Service firms know better than most how important labor efficiency is to profitability.
A study by U.S. Bank found that 82% of business failures were attributable to problems with cash flow. Companies struggle to understand what’s driving their profitability, hidden drains on capital outlay, and employee efficiency.
But it doesn’t have to be so complicated. In fact, many of these issues can be addressed with the help of just two calculations: Net profit, and labor value multiple (LVM).
What Drives LVM?
At its core, efficiency drives LVM. The more efficient your business is, the higher your LVM.
LVM is a function of gross profits divided by wages of your service personnel. The more profit you can derive from a service, the higher your LVM. (Looking at it another way, the less you can pay your employees for the same level of service, the higher your LVM.)
From a financial standpoint, a company with a higher LVM has a competitive advantage over companies with lower LVMs. For example, Company A may have an LVM of 1.05x, and Company B may have an LVM of 3.15x. In this scenario, Company A is far less efficient—spending three times as much to earn each dollar of revenue as Company B.
Drivers of Net Profit
Net profit is calculated by taking your contribution margin and subtracting the total amount of your marketing, sales, and administrative expenses. Many service firms get stuck with low, single-digit profit margins, but why? What factors drive (or limit) their net profits?
Generally, net profit drivers can be lumped into three categories:
- Labor efficiency
- Operating costs
- Service pricing
Any changes in these variables will produce a change in net profit. Simple enough. But just how much impact can these adjustments have to overall profit? As these incremental efficiencies improve, they create big downstream effects that can influence revenue.
For example, going back to Companies A and B, it’s possible Company B’s service department is more efficient, decreasing the total wages needed to deliver the product. Or maybe they have a patent on a better manufacturing method that allows them to price their goods lower. Whatever the reason, Company A is working a lot harder to earn the same amount of revenue as Company B, and that challenge is reflected in the LVM/net profit comparison.
Digging Deeper into Efficiency Calculations
Profitability calculations don’t need to be complicated, but we’re only scratching the surface here. There’s a lot more that goes into a service firm’s efficiency audit—which we’ve outlined in our new whitepaper A Practical Guide to Driving Profitability for Your Service Business.
We take these metrics and really dig deep into how service firms make these calculations on their own:
- Step-by-step guide to calculating LVM, Net Profit, Contribution Margin, and more (with examples)
- Comparison charts showing how changes to financial data produce downstream effects
- How to set up your accounting platforms and payroll services to generate these reports
- Free template (with instructions) you can use to perform a top-level assessment of your own company’s profitability and LVM
Interested in learning more?