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Maximizing labor productivity.

Every business struggling to be more profitable tries to cut anything but labor. Instead of thinking about cutting costs, there's a better idea--increasing productivity.

It may sound like a play on words, but the kitchen supplies can't be cut nearly enough to make a company profitable. In every case where business has increased profits, it came as a result of a process of improving labor productivity. A business owner or manager is likely spending the right amount of money on labor. They are just not having the right people in place to do the right things.

Here are the three key areas of focus to maximize productivity:

Measure labor through a Labor Efficiency Ratio (LER)

First, look at labor as a lever, not a cost. To do this, labor should be separated into at least two categories--direct labor and administrative labor.

* Direct Labor Efficiency Ratio. This is calculated as gross profit per direct labor dollar (the definition of gross profit is revenue minus all non labor direct costs). Revenue is a vanity number, and gross profit can only be spent to cover labor and operating costs. By focusing on improving gross profit dollars per direct labor dollars, it provides maximum flexibility to deal with price or volume as key tools.

* Administrative Labor Efficiency Ratio. This next key to holding the management team accountable is a formula that is measured by taking gross profit, less direct labor, to come up with "contribution margin." This new item is need. ed to create a line that represents the output of a business engine before any operating costs.

Contribution margin dollars per administrative labor dollars is the measurement for the administrative labor efficiency ratio. By using contribution margin as the numerator it allows a management team to focus on multiple options to get more contribution margin dollars by adjusting revenue, cost of goods sold or direct labor.

Once again, the goal can be accomplished either through volume or pricing, as long as labor is productive.

Successful Patterns of LER Using the 'Data Cube'

Even in struggling businesses, patterns of success exist that can be replicated. The "data cube" represents the various views of contribution margin that are needed in order to understand the business model. A business owner or manager should be able to track revenue, cost of goods sold and direct labor by customer by product, division, location, line of business or employee, whenever possible.

Not all of these will apply to every business, but they should be able to make a good attempt to at least measure by customer. Service businesses that track billable time also can get down to LER by person. For example, if LER can be calculated by customer, rank them by labor efficiency ratio from top to bottom. For a typical business, 80 percent of revenue will come from 20 percent of customers. Find the most successful patterns in the top customers and evaluate why they are successful, and why others are not.

This will lead either to repricing the underperformers or to finding unproductive labor. If it is a good customer but bad labor, these are the employees that require retraining or replacement. If it's a bad customer, good labor should be freed up by letting the customer go and not let effective labor go to waste. It is no more complex than that.

Hire and Adjust Pay Based on LER Targets

Once the LER is in place for direct labor and administrative labor, the team can be held accountable to a measurable outcome to base pay adjustments and future hiring decisions. Like any productivity measure, people are not likely to remain at the highest performance level forever. But, by tracking this over time, a base level can be established and exceeded, before it is likely to fall back to normal after raises or staff additions.

In today's competitive environment, all labor must be productive and there is no room to pay an employee who is not producing. Productive labor does not waste non labor costs; the business executive won't be cutting kitchen supplies to make the profit target.

Greg Crabtree has worked in the financial industry for more than 30 years. He founded Crabtree, Rowe & Berger PC, a CPA firm dedicated to helping entrepreneurs build the economic engine of their business. Crabtree is also the author of Simple Numbers, StraightTalk, Big Profits! For more information, visit:

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Author:Crabtree, Greg
Publication:Financial Executive
Geographic Code:1USA
Date:May 1, 2012
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