The #1 driver of profitability is labor efficiency, which is a measure of the productivity of each dollar spent on labor.
Notice that I am not referring to total labor costs, as a percentage of revenue or gross margin, which is how labor costs are typically viewed. This measure does not tell if labor was productive and generated sufficient profit.
You can drive profitability by tracking labor efficiency, and by shifting your view of labor costs as something that you are leveraging to generate profits.
The Labor Efficiency Ratio measures the productivity of your labor force through time (trends, changes) and can be used to optimize your economic engine for maximum profitability.
The Labor Efficiency Ratio is defined by thought leader Greg Crabtree, the author of the powerful book, Simple Numbers, Straight Talk, Big Profits!
Leverage Labor Costs
Think of labor efficiency just like you would a bank savings account. You put money into the bank because you want to make that money more productive and earn interest.
It’s the same way with labor: you are putting money into labor because you are expecting to produce and earn profits.
When you put money into a bank savings account you want to know the interest rate that you’ll be earning.
With labor costs, you want to know that for every dollar you spend on labor that you’re going to leverage it and get "something" back.
When measuring labor efficiency, we view it in terms of multipliers (e.g., for every $1 you spend on labor, you get $3 back).
The theory behind the labor efficiency ratio is that as long as you can keep applying productive labor to operations at the right multiple, you will be able to drive profitability.
The three segments of labor and how efficiency ratios are calculated are:
- Management labor efficiency: contribution margin dollars divided by management labor cost
- Sales labor efficiency: contribution margin dollars divided by sales cost
- Direct labor efficiency: gross margin dollars divided by direct labor cost
When you begin working with the labor efficiency ratio, you will gain a unique perspective about how your business model operates.
The labor efficiency ratios for each individual organization will be unique. However, be aware that the management labor efficiency ratio target is 8.0! Why so high? Because effective management is critical to achieving the desired target profit of 10%. Also, executives are the most highly-compensated people in an organization, so the higher ratio benchmark reflects this.
To determine your organization's target ratios you will need to evaluate what Labor Efficiency Ratio would need to be achieved to achieve the profit target amount.
Once you determine a target ratio for each labor category, you will know when the right time is to add more people to grow, when you are overstaffed, if you are paying too much for labor, if labor is unproductive, or other costs may be too high.
Factors that decrease Labor Efficiency Ratios are:
- revenue too low for wage rate
- wages too high in a labor category
- overtime premium
- employees in certain positions are unproductive
- management labor costs too high
- a labor category is overstaffed
Non-labor efficiency ratio factors affecting profit could be:
- direct labor benefit structure too generous
- management benefits too high
- executive expenses too high for performance level
The Labor Efficiency Ratio always indicates when decisions need to be made in order for the business to become or remain profitable.
The minimum profitability target to strive for is 10% pretax profit.
If your business is not earning a minimum of 10% pretax profit you may be thinking that your industry is an exception.
Yes, there are exceptions. However, not as many as you may think.
This may be the case if you are in a lower-margin business and must sell a significant volume of other people’s products and services to succeed. For example, a tooling distributor might average 3% profit as a percentage of revenues. Yet the ratio of profit to gross margin is 18%.
In this case, the appropriate profit target is a percentage of gross margin, rather than revenue. It is up to you to determine the appropriate profit target (revenue or gross margin).
The Labor Efficiency Ratio tells managers:
- how to grow profitably
- the right time to add new labor
- if labor is productive to generate profit
- how to optimize profit
When you start seeing how Labor Efficiency Ratios change at each level of profitability in your business, you begin developing a unique perspective on how your business model operates.
Labor Efficiency Ratio vs. Pretax Profits
This model demonstrates how the Labor Efficiency Ratio can help you make business decisions.
By looking at different labor categories [in this example, Sales and DL (direct labor)] and corresponding profits, this model explains how the labor efficiency ratio can be used to:
- asses the productivity of labor
- determine if labor costs are being leveraged to create profits
- identify the right time to add, decrease or replace staff
5% Pretax Profit
Looking at the first labor group (5% Pretax Profit) the Labor Efficiency Ratios indicate that changes must be made to improve profitability.
Questions to ask to improve profit are:
- Is the right amount of money being spent on each segment of labor?
- Are the right team members in the right place?
- What are other issues that may be negatively affecting profit?
In striving to achieve 10% profit it may be time to get real and be honest about why the business is getting these results, and get into some tough conversations with your team about their productivity.
15% Pretax Profit
15% is a strong pretax profit level for many different types of businesses.
When an organization reaches this level of profitability some decisions will also need to be made.
The Labor Efficiency Ratios are 6.0 for Sales, and 3.0 for DL (direct labor). At this level of profit, labor is productive.
To get to the next level of growth a leader/manager may ask:
- Are we understaffed?
- Do we need to add more people?
- How can we grow profitably?
Be mindful that even though labor efficiency and profit level are high, that there may be some stress occurring in personnel.
As with some metrics and ratios, they will indicate a strength, as well as a potential "red flag" warning (e.g., a high capacity utilization may indicate future burnout of employees or equipment failures because of less preventive maintenance being performed).
From this example, a leader or manager may decide to add new people, which will drop profitability.
IMPORTANT: The goal is to not let profits drop below 10%.
Yet, by successfully leveraging labor, over time profits will grow back to 15%, which is then the right time to consider adding more people.
A cycle then establishes itself:
- an organization achieves 15% profit
- more people are added to, a) relieve stress and b) stimulate growth
- pretax profit drops (but not below 10%)
- revenue grows (when labor is productively leveraged)
- profits grow back up to 15%
- more people are added ...
... and the cycle continues.
The target ratios for each of the labor categories for each different business will be unique.
Yet it can be easily seen that by tracking Labor Efficiency Ratios, that leaders and managers can make sound decisions about labor requirements to drive profitable growth of the organization.