Percentage Compensation Measures Productivity of Labor Force
Originally published: 07.01.12 by Ruth King
Are you getting a good return on payroll and payroll taxes spent?
For the past two months, I’ve written about liquidity ratios (Can you pay your bills?) and the debt ratios (Are you taking on too much debt?). This month, I’m examining the next category of financial ratios: percentage compensation. This ratio answers the question, For each dollar in revenue that the company earns, how much is the company spending on payroll and payroll taxes?
This is the only ratio that uses the profit-and-loss statement to calculate its value (unless you have work in process). It’s the only financial ratio that you can departmentalize. This means that, if you departmentalize your company financial statements (service department, new construction department, plumbing department, etc.) each should have its own measure of productivity.
The percentage compensation ratio is my favorite ratio. It tells me how productive a company’s labor force is. The companies that manage labor well tend to be profitable. The companies that don’t manage labor well tend to be less profitable or operate at a loss most of the time.
Bankers rarely track this ratio be- cause they don’t understand how critical productive labor is to HVACR companies. If they did, they would require this ratio in their analyses.
Percentage compensation looks at only payroll and payroll costs. This includes direct wages for the entire company plus payroll taxes. Many companies make the mistake of including year-end bonuses in this calculation. The percent- age compensation looks at operating requirements. Bonuses are not required in your day-to-day operations. They are given at the end of a period in addition to regular wages for a specific reason.
Table 1 shows the percentage compensation ratio that I track each month for a contractor. It is hard to decipher what is happening in this company just looking at the numbers.
Graph 1 shows the graph of the percentage compensation ratio. It’s hard to see what is happening because there are months where the ratio is as high as 70% and other months where it is about 20%. This means in some months the company spends 70 cents of each dollar it brings in on payroll and payroll taxes. Other months it spends 20 cents of each dollar it generates on payroll and pay- roll taxes. The company has productive months and non-productive months.
The trailing data graph for this con- tractor shows a good story. The percentage compensation ratio is decreasing on a long-term basis. This is good because it means that the company is becoming more productive each month.
If your company performs a lot of work that requires work-in-process ac- counting, you’ll need to add the work-in-process estimated revenue from the balance sheet each month to the sales data on the profit-and-loss statement. Take the payroll and payroll taxes from the monthly payroll reports rather than from the profit-and-loss statement. This will give you a truer value for your percentage compensation ratio.
Percentage compensation should be constant on a long-term basis since all seasonality is eliminated when you calculate the trailing data points. Most residential service-and-replacement companies should have their company percentage compensation ratio under 33%. The companies with the lowest percentage compensation are usually the most profitable.
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