Labor efficiency ratio for agencies
Labor efficiency ratio, or LER, answers one question: for every dollar you pay the people who do client work, how many dollars of gross margin does that work bring back? Utilization tells you whether people are busy. LER tells you whether busy is profitable.
The formula
LER = gross margin ÷ direct labor
- Gross margin is revenue minus what you paid outside parties for the work: vendors and contractors on a fixed fee, and other costs you pass through to the client.
- Direct labor is what you pay the people who do client work, for the same period: employees' pay, and contractors paid by the hour.
This is Greg Crabtree's definition, from Simple Numbers, Straight Talk, Big Profits!, and it's the one VERA uses everywhere it shows LER. VERA counts pay before payroll taxes and benefits. Some published benchmarks include them, which makes the ratio lower, so check which one you're comparing against.
Work out yours
Your gross margin is $1,300,000, and your LER is 2.50x: every $1 of delivery pay brings back $2.50 of gross margin.
Use the same period for all three amounts: a month, a quarter or a year.
An example
An agency brings in $1,500,000 a year. It pays $200,000 to contractors and vendors on fixed fees, so its gross margin is $1,300,000. It pays its delivery team $520,000. Its LER is $1,300,000 ÷ $520,000 = 2.50x: every dollar of delivery pay brings back $2.50 of gross margin.
Is my number good?
There's no single healthy LER worth publishing. The right target depends on your service mix, your pricing and where you're starting from. Set your own target and watch the trend: an LER that's rising means the same team is producing more margin. In VERA you set a company target, and a different one for any project that needs it.
Where LER leaks
- Senior people doing junior work. Expensive hours producing work that a junior could do.
- Work nobody priced. Scope creep, rework and hours that never reach an invoice.
- Decisions that wait on the owner. The team is paid while the work waits.
Tom Hart, who built VERA, writes about the levers that move it in Labor Efficiency Ratio, Explained.
LER in VERA
VERA works out LER from every recorded hour: by project, by client, by discipline and by project manager, against your target, with a monthly trend. Project managers see the ratio for their own projects and never anyone's pay. See every feature →