I am glad to see labor as the central topic of business for the entrepreneurial community lately. My experience has led me to the conclusion that labor productivity is the most essential ingredient to a profitable business.
More so than access to capital, tax policy, or research and development, labor productivity is what powers great businesses. It is essential to understand that you must manage the delicate balance of the right labor at the right time at the right price to maximize your profits. The business media touts technology that eliminates labor, but technology eliminates head count, not labor dollars. You may get away with eliminating low-wage, repetitive jobs, but technology-aided jobs require better skills, and employees with those skills demand higher wages and are often harder to find.
Business analysts have been measuring labor productivity all wrong as businesses create streamlined processes and technology-aided jobs. Most people measure their labor efficiency as sales per full-time equivalent (FTE). The problem is, both sales numbers and the number of FTEs are hopelessly flawed. The key is gross profit per labor dollar. I refer to this measurement as your labor efficiency ratio (LER).
After you model your target for your LER, you will find that it is the most critical indicator of your profitability. I know that if my firm hits an LER of $1.80, I hit my profit target. My nonlabor operating costs vary so little that I know it is all about my labor productivity. Every business has its own target, but many businesses within the same industry have similar labor efficiency targets. Keep in mind that a month of data is a very inaccurate period of time, so I look at my LER on a monthly, quarterly, and rolling twelve-month view so I can spot key trends in the movement of my LER.
Correctly measuring your labor productivity as gross profit per labor dollar will help you walk the tightrope of the right labor at the right time at the right price so you can hit your profit target.