As a small business owner, your direct and indirect labor are directly related to how profitable your company is. If you aren’t efficiently using labor, you won’t be able to produce the goods and services your clients need. To learn more about the connection between labor and profitability, read on.

The Correlation Between Labor and Productivity 

No matter what business you are in, some amount of labor is used to produce goods and services. Labor often makes up 20% to 35% of the cost of goods sold, so it is a major business expense. More importantly, your labor costs are directly tied to how much you produce. If your company’s labor costs dropped to nothing, you wouldn’t produce anything at all. 

The real question isn’t if you should have labor costs; it’s how much they should be. If you’re spending money on inefficient labor and not getting the right results, it’s time to rethink your labor management. 

The Labor Efficiency Ratio: Comparing Inputs and Outputs 

One way to understand the way you’re using labor is to calculate the labor efficiency ratio (LER). The LER compares your gross margin to your labor costs. Then, it represents this figure as a ratio. 

Essentially every business that has at least $2 of gross margin per $1 of labor costs will be profitable. Any business below this line generally won’t make a profit. The only exceptions are for distributors, retail businesses, and union shops. In these cases, you need to be at $2.50 instead of $2.

How the LER Works 

There are two different LER figures that are typically used. The direct labor efficiency rate (dLER) is calculated by dividing your gross margin by your direct labor costs. Direct labor is all of the labor that is directly productive and involves producing actual goods. The resulting calculation shows how effectively you are using direct labor at your company. 

For the management labor efficiency ratio (mLER), you divide the contribution margin by the cost of your management labor. In this calculation, management labor is any labor that isn’t directly tied to producing products or services. If you didn’t include the labor in your direct labor calculation, it is likely management labor.

Labor and Productivity: What the LER Is Really Looking at 

On a national basis, labor productivity is tracked in a quarterly report by the Bureau of Labor Statistics. The report looks at labor productivity for different industries and sectors. Over the last few decades, rising labor productivity has led to lower inflation, higher real income, and better profitability.

Labor is a major cost for any company, which is why it’s so closely tied to inflation. When labor becomes more productive, the United States economy can create more products for a lower price. In turn, this can have an impact on inflation. 

Additionally, more efficient use of labor means that businesses can provide more products or services for the same number of labor hours. This directly impacts your productivity. The dLER and mLER are simply the numerical representation of this relationship. When you calculate the LER, you instantly find out how productive your labor is. If it isn’t productive enough, you won’t be profitable.

Setting a Benchmark for Your Company’s Productivity 

Once you’ve calculated your dLER and mLER, you can understand how your company is using labor. Successful companies generally use labor in one of two different ways. They can run light on direct labor costs and spend heavier on management labor. Alternatively, they can spend more on direct labor and counterbalance it by spending less on management labor. 

When you have your mLER and dLER results, you can understand the way you use labor and if it is being used effectively. You can even break it down on an employee-by-employee basis. The best HR software programs are integrated with important accounting platforms, so you can instantly see labor departments for different people and departments. 

By creating and tracking a productivity standard at your company, you can discover underperformers. For example, tracking the LER may make you realize that one type of service doesn’t use labor efficiently. Then, you can stop providing the service or pass clients on to another company for a service fee. 

Similarly, you can track the labor cost and productivity of your clients. Many companies discover after LER reviews of their clients that 20% of clients are bringing in 80% of the money. Once you know which clients offer the best return for your labor investment, you can review them to look for commonalities. Then, adjust your marketing and client acquisition so that you bring in similar clients in the future.

Dealing With a Labor Cost and Productivity Imbalance 

Even with the best business strategies, you may realize that your labor costs and productivity aren’t in balance. When this happens, there are a few things you can do.

Transitioning Workers 

First, you should think about transitioning workers who have already hit the replacement zone. Normally, employee productivity goes through a training zone, a chasing zone, and a replacement zone. In the training zone, workers cost more than they produce because they’re still learning and growing in their careers. If you wait long enough, these workers will eventually produce more than they are paid. 

In the chasing zone, the employee is more productive than their pay. However, this eventually changes when they reach the replacement zone. At this point, the worker’s salary has reached a point where they’re paid more than they contribute. 

When you reach the replacement zone, you may want to transition workers out of your company. If your company can afford it, you can give them several months’ notice so that they have time to look for a new position. By focusing on hiring and retaining employees in the chasing zone and training zone, you can improve your productivity per labor hour.

Leaping the Black Hole 

When businesses earn between $1 million to $5 million in gross revenue, they have to hire additional workers, but these workers aren’t fully productive yet. This black hole can be challenging to escape, so it’s important to be proactive. Hire steadily and add people slowly, so you don’t suddenly have to train a bunch of people to be a part of your team. 

To navigate the black hole, you should also calculate your cash on hand for paying wages when you hire someone. You need to know if you’ll be able to cover the worker’s wages until they reach the point that they are productive. If you are unable to create a capital safety net, you may need to find alternative capital sources so that you can leap over the black hole and reach $5 million in revenue.

Rethinking Your Workforce

If you’re struggling with your labor productivity, it may be time to rebalance your workplace. You may want to change the way you structure your labor use. For instance, rather than spend heavily on skinny management labor, you may switch to spending less on direct labor and more heavily on management labor. However, you should never spend heavily on both types of labor if you want to remain profitable. 

Start Growing Your Business Today

How you use labor is directly correlated to your profitability. If you aren’t using labor efficiently, you’re LER and profitability will end up suffering. Fortunately, there are a few simple evaluations and adjustments you make to boost your company’s profitability.

To learn more about the best way to manage your labor, reach out to our team of small business HR and payroll experts today.