Effective Labor Rate: What is it and why should you care?
Your effective labor rate is a weighted average of all the labor rates and prices you used in a specific period.
In theory, if you multiply your posted labor rate by the total number of labor hours you sold last month, the result will equal your total labor sales in dollars. In reality, your actual labor sales were probably different. That happens when labor prices vary depending on who is paying. Consider that customer pay rates, warranty rates, service contract rates and internal rates are not always the same. Discounts (menu prices, special prices, and policy splits with customers) also affect your effective labor rate by reducing your posted labor rate on some transactions.
Your effective labor rate is more than just a simple average of the various rates and prices you use. It automatically compensates for the fact that some rates are more important than others because they are used more often, depending on your mix of customer types.
Pricing is an important part of your marketing mix and smart pricing can boost your bottom line. But you can’t simply plug your posted rate into forecasts or what-if projections and get meaningful results. Even if you don’t prepare forecasts (you should) or ask what-if questions (why not?), as a manager you should know your effective labor rate.
By the numbers.
To calculate your effective labor rate, divide your total labor sales for any period by the actual labor hours sold to create those sales.
Spreadsheet example: How to calculate your Effective Labor Rate
Beyond the numbers.
It is common to regard averages as part of the management scorecard. Caution! Averages can be useful indicators of performance or early warnings of problems. However, most of us are not in business for the purpose of producing great averages. A better goal is to maximize profit at the end of the month. This is important because you pay your bills (and yourself) with profit — not averages. For example, a well-timed special on air conditioning service might increase your total profit in a month but simultaneously decrease your effective labor rate due to discounts. It is important to know what your effective labor rate is, but it’s more important to use that knowledge to improve your bottom line.
Likewise, changing your mix of business (what percent is customer pay, warranty, etc.) can change your effective labor rate. Increasing your volume of warranty or service contract work might lower your effective labor rate while putting more total profit and/or bonus in your pocket each month.
Watching the trend in your effective labor rate over time can provide important feedback about your pricing policies. While careful discounting can be beneficial, over-discounting can erode profits in the long run.
You now have a tool that can improve your ability to forecast and ask what-if questions. It’s time to plan your work and work your plan.
View video on YouTube
View video on Vimeo
View slide deck on SlideShare
Photo credit: iStock 7674398