If you were to really consider it, what would be the most important number in your business?
If you had only one number to measure and judge as the most important, what would that be?
If you had a background in sales, you might suggest revenue, or (if you had a successful background in sales) perhaps Gross Profit.
If you had a background in accounting you might suggest EBITDA or shareholder return.
And if you had a background in engineering or operations you might suggest projects delivered on time, on budget or billing utilisation.
I put it to you that when you look for the most important number in your business you will find that you are probably not measuring it and it is probably not a priority for your people. Yet this number is the most important KPI that is not only ignored, but is the most accurate predictor or leading indicator for Net Profit.
Please allow me a moment to explain the number and why I believe it is the most important.
In our book “Scaling Up: How a Few Companies Make It… and Why the Rest Don’t”, co-author of the cash section Greg Crabtree discusses the Labour Efficiency Ratio (LER) KPI which is calculated by dividing Gross Profit (Revenue minus Cost of Goods Sold) by labour cost. For example if we had a Gross Profit of $4M and a wage cost of $1M we would have a LER of $4.00. This means that for every $1 we pay our staff the business receives a $4 return on that investment. If this is the Total LER we would then calculate Direct LER (people who spend more than 50% of their time producing a product or service the customer buys), Sales LER (sales team productivity) and Management LER (efficiency of the management team). Greg also provides a detailed overview in his book “Simple Numbers, Straight Talk, Big Profits!” on how these numbers are measured and the impact they have.
Why is it so important?
Gross Profit is the great equaliser of business models. It is not possible to compare a homebuilder with revenues of $5m, a $5m labour hire firm with salaries passing through at a low margin and a $5m service business. However once the Cost of Goods and contractors are removed the homebuilder could have $1m GP, the labour hire firm $250k and the service business $3.7m. What really matters is the ratio between the total amount of salaries and wages paid and the Gross Profit that total salary amount generates, or put another way for every $1 the business paid to staff in salaries and wages, how many dollars return did the business get?
This is the Labor Efficiency Ratio (LER) which measures the productivity of your workforce and there are four reasons I suggest it is the most important number in your business.
1. Employees are not created equal.
In my work facilitating strategic workshops for management teams one of the tools we use is a simple exercise from Liz Wiseman author of the book “Multipliers: How the best leaders make everyone smarter“. Essentially we survey the difference between a leader who accessed the least amount of your capability, and one who accessed the most. The average data I’ve observed is almost always the same, at the lower end of the scale leaders access around 30% of a persons capability, and at the higher end it is around 80%, which is also in line with Liz’s own global survey which demonstrates a leader can get up to 2.5 times the capability and productivity from employees depending on how they are managed.
Notwithstanding this, some people are simply more productive than others. Most people have worked alongside people who wouldn’t ‘work in an iron lung’ and actively try to do as little as possible, and other people who are consistently impressive with the amount they produce.
The key point however is that be it due to management style, capability or motivation, the ability for people to consistently produce acceptable results varies greatly.
2. The most expensive part of your Profit and Loss
Once we remove Cost of Goods from the equation and look at fixed expense items such as employees, rent, electricity, phone etc. then wage and salary costs (employee costs) almost always represents more that 50% of the expenses in a small to medium business, and I have seen it as high as 90%.
This effectively means that the largest part of your expenses (employees) has the ability to vary by more than 200%.
If you negotiated a better deal from your phone company, landlord or even materials supplier for Cost of Goods what would be the best reduction that you could hope for, perhaps 3 to 5%?
Metaphorically employee costs are by far the largest lever you can pull to effect change in your business and they have both the greatest variability and percentage impact.
3. It directly correlates to Net Profit
We have a series of Net Profitability benchmarks we use to determine the state of a business and set targets:
Less than 5% = life support
10% = good business
15% = excellent business
More than 15% = get it while you can as the competition will be after you
In his book, Greg Crabtree tells us that in his business if his team can produce a $1.80 LER in most cases that will produce a 10% Net Profit and a $2.20 LER will produce a 15% Net Profit.
However this is different for every business, I have seen some businesses who need to produce a $3.60 LER to achieve 10% and others who need $1.60. The point is that there is a direct correlation between what you can achieve with LER and the Net Profit this will deliver. Like most good KPI’s once generated it allows us to ask the right question – why did the LER change and how do we get it to the LER that will deliver our 15% Net Profit goal?
4. It is a leading and not lagging indicator
Net Profit is a net result or lagging indicator. It has already happened. Most businesses know their Net Profit 14 days after the month has ended because accounts need time to collate, process and close off the accounting data. Once the final Net Profit number is determined there is nothing that can be done to improve it.
However LER can be predicted on a daily basis. For example if an operations manager knows both the daily cost of each employee and the Work In Progress or work available to be performed they can allocate more or less resources to achieve a daily target LER. In our Function Accountability Chart this would mean the operations manager has a lagging KPI of Direct LER.
Therefore the person who has the ability to plan labour allocation determines the likelihood in advance that a business will achieve Net Profit and this should be their primary focus as well as how they are measured.
If the role of a business is to produce a product or service as efficiently as possible to generate profits in order to stimulate future growth and prosperity, Labour Efficiency Ratio is one of the most effective ways to measure that efficiency in any endeavour.