The path to 12% profit: The labor KPI

Click to enlarge. (Graph: Kevin Kehoe)

The industry’s average net profit is less than 6 percent. It should be more like 12 percent. Improving net profit is a big opportunity. In my last column, I wrote that it’s difficult to improve this number by simply comparing a 6 percent income statement to a 12 percent statement. That approach, for many reasons, is not apples to apples and can lead to poor decisions about how to improve a bottom line. What’s more effective is comparing high- and low-profit key performance indicators (KPIs).

These KPIs are key productivity ratios and can help you understand where to focus improvement efforts to raise net profit. They are relatively easy to understand — apples to apples — and can identify actionable improvement opportunities.

Let’s start with the labor KPI. A KPI is a simple output to input ratio. The calculation is as follows:

Realize rate divided by wage rate (see example 1). It shows earned revenue labor per hour in relation to labor cost per hour. It is easily calculated for any period using your income statement and payroll report.

The realize rate is revenue minus materials and subcontractor expenses divided by payroll hours. Labor wage rate is labor cost divided by the same payroll hours. Note that labor cost is wages plus payroll taxes paid.

Explanation:

• Realize rate is ($3,000,000 – $400,000) /73,000 = $35.62/hour earned
• Wage rate is $1,200,000/73,000 = $16.44 / hour paid
• KPI is $35.62/$16.44 = 2.17 or 217 percent return on labor.

Wow! So, is this good? If you’re a grounds maintenance company, it’s not very good given that high-profit companies have ratios closer to 2.35 to 2.40. So what would happen to profits if this company had that kind of ratio? Apply a 2.35 ratio to the realize rate = $38.63 (see example 2). I am assuming we cannot pay labor less, and there is zero markup on materials — just to keep the math simple.

Improving the ratio makes a big difference in both gross and net profit. But how can we get to a 2.35 KPI? If I were consulting with this client — as I did before founding The Aspire Software Co. — I would have looked at other data, but we would focus on discussing a combination of actions like:

• Reviewing the pricing with an eye to raising the realize rate and doing this by profit center and service line — not just a flat across-the-board price increase but through adjusting cost markups and margins.
• Reviewing customer and property cost reports with an eye to “cleaning out” or proposing significant pricing increases.
• Reviewing customer and property cost reports looking at bid budgets and actuals for over and under performance and isolating it to crews and routing to lower hours without changing pricing.
• Reviewing estimating templates and included and excluded tasks to find opportunities to gain back hours (for example, if you tell a crew to mow, they will mow; tell them to prune, they will prune, even when actual site conditions do not require it). The solution here is better job-by-job and season-by-season production planning and scheduling.

That’s it. You can drive a better bottom line by focusing on productivity of, in this case, labor. Next time, we’ll talk about the overhead KPI and how to drive it to increase net profit.