Mathematics, when applied to the realm of salaried employment, can bring to light certain inconsistencies that might otherwise remain obscured. For instance, a typical salaried role, often classified under the W2 category, has an underlying anomaly where the employee tends to work around 80 hours without compensation each year.
In this blog post, we’ll be taking a closer look at how this type of calculation relates to employment contracts, the standard work structure, and the importance of service businesses using the correct data to track profitability.
The Direct Labor Efficiency Ratio (DLER) provides insight into how efficiently a company is using its direct labor costs to produce its goods and generate gross profit.
Gross Margin (Revenue – Cost of Sales) / Direct Labor Costs
Gross Margin (often just referred to as 'gross profit') is the difference between revenue (sales) and the cost of sales (often called cost of goods sold or COGS). It represents the profit a company makes from its core operations, excluding other costs like administrative and overhead costs.
Direct Labor Costs are the expenses directly associated with the production of goods or services. This includes wages, benefits, and other compensation given to employees directly involved in the production process.
The Direct Labor Efficiency Ratio quantifies how much gross profit is generated for each dollar spent on direct labor. A higher DLER indicates that a company is more efficient at generating gross profit from its direct labor costs. Conversely, a lower DLER suggests less efficiency.
For example, if a company's DLER is 4, it means for every dollar spent on direct labor, the company generates $4 in gross profit. It's a helpful metric for businesses to determine how efficiently they're using their labor resources in the production process. By monitoring and improving this ratio, a company can aim to maximize its profitability.
Comparing the DLER across time periods for the same company, or across different companies in the same industry, can provide insights into operational efficiency and competitive positioning.
If you calculate DLER wrong then you’re at risk of running a business with an overworked culture and then will think you’re more profitable than you are.
When an individual secures a position with an organization, the nature of their employment contract is typically categorized as either a 1099 (freelance or contract work) or a W2 (standard employment). In the case of the latter, a fixed annual salary is agreed upon. This amount is then systematically fragmented for periodic payments. If the payment cycle is monthly, the annual sum is divided by 12. Conversely, for biweekly payments, the yearly figure is split into 24 even segments.
On starting their job, employees adopt the conventional work structure. This typically involves dedicating 8 hours each day, culminating in a 40-hour work week. This structure means that by the end of the month, one would assume an employee has worked for roughly 160 hours, given that a month usually has four work weeks.
As such, invoices or payment computations for salaried employees on a monthly cycle frequently reflect this 160-hour figure. However, as we will see, this calculation doesn't always capture the complete picture of an employee's labor over a year.
When projected over an entire year, the aforementioned monthly calculation suggests that an employee would accumulate a total of 1,920 work hours. However, it's commonly understood in the employment sector that a full-time employee, factoring in the standard 10 holidays (which equate to 80 hours), generally approaches a work total of 2,000 hours annually.
The underlying issue with this computation is rooted in the inherent assumption that every month uniformly consists of four weeks. A deeper dive into the calendar shows a different picture. If one were to multiply an 8-hour workday by five (the standard number of working days in a week) and then further multiply that weekly sum by 52 (the number of weeks in a year), the result would be a grand total of 2,080 work hours in a year. This discrepancy is attributable to the fact that several months in the year contain more than the standard four weeks.
Given this new understanding, a more precise monthly calculation for work hours would look like the following:
2,080 hours (annual total) ÷ 12 months = 173.33 hours per month.
This recalibrated figure reveals a consequential insight: under a standard monthly salary arrangement, employees are inadvertently working an additional 13.33 hours each month that aren't being factored into their compensation. Over time, these "hidden" hours can have a significant impact on both employee morale and a company's bottom line.
For agencies, service businesses, and other entrepreneurial ventures, the success of a project hinges significantly on its workforce. These businesses rely on their employees to ensure projects advance in order to secure payment from clients. A higher labor-to-efficiency ratio (DLER) typically signals a more profitable business. In fact, we believe the benchmark for a thriving business lies at a 65% gross profit margin.
However, there's a delicate balance to strike. Pushing employees to work excessive hours can lead to burnout, diminishing their overall quality, and productivity and can lead to high turnover. Conversely, assigning too few tasks means paying salaries without seeing proportional output. This not only affects the bottom line but can also lead to an underutilized and disengaged workforce.
To navigate these challenges, it's imperative to measure and allocate the optimal number of hours employees can work in a month. This ensures they are given the right amount of work — not too much, and not too little.
With this context, the distinction between 173.33 hours and the more generalized 160 hours per month becomes evident. At NineTwoThree, precision is a priority. By emphasizing the daily working calculation for every team member, we aim for an accurate depiction of efficiency and productivity, which is crucial, especially for tech-focused agencies and startups.
It's not about companies intentionally undercompensating their workforce. Many salaried agreements default to the 1,920-hour annual calculation. We think that both employers and employees stand to gain from a nuanced understanding of these calculations. This understanding ensures fair compensation and fosters accurate business accounting.
A helpful analogy to use when thinking about this metric is a microwave timer. Think about it in relation to the world of business: if you consistently add extra time, it's like microwaving your business. Overcooking by overworking your employees will result in an exhausted workforce and high turnover, and inevitably, your business will be "cooked". However, by selecting the perfect duration, akin to setting just the right microwave timer, your business outcome will be spot-on every time.
To illustrate, consider the microwave timer analogy: Typing in "90" ensures your microwave runs for 90 seconds. But enter "100", and it's only running for 60 seconds. It might seem minor, but it underscores how critical it is to avoid assumptions. In the same way, you wouldn't want to overcook your popcorn by an additional 30 seconds; you wouldn't want to miscalculate employee work hours.
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