Direct Labor: Standard Cost, Rate Variance, Efficiency Variance

"Direct labor" refers to the work done by those employees who actually make the product on the production line. ("Indirect labor" is work done by employees who work in the production area, but do not work on the production line. Examples include employees who set up or maintain the equipment.)
Unlike direct materials (which are obtained prior to being used) direct labor is obtained and used at the same time. This means that for any given good output, we can compute the direct labor rate variance, the direct labor efficiency variance, and the standard direct labor cost at the same time.

January 2013

Let's begin by determining the standard cost of direct labor for the good output produced in January 2013:
Assuming that the actual direct labor in January adds up to 50 hours and the actual hourly rate of pay (including payroll taxes) is $9 per hour, our analysis will look like this:
Direct Labor Variance Analysis for January 2013:
In January, the direct labor efficiency variance (#3 above) is unfavorable because the company actually used 50 hours of direct labor—this is 8 hours more than the standard quantity of 42 hours allowed for the good output. The additional 8 hours is multiplied by the standard rate of $10 to give us an unfavorable direct labor efficiency variance of $80. (The direct labor efficiency variance could be called the direct labor quantity variance or usage variance.)
Note that DenimWorks paid $9 per hour for labor when the standard rate is $10 per hour. This $1 difference—multiplied by the 50 actual hours—results in a $50 favorable direct labor rate variance. (The direct labor rate variance could be called the direct labor price variance.)
The journal entry for the direct labor portion of the January production is:

February 2013

In February your company manufactures 200 large aprons and 100 small aprons. The standard cost of direct labor for the good output produced in February 2013 is computed here:
If we assume that the actual labor hours in February add up to 75 and the hourly rate of pay (including payroll taxes) is $11 per hour, the total equals $825. The analysis for February 2013 looks like this:
Direct Labor Variance Analysis for February 2013:
Notice that for the good output in February, the total actual labor costs amounted to $825 and the total standard cost of direct labor amounted to $800. This unfavorable difference of $25 agrees to the sum of the two labor variances:
The journal entry for the direct labor portion of the February production is:

Variable Mfg Overhead: Standard Cost, Spending Variance, Efficiency Variance

"Manufacturing overhead costs" refer to any costs within a manufacturing facility other than direct material and direct labor. Manufacturing overhead includes such things as indirect labor, indirect materials (such as manufacturing supplies), utilities, quality control, material handling, and depreciation on the manufacturing equipment and facilities.
"Variable" manufacturing overhead costs will increase in total as output increases. An example is the cost of the electricity needed to operate the machines that cut and sew the denim. Another example is the cost of the manufacturing supplies (such as needles and thread) that increase when production increases. In our example we assume that these variable manufacturing overhead costs fluctuate in response to the number of direct labor hours. Recall the original estimates made when DenimWorks was formed:

January 2013

Let's begin by determining the standard cost of variable manufacturing overhead for the good output that DenimWorks produces in January 2013:
Recall that there were 50 actual direct labor hours in January. Let's assume that the actual cost for the variable manufacturing overhead (electricity and manufacturing supplies) during January is $90.
Our analysis will look like this:
Variable Manufacturing Overhead Analysis for January 2013:
Notice that for the good output produced in January, the actual cost of variable manufacturing overhead was $90 and the total standard cost of variable manufacturing overhead cost allowed for the good output was $84. This unfavorable difference of $6 agrees to the sum of the two variances:
Variable Manufacturing Overhead Efficiency Variance
As the above analysis shows, DenimWorks did not produce the good output efficiently—it used 50 actual direct labor hours instead of the 42 standard direct labor hours allowed.
The additional 8 hours no doubt caused the company to use additional electricity and supplies. Measured at the originally estimated rate of $2 per direct labor hour, this amounts to $16 (8 hours x $2). This is referred to as an unfavorable variable manufacturing overhead efficiency variance.
Variable Manufacturing Overhead Spending Variance
In the analysis above, item 2 shows that based on the 50 direct labor hours actually used, electricity and supplies could reasonably add up to $100 instead of the standard of $84. (If the good output took 8 actual direct labor hours more than the standard hours to cut and sew the denim, the company will likely have additional electricity and supplies costs since it is operating the machines for an additional 8 hours.) We find, however, that the actual cost of the electricity and supplies is $90, not $100. This $10 favorable variance indicates that the company did not spend the planned $2 per direct labor hour. (Perhaps electricity rates were lower than the rates anticipated when the standard costs were established.)
Actual variable manufacturing overhead costs are debited to overhead cost accounts. The credits are made to accounts such as Accounts Payable. For example:
Another entry records how these overheads are assigned to the product based on standard costs:
As our analysis notes above and these entries illustrate, DenimWorks has an actual variable manufacturing overhead of $90, but only $84 (the standard amount) was applied to the products. The $6 difference is "explained" by the two variances:

February 2013

Recall that in February 2013 the company produced 200 large aprons and 100 small aprons. We use that good output to compute the standard cost of variable manufacturing overhead for February 2013:
Given that there were 75 actual direct labor hours in February and assuming that the actual cost for the variable manufacturing overhead in February was $156, our analysis will look like this:
Variable Manufacturing Overhead Analysis for February 2013:
The favorable difference between the actual cost of $156 and the standard cost of $160 agrees to the sum of the two variances:
Actual variable manufacturing overhead costs are debited to overhead cost accounts. The credits are made to accounts such as Accounts Payable. For example:
Another entry records how these overheads are assigned to the product:
As our analysis notes above and as these entries illustrate, even though DenimWorks had actual variable manufacturing overhead of $156, the standard amount of $160 was applied to the products. For the month of February 2013 the company applied more variable manufacturing overhead to its products than it actually incurred.

Fixed Mfg Overhead: Standard Cost, Budget Variance, Volume Variance

"Fixed" manufacturing overhead costs remain the same in total even though the volume of production may increase by a modest amount. For example, the property tax on the manufacturing facility might be $50,000 per year and it arrives as one tax bill in December. The amount of the property tax bill was not dependent on the number of units produced or the number of machine hours that the plant operated. Other examples include the depreciation or rent on production facilities; salaries of production managers and supervisors; and professional memberships and training for personnel in the manufacturing area. Although the fixed manufacturing overhead costs present themselves as large monthly or annual expenses, they are, in reality, a small part of each product's cost.
DenimWorks has two fixed manufacturing overhead costs:
A small amount of these fixed manufacturing costs must be allocated to each apron produced. This is known as absorption costing and it explains why some accountants say that each product must "absorb" a portion of the fixed manufacturing overhead costs.
A simple way to assign or allocate the fixed costs is to base it on things such as direct labor hours, machine hours, or pounds of direct material. (Accountants realize that this is simplistic; they know that overhead costs are a result of—or are driven by—many different factors.) Nonetheless, we will assign the fixed manufacturing overhead costs to the aprons by using the same method we used for variable manufacturing overhead—by using direct labor hours.

Establishing a Predetermined Rate
Companies typically establish a standard fixed manufacturing overhead rate prior to the start of the year and then use that rate for the full year. Let's assume it is December 2012 and DenimWorks is developing the standard fixed manufacturing overhead rate to use in 2013. (As mentioned above, we will assign the fixed manufacturing overhead on the basis of direct labor hours.)
Step 1.
Project/estimate the fixed manufacturing overhead costs for the year 2013.
We indicated above that DenimWorks' only fixed manufacturing overhead costs are rents of $700 per month (space and equipment) totaling to $8,400 for the year 2013.
Step 2.
Project/estimate the total number of standard direct labor hours that are needed to manufacture your products during 2013.
We can do that from the information given earlier (and repeated here):
Step 3.
Compute the standard fixed manufacturing rate to be used in 2013.

Note: One of the reasons a company develops a predetermined annual rate is so that the rate is uniform throughout the year, even though the number of units manufactured may fluctuate month by month. For example, if the company used monthly rates, the rate would be high in the months when few units are manufactured (monthly fixed costs of $700 ÷ 100 units produced = $7 per unit) and low when many units are produced (monthly fixed costs of $700 ÷ 350 units = $2 per unit).

Fixed Manufacturing Overhead Budget Variance
The difference between the actual amount of fixed manufacturing overhead and the estimated amount (the amount budgeted when setting the overhead rate prior to the start of the year) is known as the fixed manufacturing overhead budget variance.
In our example, we budgeted the annual fixed manufacturing overhead at $8,400 (monthly rents of $700 x 12 months). If DenimWorks pays more than $8,400 for the year, there is an unfavorable budget variance; if the company pays less than $8,400 for the year, there is a favorable budget variance.

Fixed Manufacturing Overhead Volume Variance
Recall that the fixed manufacturing overhead (such as the large amount of rent paid at the start of every month) must be assigned to each apron produced. In other words, each apron must absorb a small portion of the fixed manufacturing overhead. At DenimWorks, the fixed manufacturing overhead is assigned to the good output by multiplying the standard rate by the standard hours of direct labor in each apron. Hopefully, by the end of the year there are enough good aprons produced to absorb all of the fixed manufacturing overhead.
The fixed manufacturing overhead volume variance compares the amount of fixed manufacturing overhead budgeted to the amount that was applied to (or absorbed by) the good output. If the amount applied is less than the amount budgeted, there is an unfavorable volume variance—there was not enough good output to absorb the budgeted amount of fixed manufacturing overhead. If the amount applied to the good output is greater than the budgeted amount of fixed manufacturing overhead, the fixed manufacturing overhead volume variance is favorable. In summary, if DenimWorks applies more than the amount budgeted, the volume variance is favorable; if it applies less than the amount budgeted, the volume variance is unfavorable.
Illustration of Fixed Manufacturing Overhead Variances for 2013
Let's assume that in 2013 DenimWorks manufactures (has actual good output of) 5,300 large aprons and 2,600 small aprons. Let's also assume that the actual fixed manufacturing overhead costs for the year are $8,700. As we calculated earlier, the standard fixed manufacturing overhead rate is $4 per standard direct labor hour.
We begin by determining the fixed manufacturing overhead applied to (or absorbed by) the good output produced in the year 2013:
Our analysis looks like this:
Fixed Manufacturing Overhead Analysis for the Year 2013:
This analysis shows that the actual fixed manufacturing overhead costs are $8,700 and the fixed manufacturing overhead costs applied to the good output are $8,440. This unfavorable difference of $260 agrees to the sum of the two variances:
Actual fixed manufacturing overhead costs are debited to overhead cost accounts. The credits are made to accounts such as Accounts Payable or Cash. For example:
Another entry records how these overheads are assigned to the product:

Relationship Between Variances

If the direct labor is not efficient at producing the good output, there will be an unfavorable labor efficiency variance. That inefficiency will likely cause additional variable manufacturing overhead—resulting in an unfavorable variable manufacturing overhead efficiency variance. If these inefficiencies are significant, it is possible that the company may not be able to produce enough good output to absorb the planned fixed manufacturing overhead—resulting in an unfavorable fixed manufacturing overhead volume variance.
We will pursue the interdependence of variances in the following examples.
Example 1
Assume your company's standard cost for denim is $3 per yard, but you buy some denim at a bargain price of $2.50 per yard. For each yard of denim purchased, DenimWorks reports a favorable direct materials price variance of $0.50.
Let's also assume that the quality of the low-cost denim ends up being slightly lower than the quality to which your company is accustomed. This lesser quality denim causes the production to be a bit slower as workers spend additional time working around flaws in the material. In addition to this decline in productivity, you also find that some of the denim is of such poor quality that it has to be discarded. Further, some of the finished aprons don't pass the final inspection due to occasional defects not detected as the aprons were made.
You get the picture. If the favorable $0.50 per yard price variance correlates with lower quality, that denim was no bargain. The $0.50 per yard favorable variance may be more than offset by the following unfavorable quantity variances:

• direct material usage variance
• direct labor efficiency variance
• variable manufacturing overhead efficiency variance

Keep in mind that the standard cost is the cost allowed on the good output. Putting material, labor, and manufacturing overhead costs into products that will not end up as good output will likely result in unfavorable variances.

Example 2
Let's assume that you decide to hire an unskilled worker for $9 per hour instead of a skilled worker for the standard cost of $15 per hour. Although the unskilled worker will create a favorable direct labor rate variance of $6 per hour, you may see significant unfavorable variances such as direct material usage variance, direct labor efficiency variance, variable manufacturing overhead efficiency variance, and possibly a fixed manufacturing volume variance.
These two examples highlight what experienced managers know—you need to look at more than price. A low cost for an inferior input is no bargain if it results in costly inefficiencies.

What To Do With Variance Amounts

Throughout our explanation of standard costing we showed you how to calculate the variances. In the case of direct materials and direct labor, the variances were recorded in specific general ledger accounts. The manufacturing overhead variances were the differences between the accounts containing the actual costs and the accounts containing the applied costs. Now we'll discuss what we do with those variance amounts.
Direct Materials Price Variance
Let's begin by assuming that the account Direct Materials Price Variance has a debit balance of $3,500 at the end of the accounting year. You can see from the following journal entry (a hypothetical entry which assumes that all of the direct materials were purchased at one time) that a debit balance is an unfavorable variance:
Because of the cost principle, DenimWorks is obligated to report its transactions at their actual cost in the financial statements that are made available to the public. If none of the direct materials purchased in this journal entry was used in production (all of the direct materials remain in the direct materials inventory), the company's balance sheet needs to report the direct materials inventory at $13,500—the actual cost. In other words, the balance sheet will report the direct materials inventory as the standard cost of $10,000 plus the price variance of $3,500. If all of the materials were used in making products, and all of the products have been sold, the $3,500 price variance is added to the company's standard cost of goods sold. If 20% of the materials remain in the direct materials inventory and 80% of the materials are in the finished goods that have been sold, then $700 of the price variance (20% of $3,500) is added to the standard cost of the direct materials inventory, $2,800 (80% of $3,500) is added to the standard cost of goods sold.
Let's say the direct materials are in various stages of use: 20% have not been used yet; 5% are in work-in-process; 15% are in finished goods on hand; and 60% are in finished goods that have been sold. We need to apportion the $3,500 direct materials price variance to each of these stages. Since the $3,500 is an unfavorable amount, the following amounts are added to the standard costs:
The accounting professional follows a materiality guideline which says that a company may make exceptions to other accounting principles if the amount in question is insignificant. (For example, a large company may report amounts to the nearest $1,000 on its financial statements, or an inexpensive item like a wastebasket can be expensed immediately instead of being depreciated over its useful life.) This means that if the total variance of $3,500 shown above is a very, very small amount relative to the company's net income, the company can charge the entire $3,500 to cost of goods sold instead of allocating some of the amount to the inventories.
If the balance in the Direct Materials Price Variance account is a credit balance of $3,500 (instead of a debit balance) the procedure and discussion would be the same, except that the standard costs would be reduced instead of increased.
Direct Materials Usage Variance
Let's assume that the Direct Materials Usage Variance account has a debit balance of $2,000 at the end of the accounting year. A debit balance is an unfavorable balance resulting from more direct materials being used than the standard amount allowed for the good output.
The first question to ask is "Why do we have this unfavorable variance of $2,000?" If it was caused by errors and/or inefficiencies, it cannot be included as part of the cost of the inventory. Errors and inefficiencies are never considered to be assets; therefore, the entire amount must be expensed.
If the unfavorable $2,000 variance is the result of an unrealistic standard for the quantity of direct materials needed, then we should allocate the $2,000 variance to wherever the standard costs of direct materials are physically located. If 90% of the related direct materials have been sold and 10% are in the finished goods inventory, then the $2,000 should be allocated and added to the standard direct material costs as follows:
If $2,000 is an insignificant amount relative to a company's net income, the entire $2,000 unfavorable variance can be added to the cost of goods sold. This is permissible because of the materiality guideline.
If the $2,000 balance is a credit balance, the variance is favorable. This means that the actual direct materials used were less than the standard quantity of materials called for by the good output. We should allocate this $2,000 to wherever those direct materials are physically located. However, if $2,000 is an insignificant amount, the materiality guideline allows for the entire $2,000 to be deducted from the cost of goods sold on the income statement.
Other Variances
The examples above follow these guidelines:

1. If the variance amount is very small (insignificant relative to the company's net income), simply put the entire amount on the income statement. If the variance amount is unfavorable, increase the cost of goods sold—thereby reducing net income. If the variance amount is favorable, decrease the cost of goods sold—thereby increasing net income.
2. If the variance is unfavorable, significant in amount, and results from mistakes or inefficiencies, the variance amount can never be added to any inventory or asset account. These unfavorable variance amounts go directly to the income statement and reduce the company's net income.
3. If the variance is unfavorable, significant in amount, and results from standard costs not being realistic, allocate the variance to the company's inventory accounts and cost of goods sold. The allocation should follow the standard costs of the inputs from which the variances arose.
4. If the variance amount is favorable and significant in amount, allocate the variance to the company's inventories and its cost of goods sold.

The following table will serve as a guide for reporting variances that are significant in amount: