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Welcome back to The Small Business Mentor!
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Let’s dive in…
I promised to talk about how to go deeper on using Greg Crabtree’s concept of LER in your business.
Here was the key part about from last week:
That’s where labor efficiency comes in. It’s a North Star metric for almost any business. Greg calls his metric the Labor Efficiency Ratio (LER).
Here’s how you calculate it. First, add up all the labor accounts across your P&L. That’s your Total Labor Cost.
Now here’s the two step formula:
1) Revenue-direct costs-subcontractors=Gross Margin.
2) Gross Margin/Total Labor Cost=LER.
What’s amazing is that almost every company will get around a 2 LER.
Today we are going to decompose LER into its two components. All business have two types of labor. The first is Direct Labor. The second is called Management and Admin Labor.
Each has it’s own ratio.
To get those ratios, you need to categorize everyone’s salary who directly services a customer or creates the product or service that serves the customer as Direct Labor.
That’s distinct from Management and Admin Labor which is everything else. Sales, marketing, accounting/finance, recruiting, management, etc. That’s all M&A labor.
The accounts on your P&L should distinguish between these two types but sometimes you need to just start with a bucket of people and their salaries and total it up.
You also shouldn’t divide up people. If a person is 51% direct and 49% management, include 100% of his salary in direct labor.
Doing the Calculation
Now you can calculate a Direct Labor Efficiency Ratio (DLER) and a Management and Admin Labor Efficiency Ratio (MLER).
Start with that Gross Margin total from last week and divide it by Total Direct Labor. That’s DLER.
To get MLER, we have to take one more step. Go back to that Total Gross Margin figure and subtract Total Direct Labor cost from it. That gets you what Greg calls Contribution Margin. Now divide that Contribution Margin by Total M&A Labor. That gives you MLER.
To summarize in equation form:
Gross Margin/Total Direct Labor=DLER
(Gross Margin-Total Direct Labor)/Total Management and Admin Labor=MLER
The answer is a dollar figure: you get $x in Gross Margin for every $y of Direct Labor you pay for.
There isn’t any one answer to what the targets for these figures should be. Some businesses use really senior and expensive labor to work with clients. They in turn don’t need much management so DLER is low and MLER is high.
In other cases you have a lot of expensive managers and a bunch of inexperienced and cheap people doing the real work and you get the opposite.
It doesn’t really matter which. My core business in government consulting is about a $2 DLER and a $4 MLER.
What to Do With DLER/MLER
Benchmarking: Now you have a way to compare your business against any other. You can benchmark against other businesses and in particular competitors.
Diagnosis: The real key isn’t what the numbers actually are but how they impact your business over time. You can track MLER going up and see that your profitability is going down. Now you know what to attack. M&A labor is getting too fat.
Going Deeper: After calculating DLER, you can further break it down to DLER by person, project, product, service, business unit, etc.
Greg tells a great story on the pod about a lawn care business that broke down DLER by service. They had two divisions. One did commercial mowing and got a $2 DLER for that service and the second did lawn care (residential fertilization and weed management) and got a $4 DLER for that.
After hearing those figures, a lawn care guy making $10 an hour said: “Sounds like we should do more lawn care and get out of commercial mowing.” DLER made it so clear that a $10 an hour employee could set the strategy.
Setting Salaries: Now you have a tool that can help you understand how much you can afford to pay someone. Are they producing enough Gross Margin to merit a raise? How can you get them there? Raise prices? Sell more? Etc.
I know it’s a bit of math but it’s worth calculating these figures and using them over time.
One Last Story
I did this live once in a coaching call with someone with a business similar to mine.
She had a $2.5 MLER and a $1.8 DLER. That’s worse than my business which does similar work but it was the MLER that was the real issue.
She said, “But my admin people are always telling me how overworked they are. How can they have such a low MLER?”
Now we had something to work with. We talked back and forth about some potential reasons you could have a low MLER and have a burned out staff.
What it came down to is that she had the wrong people in the wrong seats. They didn’t know how to do their jobs so they were flailing around burning themselves out but getting nowhere.
To fix it, she needed to make some real changes and rebuild her admin team to get to better profitability.
It was a tough but important lesson.
Next week I’ll cover the last key lesson from Greg Crabtree: How to use Return on Invested Capital or ROIC to guide your investment decisions.
Until then…
Keep growing,
Alan
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