What it means
In standard costing, every hour of a given type of work is assigned a planned cost. The standard might be the average wage for a grade of worker plus on-costs, set at the start of the year.
At the end of each period, the business compares the real hourly cost against that standard. The variance uses actual hours because the question being answered is simple: for the hours we really worked, what did the pay rate cost us compared with plan?
Whether those hours were too many is a separate question, answered by the labour efficiency variance. Keeping the two apart helps managers see which lever moved.
Common causes of an unfavourable rate variance include overtime premiums, using more senior or better paid people than planned, unplanned pay rises, agency staff who cost more per hour than employees, and standards that were set too low. Favourable variances can arise from using junior staff on a task, recruiting below the budgeted wage or a delay in a planned pay rise.
A favourable result may hide a quality cost if cheaper workers take longer. Responsibility for the variance usually sits with whoever controls pay and staffing mix, such as the HR team or the department head who authorises overtime.
That differs from the efficiency variance, which is normally the responsibility of production management. Assigning the right owner is the main reason for splitting the two.
The rate variance should be reviewed alongside the efficiency variance, because they often move in opposite directions. Using a more experienced and more expensive worker may create an unfavourable rate variance but a favourable efficiency variance, and the net result is what matters to profit.
Standards need to be realistic for the variance to mean anything. A standard that ignores a known pay settlement or a regular overtime pattern will produce an unfavourable variance every month, and managers soon stop paying attention.
Setting standards from recent actual rates, adjusted for agreed changes, keeps the signal useful.
In practice
Real-world examples
Example 1
A hospital plans to staff a ward with permanent nurses at $38 per hour. A shortage forces it to use agency nurses at $52 per hour for 800 hours in a quarter. The unfavourable rate variance is 14 x 800 = $11,200, and the finance team uses it to support a recruitment drive.
Example 2
A marketing agency budgets $75 per hour for its design team. When it replaces two senior designers with juniors earning less, the average cost falls to $68. The favourable variance looks good, but the account director notes that projects are taking longer.
Example 3
A food processor pays a night shift premium that was not in its standard rate. Over a month the premium adds $1.80 per hour across 5,000 hours, an unfavourable $9,000. The cost accountant recommends updating the standard so future variances reflect real surprises rather than a known premium.
Think of it
Imagine budgeting £4 per gallon for petrol before taking a road trip, but having to use premium fuel at £5 per gallon at the pump. The extra cost per gallon is your labor rate variance.
Formula
Calculation
Labour rate variance = (Actual rate per hour - Standard rate per hour) x Actual hours worked
A factory budgeted a standard rate of $20 per hour. Because of overtime and a mid-year pay rise, the average actual rate was $22.50 per hour, and workers logged 10,600 hours. The variance is (22.50 - 20) x 10,600 = 2.50 x 10,600 = $26,500. As the business paid more than the standard, the variance is $26,500 unfavourable.Case study
Seen in the real world
Linden Valley Cabinets is an illustrative, fictional furniture maker. In the spring, its management accounts showed a labour rate variance of about $18,000 unfavourable, which puzzled the owner because no one had received a raise. The cost accountant traced the variance to a large rush order that had been completed on weekends at overtime rates.
She also compared it with the efficiency variance, which was favourable by $7,000 because the overtime team worked quickly. The net effect was an $11,000 overrun, caused by the decision to accept a rush order without pricing in the premium. The owner changed the quoting process so that rush orders carried a surcharge matching the extra labour cost.
Watch out
Common mistakes
- Multiplying the rate difference by standard hours instead of actual hours, which gives the wrong figure.
- Blaming production managers for a variance that came from a company-wide pay decision.
- Looking at the rate variance in isolation, when a favourable result may be paid for by lower efficiency or quality.
Questions
People also ask
What makes a labour rate variance favourable?
Paying less per hour than the standard, for example by using junior staff or recruiting below the budgeted wage.
How do the rate and efficiency variances combine?
Together they make up the total labour variance, which is the difference between actual labour cost and the standard cost of the work done.
How often should standard rates be updated?
Most businesses review them at least once a year, and sooner if a large pay settlement or a change in staff mix makes the old standard unrealistic.