labor Rate Variance=($7.50$8.00)×0.10hours=$0.05or$0.05(Favorable)Direct Labor Rate Variance=($7.50$8.00)×0.10hours=$0.05or$0.05(Favorable)

In this case, the actual rate per hour is $7.50, the standard rate per hour is $8.00, and the actual hour worked is 0.10 hours per box. This computes as a favorable outcome. This is a favorable outcome because the actual rate of pay was less than the standard rate of pay. As a result of this favorable outcome information, the company may consider continuing operations as they exist, or could change future budget projections to reflect higher profit margins, among other things.

Let us take the same example except now the actual rate of pay per hour is $9.50. The direct labor rate variance computes as:

Direct Labor Rate Variance=($9.50$8.00)×0.10hours=$0.15or$0.15(Unfavorable)Direct Labor Rate Variance=($9.50$8.00)×0.10hours=$0.15or$0.15(Unfavorable)

In this case, the actual rate per hour is $9.50, the standard rate per hour is $8.00, and the actual hours worked per box are 0.10 hours. This computes as an unfavorable outcome. This is an unfavorable outcome because the actual rate per hour was more than the standard rate per hour. As a result of this unfavorable outcome information, the company may consider using cheaper labor, changing the production process to be more efficient, or increasing prices to cover labor costs.

Another element this company and others must consider is a direct labor time variance.

Direct Labor Time Variance

The direct labor time variance compares the actual labor hours used to the standard labor hours that were expected to be used to make the actual units produced. The variance is calculated using this formula:

Direct Labor Time Variance equals (Actual Hours Worked x Standard rate per Hour) minus (Standard Hours times Standard Rate per Hour).

Factoring out the standard rate per hour from both components of the formula, it can be rewritten as:

Direct Labor Time Variance equals (Actual Hours Worked minus Standard Hours Expected for the Units Produced) times Standard Rate per Hour.

With either of these formulas, the actual hours worked refers to the actual number of hours used at the actual production output. The standard rate per hour is the expected hourly rate paid to workers. The standard hours are the expected number of hours used at the actual production output. If there is no difference between the actual hours worked and the standard hours, the outcome will be zero, and no variance exists.

If the actual hours worked are less than the standard hours at the actual production output level, the variance will be a favorable variance. A favorable outcome means you used fewer hours than anticipated to make the actual number of production units. If, however, the actual hours worked are greater than the standard hours at the actual production output level, the variance will be unfavorable. An unfavorable outcome means you used more hours than anticipated to make the actual number of production units.

The actual hours used can differ from the standard hours because of improved efficiencies in production, carelessness or inefficiencies in production, or poor estimation when creating the standard usage.

Consider the previous example with Connie’s Candy Company. Connie’s Candy establishes a standard rate per hour for labor of $8.00. Each box of candy is expected to require 0.10 hours of labor (6 minutes). Connie’s Candy found that the actual hours worked per box were 0.05 hours (3 minutes). The actual rate per hour for labor remained at $8.00 to make each box. The direct labor time variance computes as:

Direct Labor Time Variance=(0.050.10)×$8.00per hour=$0.40or$0.40(Favorable)Direct Labor Time Variance=(0.050.10)×$8.00per hour=$0.40or$0.40(Favorable)

In this case, the actual hours worked are 0.05 per box, the standard hours are 0.10 per box, and the standard rate per hour is $8.00. This computes as a favorable outcome. This is a favorable outcome because the actual hours worked were less than the standard hours expected. As a result of this favorable outcome information, the company may consider continuing operations as they exist, or could change future budget projections to reflect higher profit margins, among other things.

Let us take the same example except now the actual hours worked are 0.20 hours per box. The direct labor time variance computes as:

Direct Labor Time Variance=($0.20$0.10)×$8.00per hour=$0.80or$0.80(Unfavorable)Direct Labor Time Variance=($0.20$0.10)×$8.00per hour=$0.80or$0.80(Unfavorable)

In this case, the actual hours worked per box are 0.20, the standard hours per box are 0.10, and the standard rate per hour is $8.00. This computes as an unfavorable outcome. This is an unfavorable outcome because the actual hours worked were more than the standard hours expected per box. As a result of this unfavorable outcome information, the company may consider retraining its workers, changing the production process to be more efficient, or increasing prices to cover labor costs.

The combination of the two variances can produce one overall total direct labor cost variance.

Think It Through

Package Deliveries

UPS drivers are evaluated on how many miles they drive and how quickly they deliver packages. The drivers are given the route and time they are expected to take, so they are expected to complete their route in a timely and efficient manner. They also work until all packages are delivered. A GPS tracking system tracks the trucks throughout the day. The system keeps track of how much they back up and if they take any left turns because right turns are much more time efficient.3 Tracking drivers like this does not leave them very much time to deal with customers. Customer service is a major part of the driver’s job. Can the driver service the customer and drive the route in the time and distance allotted? Which is more important: customer service or driving the route in a timely and efficient manner?

Total Direct Labor Variance

When a company makes a product and compares the actual labor cost to the standard labor cost, the result is the total direct labor variance.

Total Direct Labor Variance minus (Actual Hours times Actual Rate) minus (Standard Hours times Standard Rate).

If the outcome is unfavorable, the actual costs related to labor were more than the expected (standard) costs. If the outcome is favorable, the actual costs related to labor are less than the expected (standard) costs.

The total direct labor variance is also found by combining the direct labor rate variance and the direct labor time variance. By showing the total direct labor variance as the sum of the two components, management can better analyze the two variances and enhance decision-making.

Figure 8.4 shows the connection between the direct labor rate variance and direct labor time variance to total direct labor variance.

There are three top row boxes. Two, Actual Hours (AH) times Actual Rate (AR) and Actual Hours (AH) times Standard Rate (SR) combine to point to a Second row box: Direct Labor Rate Variance. Two top row boxes: Actual Hours (AH) times Standard Rate (SR) and Standard Hours (SH) times Standard Rate (SR) combine to point to Second row box: Direct Labor Time Variance. Notice the middle top row box is used for both of the variances. Second row boxes: Direct Labor Rate Variance and Direct Labor Time Variance combine to point to bottom row box: Total Direct Labor Variance.
Figure 8.4 Direct Labor Variance. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

For example, Connie’s Candy Company expects to pay a rate of $8.00 per hour for labor but actually pays $9.50 per hour. The company expected to use 0.10 hours of labor per box but actually used 0.20 hours per box. The total direct labor variance is computed as:

Total Direct Labor Time Variance=(0.20hours×$9.50)(0.10hours×$8.00)=$1.90$0.80=$1.10(Unfavorable)Total Direct Labor Time Variance=(0.20hours×$9.50)(0.10hours×$8.00)=$1.90$0.80=$1.10(Unfavorable)

In this case, two elements are contributing to the unfavorable outcome. Connie’s Candy paid $1.50 per hour more for labor than expected and used 0.10 hours more than expected to make one box of candy. The same calculation is shown as follows using the outcomes of the direct labor rate and time variances.

There are three top row boxes. Two, Actual Hours (0.20) times Actual Rate ($9.50) and Actual Hours (0.20) times Standard Rate ($8.00) combine to point to a Second row box: Direct Labor Rate Variance $0.30 U. Two top row boxes: Actual Hours (0.20) times Standard Rate ($8.00) and Standard Hours (0.10) times Standard Rate ($8.00) combine to point to Second row box: Direct Labor Time Variance $0.80 U. Notice the middle top row box is used for both of the variances. Second row boxes: Direct Labor Rate Variance $0.30 U and Direct Labor Time Variance $0.80 U combine to point to bottom row box: Total Direct Labor Variance $1.10 U.

As with the interpretations for the labor rate and time variances, the company would review the individual components contributing to the overall unfavorable outcome for the total direct labor variance, and possibly make changes to production elements as a result.

Your Turn

Sweet and Fresh Shampoo Labor

Biglow Company makes a hair shampoo called Sweet and Fresh. Each bottle has a standard labor cost of 1.5 hours at $35.00 per hour. During May, Biglow manufactured 11,000 bottles. They used 16,000 hours at a cost of $565,600. Calculate the labor rate variance, labor time variance, and total labor variance.

Solution

There are three top row boxes. Two, Actual Hours (16,000) times Actual Rate ($35.35) and Actual Hours (16,000) times Standard Rate ($35.00) combine to point to a Second row box: Direct Labor Rate Variance $5,600 U. Two top row boxes: Actual Hours (16,000) times Standard Rate ($35.00) and Standard Hours (16,500) times Standard Rate ($35.00) combine to point to Second row box: Direct Labor Time Variance $17,500 F. Notice the middle top row box is used for both of the variances. Second row boxes: Direct Labor Rate Variance $5,650 U and Direct Labor Time Variance $17,500 F combine to point to bottom row box: Total Direct Labor Variance $11,900 U.

Concepts In Practice

Labor Costs in Service Industries

In the service industry, labor is the main cost. Doctors, for example, have a time allotment for a physical exam and base their fee on the expected time. Insurance companies pay doctors according to a set schedule, so they set the labor standard. They pay a set rate for a physical exam, no matter how long it takes. If the exam takes longer than expected, the doctor is not compensated for that extra time. This would produce an unfavorable labor variance for the doctor. Doctors know the standard and try to schedule accordingly so a variance does not exist. If anything, they try to produce a favorable variance by seeing more patients in a quicker time frame to maximize their compensation potential.

Footnotes

  • 3 Graham Kendall. “Why UPS Drivers Don’t Turn Left and Why You Shouldn’t Either.” The Conversation. January 20, 2017. http://theconversation.com/why-ups-drivers-dont-turn-left-and-you-probably-shouldnt-either-71432
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