Measure the Profitability of Employees

At WCM we live by six core values:

• Work hard together
• Be responsive with respect
• Improve yourself every day
• Think innovatively
• Treat people like family
• Do the right thing

This month we want to focus on our core value of Work Hard Together. According to a New York Times article, labor productivity growth was at 0.4 percent from 2011 through 2015 which is the lowest since 1977 through 1982¹. This statistic has raised concern with economists about how competitive we are as a nation. From a macroeconomic perspective, labor productivity is a way to measure how profitable workers are. Yet, how does a business owner measure the profitability of employees in their business?

Labor Efficiency Ratio

To answer this question, we need to introduce the concept of the Labor Efficiency Ratio (or LER). There are two types of LER. First is Direct LER, which is the amount of revenue (less cost of goods sold) an employee generates divided by the employee’s wages (without taxes and benefits). Second is Management LER, which is the business’s gross margin divided by all management wages. Management LER is not separated due to the combined nature of management contribution to revenue.

Direct LER is one of the keys to profitability in your business. To illustrate, here is a comparison of two fictitious companies we will call StarCo and CalCo. StarCo and CalCo are both in the same industry but operate in different states. We can calculate the Direct LER and Management LER for these two companies that have the same sales, costs of goods sold, and operating expenses.

We can see from the table that StarCo has a higher direct and management LER than CalCo.

Managing LER

One of the most important practices to establish when managing LER is to set a consistent reporting rhythm. LER can be calculated monthly (or even daily) when your financial records are kept up-to-date. This rhythm will help you see problems with our business more quickly than just preparing a financial statement or tax return on an annual basis. Also, reporting LER to departments or individual employees on a regular basis will help them see how their work contributes to the bottom line of the business.

Once you have established a reporting rhythm you will need to establish a benchmark for your business to be sure that it is operating at an optimal level. The best way to set the benchmark is to calculate your Direct and Management LERs on a rolling twelve-month basis for the last several years. This will show you a trend that smooths out fluctuations in your business cycles.

Knowing the average LER of your business will then allow you to establish growth targets that your employees and departments can work toward for increased productivity. The beauty of this system is that it puts the responsibility of being more productive into the employee’s court, thus increasing engagement. Another way to manage LER is to offer profit sharing based on LER targets. Employees will no longer receive bonuses for simply bringing in top-line revenue. They will have to produce profit and efficiency to increase their pay.

Knowing the average LER of your business will then allow you to establish growth targets that your employees and departments can work toward for increased productivity.

Forecasting LER

Have you ever wondered “Why did I hire that person?” If so, LER forecasting LER will help you hire smarter and in a more calculated way. Using the example above, we can adjust the labor amounts to see what effect a new hire will have on your business. This information will also allow you to forecast how long you can supplement the salary of an employee before he or she must be able to be self-supporting. In your industry, you will need to decide how long of a learning curve is acceptable. This will also push you to hire the most qualified and productive employees you can if a short learning curve is necessary.

We hope you learned about LER and how it can be used to increase the profitability of your employees. Our team is available to discuss these and other tools that we can provide to as a business owner.

To learn more and please contact us at 210-684-1071 or email us at info@wsmtexas.com!

¹Why Is Productivity So Weak? Three Theories, https://www.nytimes.com/2016/04/29/upshot/why-is-productivity-so-weak-three-theories.html