New Zealand has one of the OECD’s lowest levels of productivity and to stand alone in an uncoupled world this is something we need to improve – and a very practical way to start that improvement is by understanding your businesses labour efficiency.
In his book Simple Numbers, Greg Crabtree details what he refers to as the Labour Efficiency Ratio or LER.
It is a simple calculation as follows:
Sales – Cost of Sales = Gross Profit before Direct Labour.
If you then divide your direct labour costs into the gross profit before direct labour, it tells you how many times direct labour is covered. Generally, a score of anything less than two is problematic with the goal set above three.
Let’s look at some examples where direct labour has been managed differently using automation, more flexible staffing and other approaches. Notice the correlation between the LER and percentage net profit before tax.
Note: it is important to ensure all direct costs are captured in your cost of sales. Too often equipment hire, project travel and accommodation and other direct costs are shown in overhead expenses. These should be recoded as COS to give a true contribution margin. Similarly, direct labour needs to incorporate all those in the making of products or delivery of a service. If supervisors spend more than 50% of their time on the job, then include them as direct labour, otherwise show them as indirect labour as an overhead expense.
As you can see from the examples above, getting productivity up impacts on your bottom line.
So how can the LER be improved? Here are some ideas;
- Staffing levels
- Use subcontractors until there is sufficient business to support a full time equivalent
- Employ more part time staff and map them to periods of demand
- Staffing effectiveness
- Ensure people know what is expected of them
- Remove obstructions to production
- Employ supervisors who are independent and capable of effective supervision
- Eliminate Rework
- Know your error rate – DIFOT (Delivery In Full On Time) for products or IFOTIS (In Form, On Time, In Specification) for service delivery. Target 98% or better
- Follow up on all complaints and respond with a ‘Correction Action Process’
- Post Audit Quotes & Estimates
- Conduct post audits on project work
- Review and recalibrate processes from findings
- Constantly incorporate learnings into Standard Operating Procedures (SOPs)
- Regularly debrief and reset SOPs – again, people need to know what is expected
- Look at using machinery to do the mundane
- Look to introduce robotics to significantly increase throughputs
- Use systems to capture any manual processes like books or paperwork showing units input, outputs, labour hours etc. Electronically capture and utilise API’s etc to put directly into the system.
- Proactive Equipment Maintenance
- Ensure your equipment is always functioning at full capacity
- Monitor equipment downtime within
- Have planned back up processes when failure occurs
Although not related to staffing, the following will favourably affect your LER.
- Increase sales
- Price increases – when was the last time you put them up?
- Tighter terms of trade – stop discounting and provide transparent terms based on volumes and true costs to serve
- Improved account management to increase sales
- Improved or increased effective marketing
- Improved buying
- Look at your main basket of goods and get people to bid and achieve EDLP (Every Day Low Pricing)
- Ask your suppliers for improved terms – you will be surprised
- Know your costings
- Forensically cost all your product lines and or services – the devil is in the detail
- Know what margins each of your products and services deliver
- Re-engineer unprofitable lines or services or delete them
Following all or some of these will improve your business performance.
A guide to Net Profit before Tax
Less than 5% and your business needs life support – meaning its dying.
Between 5 – 10% you are on your way to recovery, but you have a way to go.
Between 10 – 15% you are running a good business, retaining sufficient profit to manage growth and any business shocks.
15% plus puts you in a good niche but keep an eye on your competition. Unless you are nicely niched, over time, you may be seen as too pricey which will encourage new players to enter your market.
These are volatile times, and it is important we have balance sheet strength to help us get through. What is good is different for each business but as a rule of thumb, if you can access resources to sustain you for three months of overheads without any sales, then you will be better off than many others.
Simple Numbers by Greg Crabtree is available on Amazon.