If you’re a service firm, how do you control direct labor costs? This is an area where I see many firms struggle. Direct labor tends to be the most significant cost for service firms. Most firms use a timesheet and record labor costs for specific jobs. However, the labor force wants to show they’re fully utilized and bills direct labor against a job with no regard for what the original job cost estimates were. The result is profit fade from the original estimate. Those that execute the jobs and those that estimate the jobs sometimes point the finger at each other when profit fade results.
Since you can’t manage what you don’t measure, here are three things to consider when you’re managing direct labor in your service firm:
- Revenue multiplier– This KPI gives you your markup on direct labor, revenue/direct labor. On fixed price jobs, since direct labor is the most significant cost, you want your markup to be as high as the market will bear. This gives you a high revenue labor multiplier. If you deal with large firms as clients, they will sometimes dictate the hourly rates they will pay, leaving you with a lower markup, as their way of controlling costs. While it varies, most revenue multipliers seem to range between 2x and 3x.
- Labor Utilization Rate– Your labor utilization rate, direct labor/indirect labor, usually indicates how efficient your operation is because the higher your utilization rate is the more labor you have in revenue generating activities. Firms with more paid time off or more training will have lower utilization rates than firms with less. Most firms have a utilization rate of around 65%. Many firms with labor utilization rates will cut indirect labor expense. The key is to cut indirect labor, but not so much that you are impacting labor necessary for successful business operations.
- Project Review- One of the best ways to measure your utilization is a healthy review of closed projects with an eye toward gross profit estimated compared to gross profit actual. During this discovery, you will see the difference between hours estimated compared to hours executed. You can then ask questions like:
1) Did we estimate this project too low and leave money on the table?
2) Or were the hours estimated vs executed higher or lower, leaving us with more or less gross profit?
These reviews will help management understand if there are any trends on projects estimated compared to executed and whether they were poorly or well estimated and poorly or well executed. With this information, it can help on future projects to maximize profitability. You can also determine trends by customer or project type and if certain customers or project types consistently deliver high or low gross profit results.
Hopefully these KPI’s and project review processes can help your firm maximize profitability on the direct labor piece of your business consistently. If you have any questions or want to discuss this further, please contact us.