If you’re in a professional service business, you’re familiar with the rollercoaster ride largely driven by two distinct variables. First, you have the velocity of new customer sales, and secondly, having the ability to profitably execute on those customer sales. For marketing agencies, this rollercoaster can get topsy turvy fast. I don’t know about you but these big rollercoasters make me dizzy and a little ill–sounds like being an entrepreneur sometimes, right?
But for your agency, there’s a way to smooth out the bumps by gaining command of a critical metric. Because when managed well, it can help you not only anticipate the ups and downs but avoid them as well. I’m talking about the magic ratio: the Labor Efficiency Ratio. It’s big, it’s fun, and it’s a little complicated.
The Labor Efficiency Ratio (LER) is the measurement of productivity of your people within a business.
There are two types of LER’s: one for Direct Labor (the labor performing client work) and the other for Management. Today, we’re only going to focus on Direct Labor LER.
Direct Labor Efficiency Ratio (LER)
This ratio is calculated as Gross Margin (Revenue – Cost of Sales) / Direct Labor Costs
Direct Labor LER looks at how productive/efficient your employees who directly deliver services for a specific client are. These employees are usually tracking time and allocating their time across certain projects.
Below is an income statement that has been recast so we can calculate the Labor Efficiency Ratio. This is very relevant for you! In order to leverage your financial information, you must be able to pull relevant data easily and classify it in a way that allows you to make managerial decisions. You may need to set up your chart differently in order to do this. Yes, we do this at Stride.
You can see the gross margin we are using excludes labor, so we are actually able to pull out the direct labor number from your general ledger (e.g. QuickBooks).
To calculate the DLER, we divide $450,000 by $200,000 and get a number of 2.5. 2.5 means that for every $1 of direct labor cost, we are generating $2.5 of gross margin. Does this mean anything to you? Absolutely not!
You can’t look at DLER in isolation and make a business decision. You need to track it on multiple levels. Here is some additional information to chew on:
Calculating DLER by Team Member, Customer and Project Type
Some questions this breakdown of LER raises:
- We can see that Sam has a very high DLER which may mean he is super-efficient or he is extremely overworked (look at the client Net Promoter Scores to validate).
- Stride is a customer with a very low DLER compared to other customers. It could mean this is an unprofitable client. What is the Wilson Sports team doing so well?
- Consulting is a really low DLER but before you shutter that product line, you might see it’s the lower margin way to get the web development work which is quite efficiently executed.
Calculating DLER Over Time to Look at Trends and Variations
The best way to track DLER for a professional service business, like an agency, is to track it on a rolling 12-month basis to adjust for seasonality as I have shown here.
Some questions this raises:
- % profit for the company was low in March which might be explained by the low DLER. Take a look.
- What was the explanation for August’s high-profit margin? It looks like DLER was really high. Why was this the case? Oh, 2 employees were out, so one individual took over their jobs and is nearly on burn out. Oops.
So What Do I Do with This Awesome New Labor Efficiency Ratio Insight?
What the DLER helps you do is ask the right questions. It’s not a silver bullet of answers, but it presents data in a way that prompts curiosity, giving the ability to dig in and figure out the root cause of what’s going on with the crazy rollercoaster. If you want to operate your marketing agency with a discipline grounded in data-driven decisions, this is a great place to start.
If you want to do a better job calculating labor efficiency, like better time tracking, setting up the right chart of accounts, and asking the right questions to improve it, please contact us at Stride.
