Labor Rate Variance or LRV is the variation between the actual and expected or standard cost of labor. This variance is due to the difference in the standard and actual labor rate, while labor hours remain the same for production. We may also call it by names like labor Wage Rate Variance, labor Price Variance, or labor Rate of Pay Variance.
This variance is a component of the direct labor cost variance. We can say that it helps to answer a simple but relevant question – Did we pay more or less for labor as compared to what was expected?
Like other variances, the LRV can also be favorable or unfavorable. Whenever and wherever the actual cost paid is lesser than the estimated or standard rate, then it is a favorable variance. And, if the standard rate is lower than the actual rate, then the variance is unfavorable or adverse.
It is crucial for a firm to investigate and analyze the reasons for both favorable and unfavorable variance. This is because an unfavorable variance will impact the bottom line. A favorable variance is mostly good, but companies must ensure that it doesn’t come at the expense of quality or any other compromises that may affect the performance in the long run.
It may be a good option for companies to neglect small variance that does not significantly impact their profits or production. This is because companies may spend more, both in terms of time and resources, on investigating a small variance than they would gain by eliminating such variance.
Additionally, companies can also use the variance information for future planning and preparing budgets. Moreover, companies can also use the information to give feedback to the staff.
How Companies Develop Standard Labor Rates
Companies consider several factors to determine the standard labor rate. These are:
- The pay of the production staff.
- The average amount of overtime of production workers.
- The new hiring at different pay rates a company may be considering.
- The number of workers that will retire.
- Promotion of workers to higher pay levels.
- Any ongoing negotiations with the trade unions regarding production staff wages.
- Any change in contributory benefit levels or medical assistance levels.
Labor Rate Variance – Formula and Example
We can use the following formula to calculate the labor rate variance:
LRV = (Standard Rate less Actual Rate) * Actual no. of labor hours
Let’s consider a simple example to understand the calculation of LRV.
Company A makes mobile, and it knows that it needs 2 labor hours at $2 per hour to produce one unit of mobile. In a year, Company A pays $100,000 in labor costs for 40,000 labor hours and produces 20,000 mobiles.
To come up with the Labor Rate Variance, we first need to calculate the Actual Labor Rate.
Actual labor rate = $100,000 / 40,000 = $2.5 per hour
Now, putting the values in the formula:
LRV = ($2 per hour less $2.5 per hour) * 40,000 = -$20,000.
Here the actual payment is more than what the standard rate was. Hence, it is an adverse/unfavorable variance.
You can also use our calculator for a quick calculation – Labor Rate Variance Calculator.
Labor Rate Variance – Reasons
Following are the likely reasons for the difference between the standard and actual labor rate:
- If a company employs more skilled labor, that asks for higher wages.
- If there is a non-availability of the labor force, then the existing or new labor may ask for a higher rate.
- In case the supply of the labor force is more than the demand, it would result in a drop in the labor rate.
- A company employs unskilled labor at a lower rate. This would also result in a variance.
- If workers work overtime, it may also result in variance. This is because the overtime wages are generally more than the normal wages.
- Workers getting an extra shift allowance or more bonus may also result in a variance.
- If workers get more payment (incentive) for quality production, this may also result in a variance.
- There may also be a variance if there is any change in the method of wage payment.
- Any revision in the grade of workers may also result in a variance.
- Any new regulation from the government or agreement with a trade union for an increase in wages may also result in a variance.
There are several ways to reduce this variance. Some of the most popular ones are:
- Reducing overtime hours can significantly reduce this variance because overtime wages are generally more than normal wages. However, completely eliminating overtime will not be possible because it could impact the product and customers. So, the best executives can do is to manage the overtime hours.
- If possible, companies can move their production to countries where labor is cheap or costs less. This can only work when the volume is quite high, and the company has enough money muscle.
- A company can provide training to low-cost, unskilled workers to make them more efficient. Such things would help to reduce production costs over time. However, there is always a risk that workers would move to other companies after getting training in due course.
Primarily, it is the demand and supply factors that determine the wage rate. So, it won’t be wrong to say that companies have no or less control over it. However, the company can work to minimize the labor rate variance through proper planning and maintaining a cordial relationship with the trade unions and employees.
Frequently Asked Questions (FAQs)
Labor Rate Variance or LRV is the difference between the actual and expected or standard cost of labor. This variance is due to the difference in the standard and actual labor rate, while labor hours remain the same for production.
Reasons due to which labor rate variances occur:
1. Employing more skilled laborers for higher wages
2. Non-availability of the labor force
3. Supply of the labor force is more than the demand
4. Employing unskilled labor at lower rates
5. Overtime working hours as overtime wages are more than normal wages
Labor rate variances can be reduced by the following ways:
1. Reducing overtime hours
2. Moving production to countries where labor is cheap or costs less
3. Providing training to low-cost unskilled workers to make them more efficient
Several factors in determining the standard labor rate are:
1. Pay of the production staff.
2. Average amount of overtime of production workers.
3. New hiring at different pay rates.
4. Number of workers that will retire.
5. Promotion of workers to higher pay levels.
6. Any ongoing negotiations with trade unions regarding production staff wages.
Other names for this variance are labor wage rate variance, labor price variance, or labor rate of pay variance.
(Standard Rate less Actual Rate) * Actual no. of labor hours