Many digital marketing, tech, and SaaS leaders dream of a business where every dollar spent on labour brings a clear return on investment. While this sounds challenging, smart cash flow management makes it achievable.
Greg Crabtree labor and management efficiency ratios(from his book: “Simple Numbers, Straight Talk, Big Profits!: 4 Keys to Unlock Your Business Potential”) offer a fresh perspective on handling cash flow and improving efficiency. Understanding them makes it easier to see where your money goes and how it can work harder for you.
What Is Labour Efficiency Ratio (LER)?
Labour Efficiency Ratio helps businesses optimize their workforce. At its core, LER measures the relationship between gross profit and labor costs. This offers a clear picture of how efficiently a company is utilizing its human resources.
Say, you run a digital marketing agency. By calculating your LER, you can determine how much gross profit each dollar spent on labor is generating. This will help you identify where your team excels and where improvements are needed.
So, essentially, it gives a financial health check for your labour force and guides your critical decisions.
A higher LER, therefore, indicates better efficiency and profitability, while a lower one suggests that labor costs may be eating into your profits.
How to Calculate LER
Calculating LER is straightforward, but it involves a few key steps to ensure accuracy. Here’s how to calculate it.
- Determine Gross Profit. Start by calculating your gross profit for a specific period. Gross profit is the total revenue minus the cost of goods sold (COGS).
- Calculate Total Labor Costs. Next, sum up all labour-related expenses for a specific period. This may include wages, salaries, bonuses, benefits, and other employee-related costs.
- Compute the Labor Efficiency Ratio. Then, use the following formula to calculate LER.
LER= Gross Profit / Total Direct Labour Costs
So, for instance, if your company’s gross profit is $800,000 and your total labour costs are $250,000, your LER would be:
LER = 800,000 / 250,000 = 3.2
This means that for every dollar spent on direct labour, your company generates $3.20 in gross profit.
A higher LER indicates better efficiency and shows that your labour costs are effectively contributing to gross profit generation. Conversely, a lower LER might signal that labour costs are disproportionately high relative to gross profit. This implies that there’s a need for optimization.
Why Does LER Matter?
LER matters for several key reasons:
- Business Planning: A strong LER means you can confidently invest in growth, knowing your team is productive.
- Benchmarking: LER allows you to compare against industry standards or your own historical data, highlighting areas for improvement.
- Profitability: A healthy LER directly impacts your bottom line by ensuring labour costs efficiently generate profit.
What Is Management Efficiency Ratio (MER)?
Management Efficiency Ratio (MER) helps you figure out how well your management team is using your company’s resources. Put simply, it lets you determine whether your team is running smoothly and turning investments into profits.
For instance, say you run a tech startup. Calculating your MER will inform you how effectively your management team uses their time, money, and manpower to contribute to your company.
It shows you where your company is excelling and where it might be hitting some bumps.
How to Calculate MER
Calculating Management Efficiency Ratios (MER) is simpler than it sounds. Here’s how to do it.
- Identify Management-Related Expenses. First, figure out the total costs associated with your management team. This includes benefits, salaries, bonuses, and other expenses that directly relate to managing your business.
- Determine Contribution Margin. Next, calculate your company’s contribution margin for the same period. For that, subtract variable costs from your total revenue.
- Compute the Management Efficiency Ratio. Use this formula to calculate MER.
MER = Contribution Margin / Management Labour Costs
Let’s say your company’s management costs are $200,000, and your contribution margin is $1,000,000. Your MER would be.
MER = $1,000,000 / $200,000 = 5
This implies that for every dollar spent on management costs, you’re generating $5 in contribution margin.
A higher MER is generally a good sign. This means that your management costs are only a small proportion of your gross profits. On the other hand, a lower MER suggests that management costs are eating into your profits more than they should.
Overall, the ideal ratio depends on your company’s type and business model.
Why Does MER Matter?
Here’s why understanding MER makes a difference for your business.
- Cost Management: MER helps you understand if you’re spending too much on management compared to earnings.
- Investment Confidence: A higher MER gives you the confidence to invest in new projects and hire more staff.
- Performance Insight: MER provides a glimpse into your management team’s performance, indicating areas needing improvement.
LER and MER in the Income Statement
Here is a sample income statement to help you understand how LER and MER are included in the statement:
| Revenue | $ 5,000,000 |
| Cost of Goods Sold | $ 1,000,000 |
| Gross Profit | $ 4,000,000 |
| GP as % of Revenue | 80% |
| Direct Labour | $ 1,500,000 |
| Contribution Margin | $ 2,500,000 |
| Direct LER | $ 2.67 |
| Operating expenses: | |
| Facilities | $ 250,000 |
| Marketing | $ 150,000 |
| Salaries (management and admin) | $ 1,000,000 |
| Payroll taxes and benefits | $ 300,000 |
| Other operating expenses | $ 200,000 |
| Total operating expenses | $ 1,900,000 |
| Management LER | $2.50 |
| Net operating Income | $ 600,000 |
| Other expenses: | |
| Depreciation | (75,000) |
| Interest Expense | (25,000) |
| Total other expenses | (100,000) |
| Pre-tax Net Income | $ 500,000 |
| as a % of Revenue | 10.00% |
| as a % of Gross Profit | 12.50% |
Conclusion
Labour and Management Efficiency Ratios give you real-time insights into the health of your operations. As such, they empower you to make informed decisions, allocate resources wisely, and ultimately boost profitability.
However, understanding these ratios is just the beginning. To truly leverage these insights, you need a partner who can turn numbers into actionable insights.
This is where we can help. Argento CPA provides cash flow management strategies and the financial clarity you need to boost your company’s efficiency. Contact us today to see how we can drive your business forward.
FAQs
What Is Labour Efficiency Ratio?
The Labour Efficiency Ratio (LER) measures how effectively your labour costs turn into gross profit. It’s like a productivity score that shows whether your team is working efficiently and your labor costs are justified.
Why Is Labour Efficiency Important?
Labour efficiency is important because it directly impacts profitability and overall business performance. When your team works efficiently, you get more revenue for every dollar spent on labour. This means better cash flow, more resources for growth, and a stronger competitive edge.
How to Improve Efficiency Ratio?
To improve your Labour Efficiency Ratio, streamline processes by simplifying workflows and automating repetitive tasks. Besides, consider setting clear, measurable goals to keep everyone focused and optimize staffing levels to ensure the right balance.
