Understanding Your Effective Labor Rate

Nov. 1, 2014
Effective labor rate is a key indicator for understanding the profitability of your business. The simple calculation tells you what your shop is actually making per billed hour. Improved efficiencies will enable more hours to be billed out in the same amount of time.

Effective labor rate is a key indicator for understanding the profitability of your business. The simple calculation tells you what your shop is actually making per billed hour. Improved efficiencies will enable more hours to be billed out in the same amount of time. 

Will Sando, owner of Silverlake Automotive in Coeur d’Alene, Idaho, started working on improving his effective labor rate six years ago, when it was hovering around 69 percent. Since then, that number has increased to 95 percent, with the goal to reach a perfect 100. 

If those numbers seem foreign to you, keep reading; Sando explains the importance of effective labor rate and why every shop owner should understand theirs.

Tracking and controlling our effective labor rate has been one of the most important items in the ongoing profitability of our business. About six years ago, I joined a Bottom Line Impact Group, which is when I was introduced to the concept. The goal is to get your effective labor rate as close to 100 percent as you can. What that means is that for every hour you’re paying a technician to work on a car, you’re billing that hour to the customer. The effective labor rate is calculated by taking total labor sales dollars and dividing by the total labor hours billed for a given period:

Total labor sales (in dollars)/ Total labor hours billed
= Effective Labor Rate

For instance, let’s say that your labor rate is $100 an hour and your monthly labor sales were $50,000. If you have three technicians and you paid each tech 200 hours that month, that’s a total of 600 labor hours. In theory, you should have made $60,000 in labor sales. But since you only made $50,000, that means your effective labor rate is at $83, not $100. You’re paying those 600 hours to your technicians but you’re not collecting them from customers. 

The confusion with effective labor rate is in thinking that just by having a technician work faster, you can change your effective labor rate. That is not true because the technician is still getting paid for those hours. If a technician does a timing belt job that pays six hours in only four hours, you’re still paying them for those six hours. While improved efficiency will enable more hours to be billed out in the same time spent at work, you still need to bill those hours.

After the effective labor rate was explained to me, I started looking at it on a weekly basis. On a Monday morning, I would look at the past week’s worth of business and do a basic calculation. After finding the week’s effective labor rate, I would look through the invoices one by one and see when the effective labor rate was on track and when it dropped. You’re able to find patterns and trends and make those adjustments. I made a list of situations that were detrimental to my effective labor rate and came up with solutions to avoid those problems.

There are several common things that can decrease your effective labor rate. One example: diagnostic time. One of the pitfalls that people often fall into is that they will charge an initial hour for diagnosis and a tech will end up spending two to four hours getting to the root of a problem. If you’re only charging the customer that $100 hour in labor and a tech has spent three hours doing the diagnosis, your effective labor rate is only $33 an hour. Getting paid for diagnostic time is very important.

Another factor that could be detrimental is what we call non-routine tasks. There are some tasks, like a rusty exhaust, that are above and beyond what a book rate or flat rate time would be for doing a job. That extra time spent doing that task can legitimately be charged to the customer because it’s not part of a normal operation. It’s about communicating and educating the customer by showing why their car has this extra time associated with it. You need that buffer to make sure those tasks don’t drag it down. 

Finally, another thing we have found that helps the effective labor rate is getting paid to do comprehensive vehicle inspections. It’s industry standard to inspect every vehicle that comes in with a 30-point courtesy inspection. However, you’re not getting paid for that. If we sell a comprehensive vehicle inspection to a customer at the counter, now we’re getting paid an hour. Even if it’s one or two out of 10 cars that we see come in, that extra labor dollar is coming in. 

Improving your effective labor rate is all about watching the little things, which add up to bigger things. Those small tweaks can really make a difference over time. We have implemented a tiered labor rate. Our labor rate varies based on what kind of work we’re doing, the complexity, and the technician working on the job. Front-end work, line work and highly technical diagnostic work all have different labor rates. For us, improving our effective labor rate has brought in an extra $45,000–$50,000 net profit a year. That’s a substantial amount. 

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