Without the leveraging of labor, there is no profit made in an operating business. The MSP business model is one of the best at leveraging labor of all the industries my team consults with. An MSP that deploys a good labor strategy and effectively manages their team will achieve profit above the industry standard and an exceptional return on invested capital as well.
There are only two labor strategies in business:
- Flex your labor to what you sell to.
- Sell to the labor you commit to.
MSPs require highly skilled labor that is not easily found, so you will generally not be able to flex labor to what you sell to; you must commit to your current team and sell work to make that team profitable. There is some possible flex in help desk functions and other specialized services, but that is carving off a segment of your sales and letting someone else be profitable at that activity. Your margin is only what you get to keep after subcontracting it out.
The first $1 million of gross margin (revenue minus COGS, excluding labor) is the first significant data point. It has been our experience that performance ratios tend to stabilize and scale after that point is reached. To get to that point and beyond, there are only two labor growth strategies:
- Stretch your team until they are “running hot.”
- Hire labor needed for growth in advance, and push marketing and sales to get profitable.
Both of these growth strategies have their risks, and you are making a bet to stretch your team. To add labor in advance of growth can push your business into losing money and eat into your cash reserves or force you to borrow to support the growth. Being overstaffed at any point also takes the performance edge off teams, and they develop bad habits of not working with a sense of urgency. As you start to grow, the team cries for more help too soon since they are accustomed to a slower pace of work.
There is no doubt that businesses have been successful at both. However, if you have not demonstrated a history of consistent inbound leads that convert into new sales, advance hiring has the lowest possible chance of successful outcomes and will lead to reset of labor at some point and diminished reserves and lower profit distributions for the owners. If the owners require consistent profit distributions for consumption, or outside the business commitments, hiring in advance can lead to financial disaster if it fails to produce results quickly.
Using Labor Efficiency Ratio (LER) To Manage The Strategy
There are two key metrics to manage this process:
- Direct Labor Efficiency (dLER) — gross margin divided by direct labor
- Management Labor Efficiency (mLER) — contribution margin (gross margin minus direct labor) divided by management labor
(Note: For a more detailed discussion of LER and ROIC, see Chapters 1 and 8 in my book “Simple Numbers 2.0, Rules for Smart Scaling.”)
A couple of quick definitions — don’t overthink it; just be consistent on who goes where, and if it is close, put them in direct labor.
- Direct labor is the gross wages of your client-facing team. It does not include payroll taxes, just gross wages. If you have an independent contractor who mostly works for you, it is fine to include them in direct labor. Do not include work that you have contracted out to a company to handle; that is a COGS item in our approach. Also, do not split people; the whole cost goes in.
- Management labor is, by default, all labor that is not direct. This typically includes owner’s compensation at a market rate. If you are underpaying yourself as an owner, you must add in what true compensation should be. It also includes your marketing and sales labor.
Once you have your definitions, look at rolling 12 performance (highest quality number) and rolling 3 (next highest). Monthly LER can be volatile due to non-MRR activity. From our work with the TMT Mastermind Groups and other clients in the industry, we know the top performers hit 4 for dLER and 4 for mLER. At this level, the company is typically performing at 20%-plus net profit and over 200% return on invested capital. We also know the median for the group runs around 3.5 dLER and 3.5 mLER. At that level, it would typically produce 12%–15% net profit.
Using LER For Decision Making
Monitor movement of LER on R12 and R3 to see clearly “is it getting better” or “is it getting worse.” You can’t hide from the outcome!
- If dLER is at target and mLER is low, you either need to grow the contribution margin to justify the management labor you have, or you have management labor that is not necessary and needs to be trimmed.
- If mLER is at target and dLER is low, it is showing that your management labor is not being effective to get the unit economics out of the direct labor team. Management labor effectiveness is the ultimate key to profitability. When management does its job well, everything tends to work.
- If both metrics are low, your action starts with evaluating your management team first, then either trim labor to an acceptable metric or take the risk of growing into it.
Following these guidelines have helped many of our clients hit their targeted profit and turn their business into a valuable wealth-building engine.