How to calculate your labour-to-cost ratio
What is your rent or mortgage payment every month?
How much, on average, do you spend on groceries each week?
The answers to the above should come to you easily because those answers are important information that help you plan your life.
Now, do you know your average labour-to-cost ratio for your business?
Has anyone ever sat with you and explained what the labor-to-cost ratio is and why it is so important?
The ratio – displayed as a percentage – is as important as your personal costs (home, groceries, etc.) It should be constantly evaluated to ensure your business has the right balance of labour and costs to succeed.
Labour-to-cost Ratio is important because you need people to run your business, and those people cost money. It’s not only their paycheck – it is workers’ compensation, healthcare, uniforms, and any other money you spend on your employees.
The ratio is your business’s overall payroll as a proportion of your gross sales (your total sales without any deductions like discounts, returns, etc.). It’s an important metric because it gives you an objective performance of your business.
Some managers may say they can “feel” their business is running effectively, or they “think” they’re moving in the right direction. Businesses do not deal in feelings, thoughts, or perceptions – they deal in data.
Here’s an example of evaluating a business’s efficiency based on the labor-to-cost ratio…
- Let’s say your business spent €30,000 on the payroll in a month
- In the same month, you generated €100,000 in sales
- The formula would be €30,000 / €100,000 = 30%
- So, for that month, 30% of your revenue goes directly into paying your customers
- If you spent €30,000 on the payroll in a month but generated €250,000 in sales, your labour-to-cost ratio would be 12%
- The lower the percentage, the more money you are making and the more efficient your business is running
Before we discuss how to calculate this percentage, let’s talk about why it is important.
It shows if you’re over or understaffed
One of the common reasons used to explain why businesses underperform is “we’re understaffed.” Managers believe that, if they only had more people, they would be more successful. This excuse also shifts the blame away from the manager so they don’t take accountability for their performance.
Unfortunately, the term “understaffed” is thrown around so much that it has lost its meaning. The labour-to-cost ratio shows you if you are truly “understaffed” or if you’re not running your business effectively. If your labor costs are high and you’re not generating enough revenue to offset it/break even, then you know you are either overstaffed or not scheduling your employees properly.
Even though a low labor-to-cost ratio is beneficial, you have to be careful to not aim for a number too low. A small labor-to-cost ratio may mean you are overworking your current employees. This could lead to high turnover and cost you time, money, and energy in replacing everyone who leaves. Those costs may be greater than a slightly higher labor-to-cost ratio.
It shows efficiency (or lack of it)
The lower your Labour-to-cost Ratio is, the better you are performing as a business. If your employees are scheduled effectively and they are efficient in their work, then your labour-to-cost ratio will be low. It shows your employees are generating more revenue than it costs for you to pay them. If your cost is too high, then the issue may not be that you’re overstaffed – you may not have your employees scheduled appropriately to manage the daily workload.
If your labour-to-cost ratio is high, then your employees are not working as effectively as they could be. It doesn’t matter what their Performance Reviews scores are or what your “feeling” is on how the business is doing. If the cost is high, you’re not managing your employees effectively. It all comes back to what the data is telling you.
It shows how you compare to your/other industries
It’s natural to be competitive with your business and its results, and a good benchmark for how your business is performing is comparing your business to others. Seeing how your labour-to-cost ratio compares to other businesses in your industry is valuable information.
It can be used to attract and recruit candidates (“We have a lower labour-to-cost ratio, so we’ll keep you busy without working you to death.”). It can be used as a monthly score on the state of your business’s performance by displaying if your ratio stays the same, increases, or decreases. Monthly reviews of labour-to-cost ratios help you identify strengths or opportunities and adapt your workflows to the current state.
Now that we know the benefits, the next step is to understand what a “good” labour-to-cost ratio is for our business/industry. Each industry has different labour-to-cost ratios, and each industry has different ideas about what a “good” labour-to-cost ratio vs. a poor one.
The typical range for any industry is 15% to 30%.
- The restaurant industry averages around 30%
- Healthcare is around 50%
- General Freight Trucking is around 18%
As you start to research labour-to-cost ratios in other industries, there are two ideas to keep in mind.
Don’t compare yourself only to industries outside of your own.
Every industry has different and unique ways of operating, and these factors affect the labour-to-cost ratio and what is considered to be good or bad. One industry may perceive a 50% ratio as terrible, but another industry may think it should be the goal.
However, seeing how your labour-to-cost ratio compares to different industries may cause you to re-evaluate the way you manage your workforce. The “typical” labour-to-cost ratio for your industry may be X, but it’s the “typical.” Nothing is stopping you from accepting the “typical” as the “required”/”can’t change”.
Recently at Planday, we continued our quest for innovation by conducting the largest UK Hospitality Salary Survey. This survey is a first for the Hospitality Industry, and due to the overwhelming amount of valuable data, this will now be completed annually.
We encourage you to read the full report (click here to access) for some valuable insights into the current state of the hospitality industry as told by the most important factors – its employees.
Over 1,800 hospitality and foodservice professionals were surveyed on their current salary and benefits.
One of the more surprising findings is that 60% of respondents said the key driver for staying with the company (outside of pay) is working with great people. This is one of those “hidden costs” of labour.
You can’t immediately see it in a bunch of numbers on a piece of paper, but if you have a poor work environment, people will not feel motivated to do their best or even come into work.
All this data is great, but what do we do with it? Let’s have a chat and find out.