The Simple Ratio That Can Save Your Margins

In 2023 I got a call from a $100 million travel company based in Florida. Coming out of the pandemic, their revenue was up 40 percent, rising from $100 million to $140 million. Despite the increase, they found themselves “growing broke.”

Like many scale-ups, they started throwing more and more expensive people at the problem, even while offshoring some labor. As inflation ran rampant, it put further pressure on wages and drove up costs for the company’s vacation products faster than it had raised prices.

Critical Ratio

To shine a spotlight on the situation, I suggested they key in on a critical ratio: gross margin dollars divided by total compensation. Not just total compensation, including benefits and bonuses below the gross margin line, but also total loaded compensation. As a baseline, I had them calculate this ratio starting in 2019.

By 2023, this ratio had dropped in half! Ever-decreasing margins were being consumed by ever-increasing labor costs.

They made this ratio their critical number for 2024, began working with one of our coaches and used our Cash Flow Story tool to analyze which levers to move to improve cash. The results were dramatic: The company grew from $140 million to $200 million in revenue and, more importantly, brought this key ratio back to 2019 levels. They were back generating significant cash.

Inflation Is Here to Stay

Global pricing expert Hermann Simon says we’re facing 5 percent average annual inflation for the rest of the decade. And many companies are still grappling with higher carrying costs because of interest rates and continued wage pressures. Often, payroll is their biggest expense. Pile on modest tariffs, and firms are expected to see rising costs for years.

This is why this labor efficiency ratio is so important and one I have companies on whose boards I serve report it at the top of their financials. I’m encouraging all firms to use 2019 as a baseline—a golden year for business when we were way out past the Great Recession but before the pandemic.

As for the ideal ratio, it doesn’t matter as long as it’s headed in the right direction. If it’s not, here are three immediate actions:

1. Focus on your pricing strategies. A commercial landscape and maintenance firm out of St. Louis that I advise started looking at this ratio several years ago. As a result, they focused on aggressive escalation clauses in their three-year contracts beginning in 2023. Even with wage pressures, they saw their labor efficiency ratio increase from 113 in Q1 of 2024 to 131 in Q1 of this year. And they are focused on raising this ratio, through increased labor productivity, to 165 over the next two years.

Not sure where to find efficiencies? Check out Dan Heath’s Reset, with six chapters on identifying constraints to address—and several on fixing them in as little as five days.

2. Fewer people paid more. Companies often fail to raise prices quickly enough to keep up with inflation. At the same time, they ramp up hiring when revenue spikes, often without proper onboarding or structure. That creates inefficiencies.

You want to focus on having fewer people—all A players—paid more but with lower total labor costs. That really helps the denominator of our ratio. Look for people who are 3x as effective and pay them just 2x more—that’s the magic at Costco. Costco just went to $30/hour, but they’re the most efficient at generating a dollar of revenue per payroll dollar in their industry.

3. Don’t automate a mess. Use AI to make labor more productive, but learn from Elon Musk’s mistakes and don’t bring in the bots too early. Get rid of the dumb stuff, streamline and only automate at the end.

The most important thing you can do is keep a close eye on total gross margin dollars divided by total compensation. You’ll position your company to start printing cash, as if it were 2019 all over again.