We’ve seen a significant uptick in inflationary pressure across the country, with no signs of it abating. Labor increases are driving all costs up, so now is the time to manage your margins diligently — and to determine if you’re increasing your prices enough.
Gross Margin and Labor Efficiency
Gross profit is revenue less any direct material costs, including subcontracted work. For a construction company, for example, direct material costs would be sticks and bricks as well as subcontractors. The remainder is your gross profit.
I’m a subscriber to Greg Crabtree’s Simple Numbers concept, which relies heavily on maximizing labor efficiency. Most small- and medium-sized businesses do not track or monitor this number, but it is a simple concept. Direct Labor Efficiency (as opposed to administrative or marketing labor) is your gross profit divided by your total labor costs (including benefits and taxes). For example, if your gross profit for the period is $3MM and your direct labor costs are $1.5MM, your labor efficiency ratio would be 2.0.
A good target for Direct Labor Efficiency is 2.75, but that will vary by industry. Consider benchmarking your numbers against industry averages to start.
Gross Margin is a related metric that is the percentage of your direct materials and direct labor to revenue. For instance, if your revenue for a period was $4MM and your direct materials plus direct labor is $2.5MM, then your Gross Margin Percentage is 37.5%. Although gross margin is important to monitor, normally, you don’t have as much control over your vendor pricing as you do with maximizing your labor. That is why we recommend focusing on maximizing Labor Efficiency.
How to Maximize Labor Efficiency
There are a number of strategies to maximize labor efficiency. However, my experience leans towards involving your operations/production team in solving the problem and incentivizing them based upon the results. Top-down approaches don’t usually work as well as letting people solve the problem themselves.
Give them a clear understanding of the problem they’re trying to solve. In these instances, I recommend breaking the problem down to an as granular level as possible. For instance, don’t simply identify one location that has better labor efficiency than another and say fix it. Go to the shop floor, find the differences, and solve those problems.
Pricing As a Strategy
More than likely, you have some discretion in increasing your prices immediately. Analyze your customers by gross margin and unload the bottom 10-20% of them. Most of the time, you will find that you have large volume customers that aren’t contributing much margin.
Reciprocally, you have the top 10-20% of your customers that will pay you more. Have conversations with them to determine if there are any revenue opportunities (e.g., items/services that are ancillary but you don’t currently offer). Combining those two actions will have a tremendous impact on your gross profit and bottom line.
Should you need help in executing your financial growth, consider outsourcing a fractional CFO to guide your team through the business growth process. Learn more about fractional leadership here.
About the Author
As CEO of Core Group, a profit-first business and financial services firm, and a Forbes Business Council member, Christian Brim and his team help companies grow their business while saving taxes. To learn more, contact Christian on LinkedIn or visit coregroupus.com.