“People are our business,” or, “People are our most important asset,” etc. Many businesses mouth these phrases but I’ve met zero small business owners who can actually tell me what return they get on those important assets1. How do we know something is important if we don’t measure it? How do we know it’s a productive or good investment?
The business owners aren’t wrong about people being important. It’s pretty hard to do much of anything without people. Even AI companies need labor. Facebook may make $635k per employee but it still needs those employees to function. For most businesses labor is their biggest cost and for those for whom it isn’t, it is still their most important investment. The problem most business owners have is they don’t know what return they are getting on that labor.
I learned all about the importance of labor from Greg Crabtree who wrote Straight Talk, Simple Numbers, Big Profits. There are many lessons in the book but it’s most important is that labor isn’t a cost; it’s an investment and like any other investment you should measure the return.
Accountants and Quickbooks don’t make it easy. Labor costs tend to be spread over multiple accounts in your profit and loss statement (P&L) and most owners just aren’t spending that much time looking at their P&L much less isolating labor as an investment. We tend to look at the top line (revenue/sales) and the bottom line (net income). It between we get lost.
The simplest way to figure out the return on investment (ROI) of your labor is to add up all the accounts on your P&L with labor or wages in the name. Then divide your total revenue by that labor total. So if you do that division and get 2.52, it means you get $2.50 in revenue for every dollar of salary you pay. That’s a 250% ROI. That sounds pretty good.
But this is just a quick and dirty way to get a general sense of your labor ROI. If you want a more accurate calculation then you have to make three adjustments. These adjustments help you use the concept of labor ROI to run your business better.
The first adjustment is to recognize that some of the “revenue” in your revenue number isn’t really yours. If you use subcontractors, you’re really just passing money through to them. You don’t earn that money so it shouldn’t be a part of measuring labor ROI. It’s best to subtract out subcontractor payments from you revenue number.3
Second, take out any other direct costs besides labor. Direct costs are costs that you only incur when you sell your product or service. Marketing, management, administration, finance, sales, etc. are not one to one costs that change with each sale. They are indirect costs and often lumped together in a categories called SG&A and overhead. Travel needed to deliver services to a customer is an an example of a direct cost. Another direct cost might be materials that you buy only when a customer orders your product. Your employee wouldn’t travel and you wouldn’t order the materials without a sale.
So with those adjustments we now have revenue minus subcontractors minus any other direct costs like travel. Let’s call the end number Gross Margin4. Divide that Gross Margin number (let’s say it’s $250,000) by your total labor and wages cost/investment (let’s say that is $100,000) and you have your ROI number: $2.50. I get $2.50 for every $1 I pay in wages.
That ROI is fine but it puts two kinds of labor together in one pot. It’s a lot more helpful when you use two pots. So our third adjustment is distinguishing between direct labor and management and administrative (M&A) labor. Just like the direct costs we subtracted from revenue above, direct labor is any labor that you wouldn’t hire without securing a sale. If I hired a consultant to work for a client I would charge that person’s time as direct labor.
The other pot of labor is M&A. All the back office stuff we mentioned about that is in SG&A and overhead: accounting, finance, administration, and HR are M&A labor as are marketing and sales. If I hired that consultant before I made a sale because she was really good and I felt like having her would get me a sale eventually, her salary would count as M&A labor until she started billing to a client. At that point her salary would become part of direct labor.
Now we can distinguish between our two types of labor. If you want to find out your ROI on direct labor, go back up to our gross margin figure of $250,000 and $100,000 in labor/wages. But now we have two types of labor so let’s just say that $75,000 of that labor spend was for direct labor and $25,000 was for M&A. To figure out our direct labor ROI I divide $250,000 (our gross margin) by just direct labor of $75,000. The result is $3.33. I get $3.33 cents of gross margin for every $1 of direct labor that I pay.
That leaves M&A labor. To figure out its ROI we need subtract direct labor cost from gross margin. $250,000-$75,000=$175,000. We do this because we are trying to figure out how good a return we are getting on our back office labor. We need to isolate it. Direct labor produced the revenue and gross margin so it is held accountable to that figure. M&A labor manages and helps the direct labor so it is held accountable to gross margin minus direct labor5. In our example we divide $175,000 by the remaining labor of $25,000 from our total of $100,000. $175,000/$25,000=$7. That means we get $7 in return for every $1 we pay in M&A wages.
Now that we have the math out of the way, we can talk about why all of this is important. If your combined labor ROI is really good, that might be enough. Case closed, I’m getting a good ROI on my most important investment: salaries. But if things don’t seem to be going well, you can use the two pots to figure out where the problem is. Say your profitability sinks. Take a look at your direct labor ROI. The ROI number doesn’t tell you the exact problem but it helps you ask the right questions. If it went from $3.33 as it was above down to $2.75, it could be that you gave out raises or hired more expensive people without raising your prices. It could also be that you’re overstaffed or that your people are getting less efficient or maybe your sales people have been quoting too low a prices.
The same is true of your M&A ROI. A higher than normal number might indicate that the new IT system you put in to automate processes has worked. If you were getting a $7 ROI on M&A labor and it goes up to $9, it could be the software. On the other hand what if you just won a bunch of new work and the M&A staff are working harder but haven’t hired people to help? That high number could spell burnout and trouble ahead.
You can also use these ROIs to benchmark your company. Every industry is different and be careful with what costs are allocated to what buckets between companies but a direct ROI of just under $2 to just over $4-$5 is good. There are many exceptions to this rule so please don’t take that as gospel. Around $2 you either have expensive people or lower prices or some combination. If you are well over $5, you might be running Facebook.
On the M&A side, the magic number seems to be $4. I’ve looked at it across 20-30 companies and when you get much below $4, profit really decreases and when you get far above $5 your staff is about to kill you. I have seen a couple of companies with M&A ROIs in the teens. One I know in particular has the most efficient processes I’ve ever seen. With amazing process and constant training he is able to use low cost labor to perform many high level tasks. It’s a sight to behold but most of us are going to be in that $4 range.
In one session where I was doing a deep dive on calculating these ROIs for a group different businesses, one of the participants found he had an M&A ROI of $3. He obviously wanted to know why his company was missing the benchmark. I asked, are you overstaffed? He responded that his back office staff was always talking about how overwhelmed they were. Now without an ROI benchmark and calculation, he could have accepted that answer at face value and just hired more people for M&A. Most likely his M&A ROI would have declined further and profitability along with it.
But armed with this data he instead asked, why do other companies operate 33% more efficiently? They’re only a few possibilities. First, his staff could be vastly overpaid but wage surveys can benchmark that and really it just takes a sniff test. That was not the case here. Second, his staff could be low quality and unable to do the work and third he or another manager could be making their work inefficient in some way. The work for this owner was to go figure out what parts of possibilities 2 and 3 were happening in his firm. M&A ROI set him on a completely different course armed with good data.
I’ve rambled on enough about labor for one day. I hope you can get to the end of this piece. In my mind, understanding how to measure my labor ROI has been the best tool to guiding my company’s growth and profitability. In future posts I’ll write about how I’ve used this data to shape company KPIs, staffing and hiring, and pricing. But for now go read Greg’s book and hire his firm. I did and I’ve never regretted it.
That’s it for this week.
Alan
The only exception are businesses owners who are clients of Greg Crabtree
Greg refers to this as you labor efficiency ratio (LER). It’s the same as your ROI.
1099 employees are a judgement call. You can either subtract them from revenue as subcontractors or you can include them in wages depending on how integral they are to your business.
In common accounting parlance Gross Margin would also subtract out direct labor. We are trying to isolate the impact of labor so we aren’t doing that in this exercise. I don’t like using a term that means something else to other people so I often call it Real Revenue but there are only so many terms I can throw at you in one post so I didn’t do that here.
To confuse things further, the result you have after subtracting direct labor from our version of gross margin is what accountants call gross margin. Greg calls the result contribution margin.