Often, small businesses focus on building their gross revenue at all costs. In reality, this can lead to slower growth and poor business decisions. If your revenue growth isn’t making your company more profitable, it won’t help your company become financially stable or successful.
During a recent Mission to Grow podcast on, “Labor Productivity: Understanding Labor Productivity for Sustainable Growth”, Greg Crabtree, partner at Carr, Riggs & Ingram, discussed the importance of the labor efficiency ratio (LER) and labor productivity in determining an organization’s long-term success. According to Crabtree, “90% of the businesses in the US will hit their profit target if they get $2 of gross margin for every $1 of labor. It’s no more complex than that.”
If you want to be successful, focus on improving your LER. As long as your LER is above 2, your business will likely hit its profit target.
What Is the Labor Efficiency Ratio?
Your labor productivity represents how effective and productive your company is at using its labor resources. Ultimately, all types of economic productivity are tied to labor. Whether you’re mining ore or building an iPhone, you’re using labor.
While there are other costs that go into creating your products, labor is such a large one that it will predominantly determine whether you are profitable or not. If your labor efficiency ratio is 2 or higher, you’ll likely have a profit. When your labor efficiency drops below this rate, you won’t be profitable.
When you look at these numbers on a graph, the effect is remarkable. Instead of looking like a bell curve, it’s just a column that shoots upward. In fact, Crabtree says, “We’ve rarely seen a business that has a cost problem other than the productivity of their labor.”
Direct Labor Efficiency Versus Management Labor Efficiency
The LER is calculated by comparing your gross margin to your labor cost. However, there are two essential labor costs you should look at that use the same concept. To understand how your business is performing, you should look at your LER for direct labor and management labor.
Typically, workplaces use one of two strategies. They may use high direct labor costs and low management labor costs to produce products. Alternatively, they may have low direct labor costs and then increase management spending to adjust for the lower spending on direct labor. If your management labor and direct labor are expensive, you won’t be able to keep your LER at 2 or higher.
Direct Labor Efficiency Ratio (dLER)
The direct labor efficiency ratio looks at the revenue brought in from your direct labor spending. To calculate this figure, you must figure out your total direct labor costs. This is the amount of wages you pay to workers who are directly involved in producing products and services. It doesn’t include payroll taxes or benefits. For instance, these workers would include salespeople and delivery drivers.
Then, figure out the revenue from direct labor. Once you have this figure, divide the gross margin by your total direct labor cost. Now, you have the ratio of your revenue created for every dollar spent on direct labor.
Management Labor Efficiency Ratio (mLER)
With the MLER, the focus is on how productive your managerial staff are in your organization. Keep in mind that non-supervisory staff are also counted as managers for this calculation. In essence, you should include everyone who isn’t counted as direct labor.
To calculate this figure, first figure out your total management labor cost. This includes all of the salary and benefits given to management staff.
Afterward, divide your contribution margin by the total management labor cost. The result is the revenue efficiency for your management labor costs.
Typically, a high mLER or high dLER shows you’re using these types of labor efficiently. If you have a low dLER, you’re spending money inefficiently on your direct labor. The only time this is acceptable is when you’re training a bunch of workers. However, even in this scenario, the dLER shouldn’t stay low for long.
Special Exceptions
When it comes to reaching a LER of 2, there are very few exceptions to the rule. “On the high side, if you’re a distributor or a retail business, you need a 2.5,” Crabtree says. “If you’re a union shop, you need a 2.5.” Staffing companies are another major exception because the staffing labor is being sold by the company instead of being used for the company’s purposes.
Why the Labor Efficiency Ratio Matters
The labor efficiency ratio matters because it shows if your company is going to struggle financially or not. As long as you aren’t running a seasonal business, you can easily calculate the LER as you go so that you can determine your ongoing success and make on-the-go adjustments to your overall strategy.
Using LER as a Benchmark
The LER is a convenient benchmark you can use for a range of activities. Thanks to the best HR software and sales tracking, you can get immediate reports on labor spending and sales.
Then, you can break these figures down into specific departments, team members, and teams. The LER can help you determine if a specific employee or department is providing a good return on your labor costs. This type of knowledge can help with future company hiring, raises, and knowing which employees should be let go.
Discover Your Ideal Customer Profile
Additionally, you can use LER to design your ideal client profile. When reviewing the LER for different clients, you may find that a subset of your clients have significantly higher LERs than other clients. Knowing this allows you to research common client traits and products that cause this high LER. Then, you can deliberately market to that type of client in the future because you know how profitable they are for your business.
Avoiding the Black Hole
At around $1 million and $5 million in revenue, businesses hit a black hole where profitability becomes a struggle. At this point, you’re having to hire for key roles and train people, but the training isn’t paying off. Often, the founder has to hire a COO and other staff to take on some of the roles the founder used to play. It takes a while to get these people up to speed, and they are often less effective than the founder. All of these factors contribute to higher labor costs, lower revenue, and a lower LER.
It won’t be easy, but you have to do everything possible to have a good LER when you’re in the black hole. Otherwise, you won’t make it out.
Make Smarter Hiring Decisions
When you know what your LER is, you can determine if your LER is high enough to justify hiring and training new workers. If your LER isn’t at 2 or higher, you should probably delay new hires and focus on revenue growth first. At the very least, the LER is a strong indicator that you should carefully reconsider some of your hiring decisions.
Focus on Your Company’s Long-Term Growth
By incorporating LER into your business processes, you can make better hiring decisions and support your company’s long-term growth. Your labor spending is directly tied to your profitability. As a result, you need to find the best tools possible for smarter, more efficient labor spending.
To learn more about labor efficiency ratios and HR best practices, reach out to our team of small business HR and payroll experts.