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Make Your Business More Efficient By Tracking These Numbers

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This post is part of a series called Key Metrics Every Business Should Track.
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So far in our series on the key metrics every business should track, we’ve looked at measuring how profitable your company is, and how well it can cover its expenses.

Now we’re going to look at how efficient your business is. How quickly do you sell your inventory? How much revenue does each employee contribute, how effective are you at retaining your employees, and how effectively do you use your business’s full capacity?

You’ll learn how to calculate all of these metrics, why it’s important to do so, and what the results tell you about your business. We’ll also give you some tips on improving the results in the future.

As with the previous tutorials, we’re going to use some numbers from your company’s accounts, so if you’re not sure where to find them, you can refer to our tutorials on reading an income statement and on reading a balance sheet.

1. Inventory Turns

Why It’s Important

This is a measure of how many times you sell through your inventory each year. It’s important because maintaining inventory costs money, and it’s not a good business model to have piles of goods sitting in your warehouse for a long time. This metric can highlight inefficiencies in your business that are eating into profits.

How to Calculate It

The formula for this metric is quite simple. It uses one line from the income statement and one from the balance sheet.

Inventory Turns = Cost of Goods Sold / Average Inventory

Cost of goods sold (also known as cost of sales or cost of revenue), comes from the income statement. Inventory comes from the balance sheet, and to calculate the average inventory you’d simply take the average of the inventory at the start of the year and at the end of the year.

Let’s look at an example from tractor manufacturer John Deere. Its 2013 accounts show that the cost of goods sold was $25.7 billion. The inventory at the start of the year was $5.2 billion, and at the end of the year it was $4.9 billion, so the average is $5.05 billion. So the formula becomes:

Inventory Turns = 25.7 / 5.05 = 5.1

That means that, on average, John Deere sells its entire inventory about five times a year.

How to Evaluate It

In general a higher number is better, because it indicates that products are spending less time languishing in the warehouse or sitting on the shelves before they’re sold to customers.

However, it’s important to realize that this number varies a lot by industry. John Deere sells agricultural machinery, so it’s not going to cycle through its inventory as often as a grocery store, which is always bringing new products through its warehouse. Whole Foods Market, for example, has a much higher inventory turns rate of 21. That doesn’t mean it’s more efficient than John Deerejust that it’s got a very different business model.

So it’s important to compare like with like. Research your competitors, or contact an industry association or consulting firm to get average numbers for businesses in your field. Also compare your current number against your own historical averages, and watch for any decreases, which could indicate bloated inventories or slow sales.

How to Improve It

The key here is to reduce the amount of money that’s tied up in inventory. You can achieve this either by speeding up sales or slowing down the accumulation of new inventory.

Speeding up sales could be about increasing the marketing budget, for example, or opening a new store in a popular location. On the inventory side, perhaps it’s worth investing in a more effective inventory tracking system, so that you can have a clearer picture of what you have in stock and know exactly how much you need to order. If you can restock quickly and reliably, then consider waiting until the last minute before reordering, so that you minimize the time the goods spend sitting in your inventory.

Keep in mind, though, that you can’t cut too close to the bone. If you keep inventories very low and achieve a high number of inventory turns, then you’ll be super-efficient, but may risk annoying your customers by running out of stock at critical times. The aim is to keep sales brisk and inventories low, while still being sure to meet your customers’ needs.

2. Revenue Per Employee

Why It’s Important

As your business grows, it can be hard to know how many staff to hire. You need enough people to produce high-quality goods or services for your customers, but if you hire too many, your costs will be high and your profit margins will suffer. This metric gives you a good benchmark by comparing staffing levels to the amount of revenue you’re bringing in. It can help you ensure that your company provides good service, without being inefficient.

How to Calculate It: 

Simply take your total revenue and divide it by your average number of employees for the year:

Revenue Per Employee = Revenue / Average Number of Employees

If you made $2 million in revenue this year, for example, and you employed 20 people on average, your revenue per employee would be $100,000.

Revenue Per Employee = $2,000,000 / 20 = $100,000

To get your average staffing level, you could simply take the average of the number at the start of the year and the end of the year, as we did with inventory in the previous section. But you could also get a more accurate picture by using your payroll records. See how many paychecks you wrote each month, and find the average of those numbers by adding them together and dividing by 12.

How to Evaluate It

Of course, you want the number to be as large as possible here. And you certainly want it to be significantly higher than your employees’ average salary, otherwise you’ll never make a profit.

But again, it’s important to look at other companies in your industry. And keep in mind that other factors, like employee compensation, play a role here. McDonald’s, for example, has one of the lowest revenue per employee numbers of any large American company, at $65,000. Apple, on the other hand, has revenue per employee of $2.4 million.

Both companies are very profitable, but they are in very different industries. Fast food restaurants require a large number of workers, but those workers are relatively low-paid compared to Apple engineers. And McDonald’s scores very highly on other measures of efficiency (its inventory turn, for example, is a massive 141). So it’s important to compare yourself to similar companies, and aim for a higher revenue per employee than your peers.

As your company grows, you can also use the revenue per employee number as a guide to how many new staff you should take on. If your current revenue per employee is $100,000, and you have a new business opportunity that could boost revenue by $1 million, it would be worth hiring 10 new employees to get it done. But if you find yourself having to hire 20 more people to get that extra $1 million in revenue, it might not be worthwhile.

How to Improve It

Cutting staff, of course, will immediately boost your revenue per employee. But if you’re too ruthless, you risk compromising the quality of your service and possibly driving away customers, which would reduce your revenue in the long term. As with our first example, it’s about the balance between efficiency and providing a good service. If you can find ways to encourage your existing employees to generate more revenue, perhaps by offering better incentives or by giving them training, then you can boost revenue per employee without compromising customer service.

3. Capacity Utilization

Why It’s Important

This metric is particularly useful for companies that manufacture physical products, but with a little imagination you can apply it to other firms too. It measures how much of your production capacity you’re using right now, and it’s important because if it’s low, it means you’ve got a lot of fixed assets being wasted: for example, expensive machinery not being used.

How to Calculate It

This one is a little different, because we’re not using any numbers from the financial statements. The formula for capacity utilization is:

Capacity Utilization = Actual Output / Potential Output x 100

What do we mean by actual and potential output? Let’s look at an example.

Say you make T-shirts, and your factory or workshop is equipped to produce 1,000 T-shirts a month. In that case, your potential output would be 1,000. If you’re only producing 500, then your capacity utilization is 50%:

Capacity Utilization = 500 / 1,000 x 100 = 50%

As we mentioned, this number is mostly used in manufacturing, but you can adapt it to fit different businesses too. If you run a yoga studio, for example, your potential output might be the maximum number of classes you could run in that space every week. If you could run up to 20 classes per week, but you’re only running 15, then your capacity utilization is 75%.

How to Evaluate It

A higher number indicates a more efficient use of your fixed assets. In the yoga studio example, you have a lot of fixed costs associated with renting or owning the studio space, maintaining it, paying utilities, etc. You have to pay those fixed costs whether you’re running 15 classes or 20, so clearly it’s better to run more classes and make the most use of the space you’re paying for.

Generally, though, businesses don’t run at 100% capacity all the time. In fact, if your yoga studio really were at 100% capacity, it would indicate that you needed to invest in a bigger studio space to allow for future growth. The average capacity utilization among US industrial firms is around 80%, so you can use that as a general benchmark.

How to Improve It

If your capacity utilization is low, it indicates that you need to ramp up production (assuming, of course, that you can sell those extra goods). It may even be worth offering discounts to boost sales and keep production at a certain minimum level. If it drops too low, then those large fixed costs are going to be a drag on profits.

In an extreme case where capacity utilization was permanently low and you saw no prospect of increasing production in the near future, it might be necessary to move to a smaller space and reduce your overheads. It’s better to make more efficient use of a smaller capacity than to have a lot of equipment lying idle.

If your capacity utilization is getting close to 100%, on the other hand, then it’s probably time to invest in more capacity, perhaps by upgrading machinery, expanding your space, or moving to bigger premises.

4. Staff Turnover

Why It’s Important

Running an efficient business depends on having skilled, motivated employees. Staff turnover measures the rate at which your employees are leaving, and high turnover is often a sign of dissatisfied employees, which is likely to mean that even those who are staying with you aren’t fully committed.

High turnover is also inherently inefficient, because you spend time training and developing each employee, and every time one of them leaves, you have to start over again with someone new. It can cost more than twice an employee’s salary to recruit and train a replacement.

How to Calculate It

Staff turnover is the percentage of people who leave in a certain time periodusually a year, but you can also calculate it monthly if that makes sense for your business. Here’s the formula:

Staff Turnover = Number of Separations / Average Number of Employees x 100

“Separations” means the number of people leaving your firm during the year. Usually companies don’t distinguish between different reasons for leaving: they include voluntary resignations, dismissals and retirements in the “separations” figure. The average number of employees is the same figure we used in the “Revenue per employee” section.

For example, if you have 100 employees on average, and 5 of them left during the year, then you have a 5% turnover rate.   

How to Evaluate It

A lower percentage is good, because that means fewer people leaving. You can get a good benchmark from these US government statistics, which show that the average staff turnover in the US in 2013 was 38%. The rate varied widely by industry, though. The construction industry had turnover of 62.5%, for example, whereas in manufacturing it was just 23.3%. It also varied by region, being highest in the South (40.8%) and lowest in the Northeast (33.3%).

You can look through those statistics to find the turnover rate for your industry, and see how you compare. The US government categories are quite broad, though, so it’s worth doing additional research to try to find more specific information for companies like yours, in your particular region or city. It’s also good to compare against your past performance, to look for any changes. As well as looking at overall turnover, consider splitting it out into voluntary, dismissals and retirements, so that you can spot trends in each area.

How to Improve It

Reducing staff turnover is a huge subject, and it’s not always easy to fix. Part of the picture is paying people well and offering bonuses, benefits and other incentives, but money isn’t everything. High turnover can also be caused by a number of other factors, like hiring the wrong people in the first place, problems with the organizational culture or workplace environment, lack of training, limited promotion opportunities, poor management, or even an inconvenient office location.

If you have a high staff turnover rate, the key to finding out what’s wrong is to ask your employees, both through formal surveys and informal meetings. Exit interviews with people who are leaving can also help you fix any mistakes and ensure other employees are more likely to stay.

Putting It All Together

These four different measures of efficiency can be used together to give you a clear picture of where your business is working well, and where it needs to be improved. You can now measure exactly how long it’s taking to convert your inventory into sales, how much revenue each employee is generating, how effectively you’re using your fixed assets, and how much staff turnover you’re experiencing. You know what to look out for, and what action to take to improve your results.

Healthy numbers on these efficiency metrics will also boost your profits and cash flows, so you can track these in conjunction with the profitability and liquidity metrics we looked at in the first two tutorials.

The final piece of the jigsaw is to look at your customers. After all, they’re the lifeblood of your business, and you need to know how effectively you’re acquiring and retaining them. So come back next week to find out about key customer metrics in the final part of our metrics series.

Resources

Graphic Credit:  Line Graph designed by Scott Lewis and Graph designed by Michele Zamparo from the Noun Project.

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