In my previous post 4 reasons this is the most important KPI you are not measuring I explained how Labor Efficiency Ratio (LER) is the most important number to small and medium businesses for the following reasons;
- Different employees have different productivity rates
- Labor is the most expensive component of your Profit & Loss
- LER directly correlates to Net Profit
- LER is a leading indicator
As a quick overview, LER 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.
LER = Gross Profit / Labor cost
In this post I would like to take a look at using LER to determine the productivity outcomes between our people working with different clients, and the productivity of different employees, then how to identify which employees and clients are aligned with the Net Profit requirements of the business.
Net Profit targets
If we take Greg Crabtree’s Net Profit targets, we can set a benchmark from which to assess the current performance of a business.
>15% – Take it while you can
15% – Excellent business
10% – Good business
5% – On life support
From this rating system we can begin to set acceptable profit targets for a business. In general our goal should be to aim for firstly 10% Net Profit, and then 15% Net Profit, by focussing on productivity as measured by LER, whilst minimising an increase in wage costs.
LER by Customer
One of the first ways to improve profitability is to understand which of our customers are profitable, or put another way, which of our customers enable our people to be the most productive, and which customers prevent this.
The best way to measure this is to develop a LER by customer spreadsheet as shown in the example below.
Firstly we have calculated the Target LER to be 2.50. This means we have determined that based on the current revenue, if the Gross Profit divided by the Labor cost was 2.50 (the LER), the business would make a Net Profit of 10%. The current LER for the business is 1.88, so LER needs to be increased by $0.62. This can be done by increasing Gross Margin by $1,075,153, or reducing Direct Labor by $430,061 or a combination of both.
After listing each of the customers Revenue, COGS, GM, Direct Labor (Spending >50% of time producing a product or service the customer pays for), LER and Contribution margin we are able to determine that currently 4 clients (dark green) have a LER which is above the Target LER. These 4 clients represent 21% of revenue.
Customer 12 is the largest client and represents 21% of all revenue. Unfortunately at 1.59 for every $1 we sell to this client, we are $0.91 under the target to achieve 10% Net Profit. We need to either increase prices for this client, or find other clients prepared to pay more.
It may be easy to compare customer 8 and customer 16 if Gross Margin percentage was the main factor, as they both have a GM% of 60%. However we would need to charge customer 8 $52,449 more in order to achieve our Target LER (2.50) for that customer without spending any more on COGS or Direct Labor.
Equally customer 11 may appear more profitable than customer 12 as customer 11 has almost 100% Gross Margin %, whereas customer 12 has only 17% Gross Margin %. In actual fact although customer 12 is still along way from the Target LER of 2.50 (at 1.59), it is a lot better than the customer 11 LER of 1.01.
If the business achieved its LER of 2.50 across all customers it would have another $1.075m profit, this is even after taking into account losing $116k by reducing the LER of the top 4 LER customers.
Finally you can determine that the customers who are below 2.50 LER are affecting the Salary Cap by a combined $476,772. In effect this means if each customer was at a 2.50 LER we would have this amount to spend on pay rises or additional staff to grow the business.
The important question here is what action must be taken in order to increase the average LER by customers to 2.50?
LER by Employee
Lets now look at LER from the other angle, LER by employee.
The aim here is to have every employee record a productivity which will align with the company LER, thus contributing to a 10% Net Profit for the business.
As we can see only 3 employees are producing a LER higher than our 2.50 goal.
Whilst employee 7 appears the most valuable in light of being paid by far the highest, unfortunately this person would need to invoice another $8,719 whilst not costing any more in order to meet the Target LER of 2.50, and invoice an extra $21,235 (almost double) in order to be as productive as employee 1.
If the billable hours ratio was the most important metric the company observed, employee 1 and employee 5 would both be measured around the same at 52% & 50% respectively. The LER is 1.60 better for employee 1 and whilst employee 5 has cost $1,051 less, employee 1 has invoiced $7,963 more.
The important question here is what action must be taken in order to increase the average LER by employee to 2.50?
Determining LER for a company is not enough, in order to take the right action, it is important to analyse LER from different angles for your business and then once accurate data is available ask what actions must be taken to grow LER to achieve the Target LER.