As a small business owner, you need to understand how an employee’s productivity lifecycle works. From the start of an employee’s career to its end, the ratio of labor cost to profit significantly changes. By understanding how this lifecycle shifts and how to track the changes, you can ensure your company’s ongoing profitability.

How the Employee Lifecycle and Productivity Works

The labor efficiency ratio (LER) compares your labor costs to your gross margin. When you look at profitable, successful companies, the LER is always 2 or higher. If the LER is too low, you’ll struggle to bring in enough cash flow. 

In a recent Mission to Grow podcast on “Labor Productivity: Understanding Labor Productivity for Sustainable Growth,” Greg Crabtree, partner at Carr, Riggs & Ingram, discussed some of his experiences with small and large businesses. He said that he often asks a room of entrepreneurs what their biggest challenge is. “And a third of the room will say a cash flow problem. They learn this pretty quick. As soon as they say they have a cash flow problem, I start digging in and I say, you don’t have a cash flow problem. You have a profit problem,” says Crabtree.

By understanding LER, you can make adjustments to your labor spending. In fact, Crabtree says, “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.”

Training Zone 

To improve your labor efficiency, you need to understand the lifecycle of an employee’s LER. In the training zone, an employee isn’t fully productive yet. They’re just getting started in their career, so some of your time and energy is spent on training them. You don’t have to pay a lot for these workers, but they also aren’t your most productive employees. However, they will soon reach the chasing zone, which is where you want the majority of your workers to be.

Chasing Zone 

The chasing zone is what Crabtree calls the point where “I’m producing more than I’m being paid, and my pay should chase my performance.” This is the point where you want to hire people. The employee’s pay is going up because their performance is improving, but their pay hasn’t increased excessively. These employees boost your LER and overall profitability because their performance outweighs their pay.

Replacement Zone 

In the replacement zone, the balance between pay and performance reverses. Rather than pay chasing performance, performance chases pay. When workers reach the replacement zone, they’re getting paid more than their performance level can justify. 

The replacement zone isn’t necessary at the end of the employee’s career. They could reach it much earlier through promotions and raises. Additionally, they can hit the replacement zone if their job suddenly disappears, and job transfers at the company aren’t feasible. 

For example, Netflix famously had to downsize a significant portion of its mail-order DVD division when streaming became more popular. These employees didn’t have readily transferable skills, so they couldn’t simply be moved to another division. Rather than spend extra money on training these workers to handle an entry-level position in a different department, Netflix let them go.

How Can You Assess Employee Performance in Each Zone? 

Assessing an employee’s performance doesn’t have to be challenging. Thanks to modern HR software, you can integrate payroll and HR data into your accounting system. Then, you can instantly calculate the LER for each worker, project team, and department. 

For example, you can calculate how much you pay each member of your sales team as well as the sales that each person brings in. If their personal LER is above 2, then they are a profitable team member. When the ratio of labor spending to gross margin is below 2, the worker needs to be retrained or let go. 

Managing Difficult Transitions With Compassion 

One of the hardest parts of HR is transitioning workers out of your workforce. However, holding onto an employee who is in the replacement zone will only end up hurting your company’s competitiveness. 

Rather than retain these workers, your company needs to transition them out of your employment with as much compassion as possible. As long as you can afford it and they continue doing good work, you can give them several months’ notice. Often, employees will understand the situation if you are honest and fair during the process. 

Why the Labor Efficiency Ratio (LER) Is the Most Important Factor in Your Success 

Labor spending is directly connected to the amount of goods and services you can produce. At many companies, it is the largest cost of doing business. By using the LER, you can see how effectively your company is using labor. As Crabtree says, “The way you defend profit is managing labor efficiency.” 

When your LER is below 2, you can either tell yourself that you’ll grow into reaching 2 or cut labor to boost your LER. In most cases, companies that try to grow their business to reach a 2 don’t. Instead, they keep trying to play catch up until they fail. 

Rather than play catch up, cut your labor spending until your LER is at a 2 or higher. You may need to evaluate your LER per employee, department, or individual client. Afterward, low-performing departments may need to be removed. 

Crabtree previously used the example of a landscaping company in Omaha that his team evaluated. The landscapers performed irrigation, landscaping, land mowing, and snow removal. After evaluating every sector of the company, they found that the business had a direct margin to labor of $2 or higher for every sector except mowing. Lawn mowing had a direct margin to labor of just $0.50. As a result of this analysis, the company started subcontracting mowing to another business and receiving a referral fee. 

Knowing your LER is power. It allows you to make wiser business decisions that will help your company grow. If you don’t track this key data, you won’t know when you need to grow, shrink, or maintain your labor pool. 

Take the Next Step in Your Company’s Growth 

For your company to succeed, you need to understand your employee life cycle. The best employees are found in the chasing zone. While you can hire an employee who is still in the training zone, you should transition away from workers who have reached their replacement zone. 

By gaining a better understanding of employee life cycles, labor productivity, and the LER, you can boost your company’s growth. Learn more by reaching out to Asure’s team of small business HR and payroll experts today.