We often run into companies that book costs under one category — Payroll. And that Payroll line is often found in the expenses section of the P&L, not up in Cost of Goods Sold.
So who cares? Labor is labor — especially if you are paying salaries, right? It’s not a variable cost, right?
When you lump labor “below the line” — meaning below Gross Margin, you are missing out on a ton of great information that can help you improve your margins, improve your pricing and give you insights into productivity.
Let’s get a little deep into accounting speak for a second. If you ran a manufacturing plant you know that some of your costs like material and labor go up and down with every widget you make. Those are called variable costs or “Cost of Goods Sold.” (COGS)
Service based businesses aren’t that clear. You don’t have material that runs through machines powered and supervised by a staff… Or do you? Instead of generating widgets your people generate content, or solve IT issues, or manage clients, or engineer solutions etc. In other words they are knowledge workers.
They are your machines.
So why wouldn’t you want a better understanding of how efficiently they are producing your service? Once you start breaking out your staff costs between direct (COGS) and administrative you will get some valuable insights not only into margins but also the overhead costs you have to carry for them to support the administrative, business development or operational aspects of your business.
There are a number of benefits when you properly classify labor costs.
1.) Get better at pricing: When you have your costs properly allocated you will start to get insight into how well you did with your estimates when you quoted jobs. You will also have good baselines that you can use when you propose and price future work.
2.) Isolate the issues: When you have solid margin numbers (no matter how bad they look) you now have knowledge to work with. You can start identifying which customers, which product lines or what channels, sales reps etc. are driving profitability and then take action to rectify it.
3.) Capacity planning: When your staff says they are maxed out you can look at their time spent on client services vs admin/ in-house time. You’ll begin to be able to answer the question “Do I need to hire another person?”
These are just a few things you do with the valuable information you get when labor is allocated appropriately. You may need to spend some time to determine how you will allocate those costs above and below gross margin, knowing that, in some cases one person may be allocated to both places. The effort is well worth the knowledge you will get, though.
So go ahead… Get clarity on your margins and stop lumping labor below the line (Gross Margin). It’s bad for business.