Understanding Labour Efficiency Ratios For Business Growth

When considering expanding your business by adding new staff, it’s essential to understand how efficiently your labour is contributing to profitability. In his book Simple Numbers 2.0, Greg Crabtree introduces two key metrics that help assess labour efficiency: Direct Labour Efficiency Ratio (DLER) and Management Labour Efficiency Ratio (MLER). These ratios help you make informed decisions about staffing and ensure that new hires contribute positively to the bottom line.

1. Direct Labour Efficiency Ratio (DLER)

Direct Labour Efficiency Ratio (DLER) measures the productivity of employees directly involved in producing your goods or services. This group includes anyone whose work directly generates revenue, such as technicians, sales staff, and manufacturing workers. DLER helps you evaluate how effectively these employees are converting their labour into profit.

Formula:

Gross Profit

DLER =             ——————-

                     Direct Labour Cost

Gross Profit: Total revenue minus the cost of goods sold (COGS), excluding labour costs.

Direct Labour Cost: Total wages and benefits for employees directly involved in revenue-generating activities.

How to Use It:

A DLER of 2.0 is the benchmark. This means for every dollar you spend on direct labour you should generate $2 in gross profit. If your ratio falls below 2.0, it may indicate that your labour is underperforming, and adjustments are needed. This could mean restructuring roles, improving training, or rethinking processes to get more efficiency from your direct labour force.

Key Consideration:

Before hiring additional direct labour, ensure your existing team is working efficiently. You want to be sure that adding more employees will drive more revenue, rather than just increasing your expenses. If your DLER is high (above 2.0), it suggests that new staff can be a good investment because the existing team is operating efficiently.

2. Management Labour Efficiency Ratio (MLER)

Management Labour Efficiency Ratio (MLER) evaluates the effectiveness of your management and support team. Unlike direct labour, these employees don’t directly generate revenue but are essential for the smooth operation of the business—HR, finance, marketing, and management fall into this category.

Formula:

Gross Profit

MLER =            ——————-

                   Management Labour Cost

Management Labor Cost: Total wages and benefits for non-revenue-generating staff such as managers, administrative staff, and support roles.

How to Use It:

An MLER of 3.0 is the standard goal. This means for every dollar spent on management labour, the business should generate $3 in gross profit. If your ratio falls below 3.0, it may indicate that your management structure is bloated or inefficient, and adjustments are needed before expanding this team.

Key Consideration:

When deciding whether to hire additional managers or support staff, the MLER is crucial. If your current management team is not performing efficiently (i.e., below 3.0), adding more staff may simply increase overhead without delivering additional value. Focus on improving the productivity of your existing management team before expanding it.

Applying the Ratios When Adding Staff

When considering expanding your workforce, both ratios should be analysed together. For example:

• If DLER is below 2.0: You may not need more direct labour yet. Focus on improving the productivity of your existing team before hiring.

• If MLER is below 3.0: It’s a sign that your management team may not be supporting the direct labour efficiently, and adding more management staff could make things worse.

• If DLER is above 2.0 and MLER is above 3.0: This indicates that your business is running efficiently, and adding either direct labour or management staff is likely to enhance profitability.

Some Things to Consider About Your Numbers

The ratios you calculate may be impacted by a number of things

1. Whether you use contract labour in the production or delivery of your sales
2. What items you include in your cost of goods sold in your profit and loss statement
3. Whether as business owners you pay yourself a wage versus taking distributions/dividends

It is important to make sure cost of goods sold are properly classified and that direct labour cost and management labour cost take into account the above

Also keep in mind that there is no data like your own data. To get some idea of how you have gone historically go back over a number of years/periods and do your calculation and determine whether there may be some more relevant benchmark for the ratios that you need to use

Please contact your Vincents advisor for any guidance you require or questions you may have.

Conclusion

As a business owner, understanding these labour efficiency ratios is critical to making smart staffing decisions. The DLER and MLER help you measure the effectiveness of both your revenue-generating and non-revenue-generating teams, ensuring that any new hires contribute positively to the growth and profitability of your business.

Before you hire, check your DLER and MLER. If your numbers are where they should be, you’re likely in a good position to expand. If not, focus on improving internal efficiencies first to make the most of your current resources.

Disclaimer: The content of this article is general in nature and is presented for informative purposes. It is not intended to constitute tax or financial advice, whether general or personal nor is it intended to imply any recommendation or opinion about a financial product. It does not take into consideration your personal situation and may not be relevant to circumstances. Before taking any action, consider your own particular circumstances and seek professional advice. This content is protected by copyright laws and various other intellectual property laws. It is not to be modified, reproduced or republished without prior written consent.