The cost of labour is one of the largest overhead expenses in most businesses. Any inefficiency here is an expense that must be recovered from the potential Profit of the organisation. Labour tends to grow of its own accord and it is very difficult for the business operator to know just how labour productivity is going as costs are rising. The Labour Efficiency Ratio discussed in this article is an early warning alert if wages are moving in the wrong direction. Read this if: You have have sufficient staff to find yourself losing track of their costs and contribution to company productivity / profitability or if you are looking at putting on staff, like accountants, that don't directly contribute to profit generation. Probably more likely to appeal when you have 10 staff or more. Relies on: mentions a metric dashboard to monitor your business. Audio/visual materials: none Degree of Difficulty: Blue Belt (intermediate)
Labour Efficiency Ratio Metric
Over time, your labour use and associated costs will tend to creep up as you typically:
- Hire new staff in the expectation of increasing your Revenue and/or Growth.
- Fail to prune out weak staff who are not contributing to Profit at the rate of a multiple of several times their Salary.
- Retain staff in directions that your business is no longer traveling down. These might be geographic locations or product types.
- An increase in number of "not-directly-productive" staff like Managers, Accountants and other service personnel. To some extent these are necessary, but they tend to breed. They do not add anything to the bottom line productivity of the business.
Calculating the Ratio
A key, and simple, metric for your business is to measure your Labour Efficiency.
Choose an Income related measure, such as Income or Gross Profit, divide this by your Labour cost.
Income = $500,000
Labour cost = $150,000
Labour efficiency = 500,000/150,000 = 3.33
In this example, for every dollar that you spend on Labour you get $3.33 of Revenue.
Measure by Labour Type
You can further divide this into specific elements of your Labour, such as:
- Direct Labour Efficiency: Revenue divided by Direct Labour costs.
- This is labour that is directly involved in producing your product or service in a ‘hands-on’ way.
- Sales Labour Efficiency: Revenue divided by Sales Labour costs.
- Management Labour Efficiency: Revenue divided by Management Labour costs.
- Accounting Department Labour Efficiency: Revenue divided by Accounting Department Labour costs.
- Indirect Labour Efficiency: this can be all the labour costs other than the Direct Labour.
This will give you an idea how the cost of labour in various elements of your business is trending. You could go on with this as a method of measuring the labour productivity of some of the departments that do not contribute directly to Income.
Measure by other than Revenue
You can also measure the Labour Efficiency Ratio by dividing Labour costs into different income-related elements of your business.
If Income is not the best measure, for your business, you could use either Gross Profit or Net Profit in the calculations.
Allow for Outsourcing
If you outsource some elements of your business that consume labour, you should factor in the cost of the outsourcing when you count up how much you are spending on labour. Otherwise, there is a risk that you will camouflage the real cost of labour by outsourcing and not counting it in your Labour Efficiency Ratio
When calculating these figures, and particularly with staff that have more than one function as might be the case with a small business, you may have to use part equivalents of a person with a Departmental Labour Efficiency Ratio. However, as your business grows larger it is not necessary to split part persons across several departments as the impact will be small. As you will see below, you are measuring changes in the Labour Efficiency Ratio over time so, providing you count the Labour in the same bucket each time, the trend will still be there.
For the same reason, you do not need to spend a lot of time on allocating Payroll, Taxes, Benefits and Retirement money when working out the cost of staff. These will tend to be highly correlated with the dollars in the Payroll and again the Labour ratios will work this out quite easily.
Mine Historical Data
Don't forget that you can easily get a trend going for your labour effeciency by using historical data.
At the very least, you will have annual accounts streaching back over the life of your business. All you need is Income and labour costs which you will almost certainly have availalbe in your historical data.
You can make notes on the changes to your types of labour for each year to see why the ratio has flucuated in the past.
Using the Labour Efficiency Ratio
Measuring Labour efficiency once will give you very little information unless you are able to benchmark your results against industry averages.
It is important that you measure these Labour efficiencies periodically and look for any trends.
Say you do this each quarter and look for efficiencies that are getting worse. This is a sure sign that some part of the business that you are monitoring is beginning to bloat and you should direct your attention to improving that in the next quarter.
If your business is seasonal (like the tourist industry), rather than measure one quarter against the next one, you might measure each quarter against the same quarter last year and that will tend to remove the effect of seasonality in the data.
Because your business is becoming more efficient over time, your Labour Efficiency Ratios should always trend up. The bigger the figure gets, the more Revenue you are getting per dollar of labour.
Normally however, as a company grows, the Labour Efficiency Metric will slowly get worse. Among other reasons, you will start to introduce layers of managers who do not contribute directly to productivity and are disproportionately higher paid – two strikes against the Ratio getting better.
You may choose to have a matrix of these measurements with Revenue, Gross Profit, Net Profit on one axis and the various types of Labour (Total, Direct, Management, Accounting etc) down the other and fill in the blanks in each cell with the relevant Labour efficiency Ratio. If these are in a spreadsheet, the calculation is quite straightforward.
You are looking for Ratios that get worse over time and you want to think about the underlying reasons for this.
- Total ratio goes down: either your Income has dropped, which might signal that you need to let some staff go, or your labour has become less efficient. If the Direct labour ratio stays about the same but the Management and/or Accounting one has dropped, you have added more Managers / Accountants.
- Accounting Department ratio drops: you have hired more accounting staff or your Income has dropped.
- Sales Ratio drops: you have either added more Sales staff or the Income has dropped, which might mean they are not selling as well as they used to
- Indirect Labour Ratio drops: the proportion of your wages cost going to persons not directly productive has gone up. You might be overstaffed and/or loading up with ‘drones’.
Elsewhere we discuss having a “Dashboard” for your business that shows some basic and important statistics that you can easily monitor (see the Dashboard article).
If you have a business with (say) ten or more staff, you will find the Labour Efficiency Ratio a useful metric to have. It will make it easier to digest the trends of your labour costs.