008: Greg Crabtree - What Is the Labor Efficiency Ratio and Why Should You Care?

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Yeah, appreciate it, Bill. And always great to talk simple numbers.

Nice. Well, welcome to the show. So where are you today?

I'm in Huntsville, Alabama. That's where our staff is. So we're able to actually, we pretty much do work all over the world. So we've got clients outside of the US as well as all over the US and in Canada. So. So fortunately, our methodologies allow us to deliver that from right here in Huntsville, Alabama, of all places.

Well, I know I feel like I run into you in different places from LA to DC to Dallas and so on. And today over the fabulous Interwebs. All right, well, thanks for being with us. Let's start with just a little background before we get into the power and magic of the labor efficiency ratio. The ler. How do you come into this? You know what, what terrible thing about your childhood had you be in this line of work?

Well, fortunately, what drove me to this line of work is growing up on a chicken farm in Alabama. You realize that you don't want to do that for a living, so you find something else. And particularly you find something that works in an air conditioned office. I wish there was a greater, loftier reason why I chose accounting, but, you know, it was a very fortuitous event. When I was 14, I went with my mom to get her taxes filled out. And I realized that it wasn't so much the fascination of tax accounting, it was the fact that, you know, she had really high regard for the guy, Harry Carpenter, who did her tax return, but he worked in an air conditioned office. And I thought, gee, that is a whole lot better than dealing with chickens. And so realistically, I never.

So you went into accounting for the glamour, is that what you're saying?

That's right. Absolutely. Yeah. So, you know, but I will tell you this. I was listening to an audio book from Dr. Bob Rotella on his latest one, and the name of it escapes me, but I think it's about building successful teams. And, and so. But he was talking about, you know, somebody that told his dad, I think, told him one time, you know, either do what you love or love what you do. And there was a time that I think I changed my focus and because I'll tell you, the basic accounting that you do, coming straight out of college in most places, you know, you're not given a sense of purpose as to what it means or how it impacts the world. And so it's pretty mundane work. And, and so there were times in my career where, you know, I tinkered with doing different things. And really the magic came when I realized that, you know, I could actually take this tool and do magical things with it, you know, that really help people run a more profitable business. And really, once we set the purpose of helping entrepreneurs to run profitable businesses, you know, it really just changed our outlook. And so now even our young staff come in with a sense of purpose as to what they're doing, you know, and really we've kind of tightened up kind of our phraseology of it of just saying, hey, we provide simple numbers for powerful decisions. And that's really what we're aiming at. And I do believe it actually works that way because we keep refining it to where it's fewer and fewer numbers that really matter. And it may not be the greatest in terms of revenue maximization for me, but, you know, I'm more about impact than, you know, I'll make a good living and we'll do fine. But at the end of the day, it's doing what is, what does the client need and what is it that gets them to respond. Because it's really one of the areas that I really become fascinated with of late has been this area of behavioral economics. And I really have begun to believe that a lot of the work that we do is probably more geared into that genre. It's just that we use accounting to do that, that impact. And so we've had some really phenomenal success stories of once we present data in truth, people respond to it differently than what they've done when they just do accounting. And I think there's always an excuse when you do things in the traditional accounting approach that lets people off the hook and they have an excuse. Or the dog ate my homework or. Well, that's not completely correct. Well, let's define what completely correct is. And I think in our methodologies we've really helped push to a definition of what financial truth is that isn't generally accepted accounting principles in most cases. But once you establish that definition, we hold people accountable to it. So listen, are you going to accept underperformance of your business or are you going to do something about it? And it is extremely gratifying to see how people respond to financial truth in a simplified format.

Yeah, well, I think we can already hear it in your remarks, but I've known you for a few years now and in your care and generosity and desire not just to produce statements or pass audits, but to actually help business leaders to make thoughtful decisions that impact their business is abundantly clear from all of your work. And not just to have a document produced, but to deliver actionable information. So thank you.

Yeah, you know, it's. Eli Goldratt actually wrote a book that impacted me even more than the goal. His book on necessary but not sufficient was an allegory about his own personal life story of being kicked out of his own business because he pursued truth and data. And it was really a fascinating story. And so to a large degree, I think that that is probably a good depiction of the accounting profession. The numbers are necessary, but it's not sufficient. What is sufficient is entrepreneurs are desiring meaning and direction from it. And once I realized I was sitting on an enormous wealth of intellectual property, which is in essence the intellectual value of the client data that I have deep access to and I can't reveal, you know, obviously you know, their, you know, company secrets or those things, but there's really rarely any secrets. I mean, but there is data that you can mine to look at and say, what is it telling me? What is it speaking to me? And. And it was in that process of actually doing a research project on our own client data sets that I didn't get paid for at the moment, but it's paid itself back in many ways later of developing a way to look at comparing businesses that may be in different industries, but yet putting it on a comparable basis so that we can have a robust discussion. Your business might be different than mine, but we can still structure it in a way that we both can learn from each other and help each other optimize what our business is potentially capable of.

So talk to us about this, about the idea here. What is it? How do you use it like that? Let's start with the definition.

Yeah, so really the first thing that we always apply to data is the clearing distortions process. And typically in most entrepreneur businesses it's going to be owner's compensation that they don't account for correctly. And we're not going to get into the discussion of tax reasons or whatever because I'm talking about, you know, whatever you put in your accounting record. That's when you and your tax accountant. But at the end of the day, I always apply the get run over by a bus question. So if you get run over by a bus and your family decides to keep your business going, what would they pay somebody to do the job that you do in the business? Yeah, and you have to make a plus up or down adjustment to the compensation lines in the business. And typically we only have two major lines of compensation that we delineate in the business model. We want to isolate what we call direct labor, which is any labor that faces the customer person that spends 50% or more of their time doing whatever you do in your business, whether it be product, service or whatever. And so we want that person to go into direct labor and then by default everybody else goes into management labor. And so in most cases the owners of the business will fall into management labor. Now in some cases like myself, I'm considered direct labor because I would tell you that that CEO title is a little more of a, of a non functioning title because there's not enough CEO and to do, I mean we got 25 employees, we'll do about 3 million in revenue. And it's like, well, yeah, I mean I carry that title but that's not my primary job. Now if we were 10 million, yeah, they'd probably be a full time job. And guess what? That would be the job I wouldn't want. I would want somebody else to do that job because my highest is in both the client facing work and doing more research on data and then also doing some of the marketing as well. So in Our model, I'm considered direct labor. We always tell people, just don't get hung up on classification in that. Take your pick, Put them in one bucket or the other. Just be consistent and put a But in a bucket. We don't want people splitting somebody. Because ultimately, the idea is we think the methodology helps you work your way out of that, you know, working in the business to working on the business role. Because typically you think of a direct labor role as working in the business. A management labor role is more working on the business in that regard. And so once you isolate the two buckets of labor, there's just a really simple model that. Let me talk about kind of the top part that we call the business engine. So we look at revenue minus direct costs that do not include any labor is the key true top line of the business, which we call gross margin. And so, you know, we always tell folks that really, revenue is the slipperiest number in any P and L. So really, you know, externally, talk about revenue all you want. We really like gross margin as being internally the highest quality number to start the value chain of what you look at. And then the relationship of direct labor to that gross margin number is how we get the direct labor efficiency ratio of. So if that gross margin number is, say, 600,000 and direct labor is 200,000, then direct labor efficiency ratio is the 600,000 divided by 200. So that would be a 3 Ler. And so we look at labor as a multiplier. So the idea is, I could look at labor as a fraction, but once again, we go back to behavioral economics. Tell me, whether or not you, as a direct labor person, do you want to be known as a multiplier, or do you want to be known as a fraction? I think people like being a multiplier. When I tell that person, hey, for every dollar I pay you, I need $3 of gross margin. That communicates a whole lot better than saying, hey, I can pay you, you know, 20% of every dollar gross margin that we get. Well, that's more of a salesman's mindset. That's not a production mindset. And even though I mean it, still, to me, it just doesn't communicate as well. And so once we get to direct labor. So gross margin minus direct labor is a term we had to create because it's what most people would refer to as gross profit. But when I was writing the chapter for Vern Harness's book on profitability and his book Scaling Up, Vernon and I had this discussion, and he suggested, you know, let's use gross margin for that first one. And then we agree on contribution margin as the second subtotal which in most people's books would be gross profit. We don't like the term gross profit because profit indicates more of an indication of a bottom line number. So we'd like to save the term profit, you know, for the, you know, the true net profit, you know, of the business.

Got it.

So that's kind of how we define it.

Got it.

But the beauty of it is we believe contribution margin dollars the highest quality number in a P and L because it has no discretion in only has your productive people. It doesn't have your cousin that you're employing just because you want to. Or it doesn't have a spouse who's maybe doing a few things in the business but not really relevant to the business or whatever. Or it doesn't have a lot of times your labor that you may be distorting either on the high or the low side. So to the large degree we really like focusing type of production metrics, whether it be incentive plans or those things off of contribution margin dollars. Because with our modeling techniques we've learned that if you tell me contribution margin dollars I can predict up to revenue and I can also predict down to net income. So that's the other reason why we like it in that regard. Now the other beauty of it is contribution margin becomes the dollar amount that we hold management labor accountable to. And so all that other labor that's is management labor and your admin labor. Now you've got something to hold that team accountable to because they can produce revenue. But if it waste cost of goods sold or direct labor producing it so that it doesn't produce any net contribution margin, it was like well what? We didn't gain anything. We did more activity and got less for it. And you'd be amazed at how many times we see people go from a million dollars of revenue to $2 million of revenue and contribution margin stays flat to possibly even goes backwards. And they're going, we don't understand. Well, it's because you didn't understand it's about getting the next margin dollar that matters, not the not top line activity. And so we highly recommend that you never ever, ever base anybody's compensation off of a percentage of revenue. Because like I said, we think it's the weakest number there. So the management labor efficiency ratio that is similar to the direct labor efficiency ratio, Management labor efficiency is contribution margin per management labor dollar. And so the interesting thing is in different business Models we've seen direct labor efficiency vary by type of worker and type of business model. Think of it like a sports team, you know, are you a passing team to where I may have some misses, but when I have a gain, I gain in chunks of yardage. That's typically, you know, someone who has a, you know, a 6 or 7 direct labor efficiency ratio. But it's because I have a very expensive person who's throwing the ball to them in management. Because low cost, highly productive direct labor typically takes a lot of active management versus if I have high cost direct labor people, typically professional services environment, you have a much lower direct labor efficiency ratio because you hand them a project, but you don't tell them what to do. Step by step by step, you've defined it. They're professional, they're self motivated, they're self managing. And so generally professional service firms, accounting, law, architecture, engineering, they have very low direct labor efficiency ratios because you have very low management requirement in that regard. But interestingly enough, once you get the contribution margin dollars, there's a normalization management labor efficiency. And so what we've seen is somewhere between a 3 and a 4 management labor efficiency. So what we developed is this idea that if you tell me the people on your management team, I take that dollar of wages, multiply it times a minimum of a three. But really I want to target a four. So let's say I've got $500,000 in management labor. Well, let's say I'm targeting a four management lar. So that means that that $400,000 $500,000 in management labor times four is $2 million. So I got to have $2 million of contribution margin. Well, if contribution margin is roughly 50% of revenue, by the time I paid for any cost of goods sold and paid for direct labor, I'm now looking at a multiplier of saying I really need eight times that wage, then those management wages I need, you know, if I got $202 million of contribution margin, I need $4 million of revenue to make that work. And it's amazing. That multiplier effect of management labor all the way up to revenue is 8's a pretty good average across all kinds of business models. And I've seen a low 6 and a high 10, you know, somewhere around in there. But it actually is amazing how consistent that number is. And so if I've got a high cost of goods sold but low labor, those things kind of measure themselves out and you kind of work your way all the way back up to the top. So it is amazing kind of how that modeling piece works. And once again we're dealing with, we've got even one model that I use where we take all the operating expenses of facilities, marketing, payroll taxes and other opex and just shove it all into one line. So, you know, I mean, those all matter. And if you're getting detailed and forecasting, each of those act differently. But you know what, it's amazing, especially if it's a 5 million and under business, those costs all together kind of move in a fairly consistent percentage as a kind of a slow moving variable cost, even though some of them are fixed and some of them are variable. And so the idea is if you really focus on getting what is the productivity I need to get out of the dollars of labor spent both for management, indirect, that tells the story.

My sense is that all the way up till about 12 million, roughly, there's a lot of what you referenced earlier where there's a lot of funny owner accounting kinds of practices that go on. A muddling of performance labor with ownership distributions and all of that gets kind of muddled. And of course when you go for a transaction, you end up doing some kind of pro forma financial to try to restate that. But you're saying actually it'd be useful to try to clean that up in the beginning so that you can run your business smart.

Absolutely. So let me give you a live example. So I teach this when I do my presentations. We had this, this business come to us when they had 600,000 of revenue. I think, you know, just that they were, and they told me it was two guys, 50, 50 owners, and they said, we got 25% profit, but we're struggling with cash flow. Can you help? Yeah, I go 25% profit, struggling with cash flow. Something's not right.

Right.

So when I met with them, I realized that they were taking about $120,000 of salary, about 60 grand a piece of as wages. Except they weren't counting them as wages, they were counting as distributions. So they really weren't at 25% profit. Once I reclassified their 120,000 in wages, they were at 4% profit.

Right.

And I said, well, we found the problem. You know, you only, instead of thinking that you had 140,000 of profit, you only have 23. And so, okay, so let's get busy. And so the first thing we did is, all right, at 23,000 of profit, 4% of revenue, you're not demonstrating that you've earned your pay. That's the first harsh reality that they have to get through their head, it says, all right, so we're going to do it correctly, pay you the 60,000 apiece, and I'm going to hold you accountable to the 3 and a half management Ler and give you a new target for contribution margin. So you only have to do about 140,000 more in contribution margin. And that then in turn works out to be not a whole lot more in revenue. So probably revenue target, they probably need to be another about 140 on top of that. Because the thing was, in that case, they were paying the right amount of direct labor. So their direct labor, they had the right people. They just weren't getting enough out of it. So I'm just increasing the rate. So there wasn't this big multiplier effect. I just had. I'm. And the basic principle is I'm spending the right money, I'm just not getting enough for it. So I said, so I gave them their new target. Yeah, right, right. Well, they go out, guess what, they hit it. And so when they did, they got their salary, but they also made 130,000 true net operating income, 19% profit first year. I go, great. So that means they were about 700,000 of revenue. I said, good deal. So you've proven that you can do it, your profit. Guess what, you need a raise. So we raised them to a little over 100 apiece. Now, when you apply the same math again, so if you take that 200,000 of wages times three and a half, guess what? Now their target is about 700,000 contribution margin. So you jump from 450 to 700. And then from a revenue standpoint, you go from 700,000 of revenue to a million in revenue. So those multiplier effects happen really fast. And oh, by the way, you have to hire about $120,000 of additional direct labor because you can't stretch your current team that far. So if you can go get the revenue, if you can go build your team, you could then prove them that you've earned your pay. So we said, all right, here's your target. Go for it. Well, they kind of did it, but they missed it a little bit. They didn't produce the right amount of gross margin. They were close to their revenue target, but they had to use too much freelance labor to make up for the people that they didn't hire fast enough. Classic scenario of growth constriction. Yes, it sounds great. In their case, they were able to win the new work. They just weren't able to produce it and hire the team to do it fast enough. So by hiring freelancers, they gave up margin.

Yeah.

But they also then stretched their team to an unhealthy level of productivity. So their direct labor efficiency ratio, instead of a 3, was a 350. So even though that number sounds better, when I teach this in the presentations, I say, well, if 350 good or not, and people finally go, oh, yeah, I'm probably burning up my people, because if my target is three, I'm probably being a little too aggressive. And that's where your eyes have to balance using the numbers. It's not just about numbers. You've got to correlate what you see with the numbers. You can't rely on one in isolation to itself. But sure enough, they were burning up their team. And so we had to sit down and say, good job. You made 22% profit over 230,000 a net profit on that activity. I mean, like I said, this is just the second year into this process. They've gone from making 60 grand apiece, 20,000 a profit, to making 100 grand apiece, plus on top of that real profit of 230,000. And so, and this is just applying these simple principles of targeting and then go do it.

But it really seems like you're doing more than we often get from our tax preparers and our CPAs. You're actually giving them some feedback on, hey, you should consider some different targets and you should do something now. Just here's your statement.

Absolutely, absolutely. Yeah. And I contend that I wish my peers, you know, would be bold enough to do it, but they've not invested like we have in determining. Here's what we believe about business. We've studied enough data points to where, you know, we really believe this stuff works, and we've seen it in time and time again. And so, you know, but like, in these guys, the same thing that, you know, that you talk about in your coaching in terms of, well, guess what? You know, their biggest constriction was they weren't able to hire fast enough. So what do they have to do? They have to build a recruiting process that allows them to constantly be trolling for talent and make sure that they hire, you know, at the right time. You gotta hire a little bit ahead. Obviously, it'd be perfect world if you could hire just as you needed it, but that always doesn't come out to be the case. But when they reroll it for the. For the next year, they absolutely nailed their target. They actually oversold Again, still had to use a lot of freelance talent, but they hit their gross margin target and that next year they hit 1.3 million of gross margin, still 22% profit. So they made 330,000 a profit on top of $125,000 salaries apiece. And it's all because we say once you set your wages as a management team, you hold your management team accountable to what they must do to earn it. And we call it bottom up targeting.

Yeah.

And as much as people like to start at the top, I really think it does start with hold your management team accountable or else I got the wrong management team.

That's really powerful. That's really great. Well, we. And of course, when we implement the LER within a company, as people start to track it, we say there's really three things to go to work on. The easiest and fastest place to get money is to cut out your unperforming people. So lop off the C players, maybe even some of the marginal B players. And then the next thing is to tighten up the execution habits. Look at how well you're executing on plan and what you're doing and whether that's efficient or not. And of course, some of the biggest returns come from improving the targeting, being smarter about what you offer to whom and everything that goes on the strategy side of the equation. But they take longer to implement and pay off.

Yeah, well, and there's an interesting thing that we started doing that I'm still refining the presentation of it, but I really think it's been resonating with people is this idea of investing in your business. And so if you think about it, I mean, investing in your business no longer is building a plant like it was in the industrial revolution. It's not in now. If you're in technology. Yeah, it might be building a new piece of software. But really, at the end of the day, what it really comes down to is I've got to spend expenses before they're productive. That could be a research and development activity. It could be hiring a key member of management team until they're productive, hiring a salesperson, but they're not going to be productive for six months. It could be research and development of new marketing techniques that are unproven, all types of those things. And so when you think about competition for profit, when I wrote my original book, I talked about the four forces of cash flow, that once you're profitable, you've got to pay taxes as force number one, you got to repay debts. Force two, you got to build to your core capital target as force number three, and then you get to take dividends AS Force Number 4. Well, I mentioned it in taking dividends that you have a possibility of also reinvesting in the business. And I really think I almost would retitle that today, the five forces, because I would put reinvesting right at the beginning of that chain. Because if I reinvest in the business in an expense, I get to do it in a deductible way. Because if I hire a person, I'm getting to deduct what I'm paying that person today. And so it's a supercharged dollar of tax deductibility. But I do want it to become profitable and productive. Not to. You don't ever want to spend a dollar to save 40 cents in tax. You really want to spend that dollar to have it produce. But that's just the nature of business. And when you really function, you know, couple that with the idea that a 10% or better profit business is fully capitalized, makes a minimum 50% return on investment. Why would you ever not reinvest in your business if it has the chance to grow farther, but there is a risk that it won't work? I mean, that's why, you know, when something comes with 50% return, it generally means it's a higher risk than something with a 2% return. But always I teach it in a way that said, listen, if I gave you 100,000, an opportunity to put $100,000 in a CD that pays 50% interest, well, you hold it in there for a year and at the end of that year I got 50,000 dol interest that I'm going to be paid. I could reinvest it in the CD and roll it for another year at 50% or I could take it out. How many of you would take out that 50,000 to go spend it to buy a car or, you know, consume it some way, or would you reinvest it? Well, everybody says, oh, I'd reinvest it. And I said, well, that's what you're doing to your business. Your business is sitting there screaming, says, if you'll reinvest in me, I'll give you a 50% or better return. Now, there's a point that either, like you mentioned earlier about strategy, you know, if I have maximize the marketplace that I'm in, then that next dollar investment isn't going to produce 50% return because you've maxed out where that business, you know, in terms of its either geography or product or service offering in the area that you're serving. But, you know, we were talking to a client up in Canada, you know, a couple weeks ago, and he had pretty much maxed out, you know, his business in the region. But essentially we said, well, but you can always go to another region. You're somewhat doing business there anyway. You just don't have a physical presence. And so it opened up his mind to, well, gee, why wouldn't I go buy a competitor in that arena that's on the small side that can't do what I do? But it's a good foothold to then build on. And you know, that's, that's a change in mindset because you look at the return potential because what, you know, I mean, yeah, you could consume it, but how much fun is that? It's okay for a point, but it's not near as satisfying as building a successful business.

I think you've given people a lot of great takeaways to do. Are there any to think about and to work on? Are there any particular resources that you'd like to point to? We'll of course have your website and link in there. But anything that you'd like to focus on?

Yeah, I mean, I do think, I mean, obviously my original book, Simple Numbers, Straight Talk, Big Profits, I mean, it's available either from my website, Simple Numbers, not me, or from Amazon, but also the latest work that I've done. It's a little, in my original book, I did not do the complete explanation that I just went through of separating direct labor efficiency from management labor efficiency. And in 2011, when I wrote that book, we were in the, in the middle of that research of isolating, you know, those two drivers. And so that work was later included in Vern Harness's Scaling up book. So chapter 13 is the chapter I wrote for Vern's book. And so I would highly recommend both looking at my book as well as Vern's book, you know, to be, you know, the most recent stuff that's written. And then I've got, you know, certainly some other articles and stuff we put on the website and the white papers and blogs and those things that people can download. And then also there's a, there's a, I think a 90 minute webinar that's on the Gazelles Growth Institute website that can be viewed. That's kind of my basic, you know, presentation of kind of our philosophies and things. So those are, those are, you know, pretty good resources, you know, to get people familiar with kind of how we look at things and there's free downloadable templates that are on the book website as well. Oh great.

So we'll point people to all those links in the in the show notes and people can go right right to those as follow up. Of course our client members also get access to all of the Growth Institute videos as part of their their retainers and so thanks for talking with us today.

Good deal. I appreciate.

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