The #1 metric to track to improve profitability in your business

when it comes to running our small businesses most people like to have hard and fast rules that they can point to and say yes my business is doing that check some kind of metric that they can measure their business against and a lot of times as a financial professional I have to say well it depends but not today I have a hard and fast ratio that I want to tell you guys about and this is one of the number one metrics that I would say any business needs to track in order to be profitable so if that sounds good I'm going to get into it in just a second if you aren't already subscribed to the channel I'd love to have you here as a subscriber to the Clara CFO group Channel I am a fractional CFO I do fractional CFO work for small businesses I see what's happening every day in small businesses and the stuff that we bring to you on this channel is coming directly from those conversations we're having with real life clients so this metric that we're talking about today is absolutely something that we talk to our clients about all day every day okay so if you'd like to glean some of that information that we're talking to our clients about that's what this channel is for okay so we'd love to have you here as a subscriber thanks so this ratio that we're talking about is a labor productivity measurement called the labor efficiency ratio and if you have ever heard me talk about it before it's because it is coming from this book Greg Crabtree simple number Straight Talk big profits we're big fans of Greg CRBT tree over here we have interviewed I have interviewed him here on the channel and I also just had him on the Financial Clarity podcast we'll link both of those in the description box below so that you can go and watch those if this if you want to learn more about these types of topics also grab the book If you don't already have it it is a fantastic read if you're trying to run your business in a more financially profitable way which who isn't okay so labor efficiency I'm going to tell you what it is I'm going to use labor efficiency and labor productivity pretty interchangeably so labor productivity is this idea that every dollar of Labor should be producing something for your your business so should be actually coming into your business for some type of return with Revenue okay now the labor efficiency ratio is the metric that is going to measure your labor productivity okay so when we say labor productivity and labor efficiency we really kind of mean the same thing all it's all about that concept of like when you hire somebody and you're spending money to have them work in your business you want that to be moving forward your business in some kind of way so even an admin assistant that may not be necessarily directly relating with clients or be a revenue generating professional if you're in a Services business if they're not Revenue generating they're still they still should be producing efficiency by maybe taking off some of the workload of somebody who you know is a client serving professional for example so anybody that you have in your business should be moving your business forward in some way whether directly or indirectly that's the concept here okay and so the labor efficiency ratio is how we calculate that is we say every dollar of gross profit over every dollar of Labor okay so we take gross profit as the numerator and then all labor costs as the denominator and that will give us labor efficiency ratio now before you freak out about like ratios and numerators and denominators I'm going to show you how this works out and we can also put it up here on the screen somewhere but gross profit on top labor cross on the bottom equals labor efficiency ratio it's really not too hard but the hard part is sometimes knowing how it works directly in your business with your financials and so I want to talk about a couple nuances and um the target number I will talk about nuances and I'm going to pull up some actual real pnls that I've doctored a little bit so they you can't tell who they're from but I'm going to pull those up and actually show you how to calculate this directly in a profit and loss statement but before that I want to make sure that I tell you what is the goal you I I started out this video saying there's hard and fast rules the hard and fast rule is that usually in most Industries I'd say 99% of Industries if you have a labor efficiency ratio of two that means for every dollar of Labor you are producing $2 of gross profit if you can achieve that and that you know assumes that you're doing your accounting correctly if you can achieve that you will most likely be profitable and at 10% or more of of profit percentage okay now there can be lots of different reasons why maybe you're not calculating that number and you're still or maybe you think you have a two or above but then when you actually go and you look and you say hey I'm I'm still not profitable but my labor efficiency ratio is 2.5 if that's the case I'm going to talk about some of those nuances that might be throwing off your labor efficiency ratio okay so couple things I want to mention first on those nuances that could be throwing off the ratio one you you might not be including your owner's compensation in your labor cost so for all of you guys who are operating as an LLC or even a sole proprietor you are just taking draws from the business and that means that your wages are not showing up on your profit and loss statement those are actually a balance sheet transaction so your profit is going to be falsely quite High because you're actually distrib distri Distributing to yourself wages from your profit so it's not showing up on your profit line okay so what you need to do when you're calculating your labor efficiency ratio is you need to take all your wages that are on your profit and loss statement and then add in what is a reasonable compensation for you which you know could look like what are those draws that you're taking to sort of pay yourself for your services so you do need to kind of create a different calculation for yourself in that way now another thing that could be falsely throwing off your leer calculation is that you might not be including the right things in your cost of goods sold so to get gross gross profit you need Revenue Minus cost of goods sold equals gross profit revenue is pretty straightforward that's all the money coming in but cost of good sold a lot of you guys will be including things that shouldn't be in cost of good sold or maybe maybe you're not including enough in your cost of goods sold so maybe your gross profit looks really high and you're thinking hey yeah I'm I'm looking really good my labor efficiency ratio is great but actually you have a lot of direct costs that are should be considered cost good sold that you're not actually including in there okay so these are some things that can throw things off I want to hop into an Excel spreadsheet I've got two examples to show you one of a business that is quite profitable and doing well and has a good leer and then one that also includes contractor cost because that's the other Nuance I forgot to mention to you guys is contractor cost sometimes we have employees and then we have contractors that we're kind of using as staff augmentation or we can use those people to actually service clients in some ways and then some people use a full contractor model where that's all of their labor really is contract labor if that's the case you need to include contractor wages into your ler calculation for the total labor costs as well so I'll show you an example of that because I have a good example for you okay so without further Ado let's go ahead and get into the Excel spreadsheet real quick and I'll show you how to calculate labor efficiency ratio in two different ways okay I have two examples here for labor efficiency ratio and I've chosen these two examples because they are both service-based businesses that are actually B2B companies but really it's it's more that they're service based most of the people who watch this channel are service-based businesses and that's one of the reasons why I wanted to talk about Labor efficiency ratio with you guys today because this is one of the big things that we're seeing over and over again as we talk to our CFO clients so just real quick run through the p&l uh Top Line is 2.7 million gross profit is basically 2.6 million they have a little bit of cost of goods sold it's really not much it's really just merchant service fees and a little bit of direct travel not a lot of cost of goods direct cost of goods sold here so gross profit is 2.6 million and then we have wages here and they don't really have any other contractors that they use everybody that they use is an employee and so they're all calculated here in the salaries and wages line and then um what we have not included is we did not include payroll taxes or benefits here this is just wages okay and then when you look at this business i' I've collapsed it so you don't see all the detail here but when you look at this business the net income was 575,000 which calculated out when we take 575 divided by the 2.7 up here is 21% profit that is an incredible profit margin now I know this business that the business owner is paying themselves a reasonable salary they're not taking exorbitant draws out of profits so we're not going to modify labor costs anymore because we don't have contractors cost of good sold looks good and we don't and the owner is paying themselves a reasonable salary so I think it's fine that we don't modify labor costs at all for this leer calculation so what we're going to do is we're going to take this gross profit and then divide it by this salaries and wages number very simply this number divided by this number is 1.94 now this is really interesting because here even though our Target is two we're this is basically saying that this business is doing great at even less than a two labor efficiency ratio okay so if this let's just say this income was a little bit higher for the same amount of wages then we'd be at the two but you know they're already making a 21% profit margin that just means that they're not spending a lot on their other operating costs they are you know they are able to to operate pretty well so overall this business is operating very efficiently we so I mean even though we're not even at that too we're still at a good profit margin we talk about this with the business owner that we're trying to get to two or above but in this case this still looks quite healthy so let's move along to this design company and this is a design company that does leverage subcontractors for a lot of their client work so they have a lot of different contractors that they can hire out for different projects and let's look at this so in this situation total income is $812 ,000 and then they've included their subcontractors up here in cost of goods sold so making the gross profit lower Greg Crabtree actually recommends not including direct labor up in cost of good sold but rather put it down in operating expenses so that you can have more apples to apples comparisons between different companies and compare the gross profits you know in this case we just do a little bit of extra calculation to figure out what that would be otherwise and I'm going to walk through that in just a second so gross profit is 44 7 you can see we have wages here of 177 and then when you get down to the bottom line this business actually was just barely break even at a 1% profit for the year and only made $4,000 you know um so this is obvious obviously a business we want to help and try to improve that profit margin so what we've identified is that uh they probably have too much labor cost for the amount of Revenue that they're bringing in so how we calculate this because they have so much in subcontractor cost and so and then they have wages as well is that we actually add the two together so I've done this calculation over here the labor costs will be the employee cost which is pulled from here on the p&l and then we have the contractor cost which is pulled from here on the p&l to get our total labor costs here of 514 and then our gross profit we have to we can't take it out here and use this number as our calculation because that's going to give us really weird math and that's not going to work we're not going to take 514 and divide that into 447 so we need to add back the subcontractor cost that we're using into labor costs we're putting into labor costs so we take this number the 447 and then we add back the labor costs to say and I'll show you the math here if if we H did not have subcontractors up in cost of good sold it would be 785 here so we're just going to undo that and so you can see why I did that there okay so gross po profit we're adding back in those contractors so our gross profit would have been 785 if we didn't have direct labor up there so now we can take our gross profit number that we recalculated divide it by the labor cost and then you'll see here our labor efficiency ratio when we take 785 divided 415 or 514 is 153 1.53 that is not getting us to where we would like to be so this is an indicator all these numbers are indicators to say well we've got a couple problems we've got maybe multiple problems maybe our labor is not being efficient enough maybe we're not charging enough for the work that we're doing maybe it's a little bit of both more than likely almost always it's a little bit of both we're not being as efficient as we need to or we are not charging enough or both okay so this might mean in this case that this business owner needs to really look at their labor costs see if they've got any overhead labor that really that they can cut down are the owner compensation is the owner compensation reasonable in this case I know the owner's compensation is reasonable and in most mostly this means that their subcontractors are getting paid way too much for the amount of Revenue that they're bringing in so that's where they're looking at adjusting that ratio there this is why these numbers matter is so that they can help you identify problems in your business and then you can go and take action and change them labor efficiency I hope that is really helpful to you I hope I've explained it well if you have any questions please put them in the comment section below and um you can also read up on labor productivity here in this book and go and watch the interviews with Greg Crabtree as well I will make sure to link them here so you can check those out all right thank you so much for being here talk to you [Music] later

Channel: Clara CFO Group

Views: 1,764

Keywords: labor productivity, labor efficiency ratio, labor efficiency, labor productivity ratio, greg crabtree, simple numbers straight talk big profits, profitability metric, profit metrics, improve profit, profit kpis, kpi for small business, kpi for labor, kpi for profit, lagging measurements, kpis and metrics, small business kpi, small business metrics, labor efficiency metric, labor to gross profit, labor productivity tutorial, calculate labor productivity

Id: gntcIuOPl80

Length: 14min 28sec (868 seconds)

Published: Fri Mar 08 2024