Labour Cost to Revenue Ratio

What the labour cost to revenue ratio is

The labour cost to revenue ratio (نسبة تكلفة العمالة إلى الإيراد) is an indicator that shows how much of an organisation’s revenue is taken by the cost of its workers in a stated period. It is calculated by dividing labour cost by revenue and multiplying by 100. If the cost reaches 20 million in a year and revenue reaches 80 million, the ratio is 20 ÷ 80 × 100 = 25%, which means that 25 units of every 100 units of revenue went to labour.

It is a financial indicator that human resources and finance calculate together, and it has only two inputs: labour cost in the numerator and revenue in the denominator. All the work lies in defining them, because each is a decision, and the ratio changes with the decision although nothing changes in the organisation.

What goes into labour cost

The narrowest definition is what is paid to employees as wages and allowances. The widest is what the organisation bears to fill the post as a whole: what is paid to the employee in cash, what is paid on the employee’s behalf to other bodies, and what is set aside for a deferred obligation. This is the meaning that cost to company gives to the cost of one employee. There are degrees between the two ends, and the person calculating chooses among them.

The narrow definition leaves some questions unanswered:

• People who do not appear on the employee register. People who do work for the organisation without being on its register of workers are what the contingent workforce describes. Their cost may be recorded under an item other than wages, so it falls out of the numerator unless it is expressly included.
• Work assigned to an outside party. It is paid under a services contract. This is outsourcing, in which the work is done by people other than the organisation’s employees.
• The period. Is cost counted as what accrued in the period, or as what was paid in it?

What goes into revenue

The denominator looks simpler and is less clear in practice than it seems. Is it gross revenue, or net revenue after discounts and returns? Is it what accrued in the period, or what was collected in it? Does it include revenue unrelated to the main activity? Any choice is valid, provided that every period is computed with it and that everything compared with one another is computed with it.

For this reason the ratio should come with a statement of what the numerator was computed with and what the denominator was computed with. Whoever presents it without that leaves the reader no means of checking.

An organisation with revenue of 80 million across the quarters

Imagine a hypothetical organisation whose labour cost is fixed at 5 million in every quarter, which is 20 million for the year, and whose revenue varies between quarters: 12, 16, 20 and 32 million, totalling 80 million. The ratio comes out for each period as follows:

• First quarter: 5 ÷ 12 × 100 = 41.7%.
• Second quarter: 5 ÷ 16 × 100 = 31.3%.
• Third quarter: 5 ÷ 20 × 100 = 25%.
• Fourth quarter: 5 ÷ 32 × 100 = 15.6%.
• The year: 20 ÷ 80 × 100 = 25%.

The decimals are rounded to a tenth. The cost did not change across the four quarters, yet the ratio ranged from 15.6% to 41.7%, so the whole change comes from the denominator. Whoever compares the first quarter with the fourth and says that the organisation cut its labour cost says what did not happen. So the ratio is examined over a period that includes the whole revenue cycle, and compared between two periods that are alike in their season.

The labour cost to revenue ratio by branch

The ratio is calculated for the whole organisation and for the units that make it up, but the ratio for the total is not the average of the units’ ratios. Compare two hypothetical branches. The first has revenue of 30 million and a labour cost of 10 million, and the second has revenue of 50 million and a labour cost of 10 million. The ratio of the first is 10 ÷ 30 × 100 = 33.3%, and that of the second is 10 ÷ 50 × 100 = 20%. Their average is (33.3 + 20) ÷ 2 = 26.7%. But the ratio of the organisation is (10 + 10) ÷ (30 + 50) × 100 = 25%.

The difference is that the average gives the two branches one weight although their revenue is unequal. So cost and revenue are added first and then divided, and the ratios are not added. It then appears that the first branch is heavy in cost relative to its revenue. That may be a young branch that has not reached its size, or it may be a fault, and the ratio does not distinguish between the two.

What happens to the ratio when revenue falls

Part of labour cost does not change quickly when revenue changes. Suppose the organisation’s revenue fell from 80 million to 64 million, a fall of (80 less 64) ÷ 80 × 100 = 20%, and the cost stayed at 20 million. The ratio rose from 25% to 20 ÷ 64 × 100 = 31.3%. It rose by about 6.3 percentage points with nothing changing in the workforce. So a high ratio after a fall in revenue is taken as an effect of the denominator before any other cause is put forward.

The reverse can happen in growth. Revenue rises, the ratio falls and efficiency appears improved, while the same employees may be at the limit of their capacity. This is what workload management monitors, by distributing tasks in proportion to the capacity available. A falling ratio shows that the share of labour in revenue is smaller, and it does not show that individuals are working within what they can sustain.

How the labour cost ratio can mislead

A serious weakness is that the ratio can improve through a decision that has nothing to do with efficiency. Take a hypothetical example. The same organisation outsourced part of its work, so a cost of 4 million moved from the cost of employees to external services costing 5 million. The cost of employees becomes 20 less 4 = 16 million, and the ratio becomes 16 ÷ 80 × 100 = 20%, so the organisation appears to have improved by five percentage points.

But the organisation now pays 16 + 5 = 21 million for the same work. If the cost is counted as everything paid for the work, with the outsourced part included, the ratio is 21 ÷ 80 × 100 = 26.25%, which is about 26.3% and worse than 25%. The improvement was only apparent. So the definition of the numerator is announced before any comparison, and the ratio is computed under both definitions if outsourcing took place in the period.

Figures that resemble the labour cost ratio and are not the same

The ratio overlaps with other indicators in name and not in meaning, and each has a different denominator:

• Revenue per employee. It is the indicator revenue per FTE, and it divides revenue by the number of full time equivalents, so its denominator is a unit of labour and its result is an amount, not a ratio. In that indicator too, outsourcing can improve the figure. The two questions differ: that figure asks how much revenue corresponds to a unit of labour, and this ratio asks how much of revenue went to labour.
• The cost of one employee. Cost to company is a figure for one person in a year, whereas the ratio is a figure for the whole organisation set against its revenue.
• Return on the workforce. Human capital ROI puts the cost of the workforce in the denominator, after deducting other expenses from revenue. Its question is close: how much came back for each unit spent on workers? The denominator in it is cost, and in this ratio it is revenue.

How the labour cost ratio is used in decisions

The ratio suits two questions: do revenue and labour move at the same speed, and how does cost change if volume changes? It connects to planning. When a headcount plan is adopted with its funded posts and their cost, the question is asked which ratio results from the expected revenue. Workforce planning estimates the numbers and skills the organisation needs, so the need turns into a cost that is compared with revenue.

The ratio alone is not turned into a decision to cut or to hire. A high ratio may mean an organisation building a team ahead of expected growth, or a team bigger than needed. That is a difference that does not show in the ratio and is visible only to someone who has seen the organisation’s plan. Our reading is that the ratio is examined with the trend of revenue and with the number of vacant and planned posts. If the organisation has more than one source of revenue, the ratio is calculated for each source wherever labour can be separated by it, because the overall average may hide a profitable activity and an activity weighed down by labour.

What raises the labour cost ratio apart from the labour

The ratio rises for reasons that do not concern the workers. If the organisation lowers its prices to compete, the revenue of each unit sold falls and the ratio rises while the work is as it was. If recognition of revenue is delayed by the nature of the organisation’s contracts, the revenue of the period falls and the ratio rises. If the business model depends on highly paid experts who serve a small number of clients at high prices, the ratio can be higher than that of an organisation that sells in volume, and it is accurate in both.

So the question asked about every change is whether the numerator moved or the denominator. The difference between two periods is split into two parts: what is due to a change in cost and what is due to a change in revenue. In the quarterly example, all the change came from the denominator. This single question spares much guesswork.

Is there a benchmark labour cost ratio?

External comparison runs into the earlier definitional decisions before it runs into anything else. What enters labour cost and what enters revenue differ from one organisation to another, so another organisation’s figure serves as a reference only after its definition has been learned. In the sources we reviewed, we found no figure to take as a benchmark, and no threshold above which a high ratio signals a fault. The ratio is affected by the organisation’s activity and how much of its work depends on labour, by what the organisation assigns to others, and by its size.

What serves is to examine the ratio on the organisation’s earlier figures, under the same definition, and across its similar branches. If benchmarking against other organisations is wanted, those organisations are asked for their definition first, otherwise two figures from two definitions are compared.

This is an explanation of the concept, not legal advice.