There are lots of ways to measure operational efficiency - from formulas and formal metrics, to getting a gut feel for how well things work on the ground.
In service-based businesses, quantitative measures of operational efficiency include the aptly named operational efficiency ratio - which calculates how much of your net sales are absorbed by costs - as well as resource utilization rates.
More qualitative measures look at factors like staff feedback and frustrations; customer satisfaction levels; and speed of service delivery.
Improving your operational efficiency creates a range of benefits for businesses - from lower costs and higher productivity, to happier clients and more innovation. So let’s look at what you need to measure.
To measure operational efficiency in a way that is relevant to your business context, you need to understand which metrics are worth tracking.
The tl;dr version of the situation is this: most service-based businesses will find value in calculating the following:
But, as always, the issue is a bit more nuanced than that. So, let's break these down in a bit more detail - starting from the top.
The operational efficiency ratio is one way to measure whether your business is operating efficiently against your target or benchmark. It’s the ratio of input made to output gained.
It adds operational expenses (OPEX) to the cost of delivering your services or products (Cost of Goods Sold or COGS), then divides that number by your net sales.
(OPEX + COGS) / Net sales = Operational efficiency
This results in a number, which can be expressed as a percentage, that shows how much of your net sales are absorbed by costs.
You can compare that percentage to industry benchmarks, your own target, or past performance to see how you’re doing.
To calculate your operational efficiency ratio, you need to work out your operating expenses - your OPEX. You - or your finance team - likely already know this.
Your OPEX comprises items like:
You also need to know the Cost of Goods Supplied - your COGS. This includes costs like:
‘Direct’ means these are costs directly associated with delivering your goods and services. So - in an IT consultancy, for example - your OPEX might include wages for administrative staff, HR, etc. But your COGS would include wages for the staff delivering a project, like developers and engineers.
[You’ll notice that OPEX and COGS contain similar items. Indeed, some businesses record COGS as part of their OPEX. But to calculate operational efficiency, you need them to be separated - so you can add them together without the risk of duplicating any items.]
Imagine your business makes $10m in net sales per annum. To generate those sales, it has cost $1m in OPEX and $2m in COGS. This delivers an operational efficiency ratio as follows:
(OPEX + COGS) / Net sales = Operational efficiency
($1,000,000 + $2,000,000) / $10,000,000 = 0.3 or 30%
This means 30% of the business’s net sales are taken up by operating and direct costs.
You measure improvements to operational efficiency by comparing your operational efficiency ratio over time. Imagine the following year, the business above introduces efficiency improvements.
They make the same amount and incur the same OPEX. But they manage to reduce their COGS to $1.5m. This changes their operational efficiency ratio.
(OPEX + COGS) / Net sales = Operational efficiency
($1,000,000 + $1,500,000) / $10,000,000 = 0.25 or 25%
Now only 25% of the business’s net sales are taken up by operating and direct costs.
By monitoring your operational efficiency ratio, you can benchmark your performance and measure how you’ve improved operational efficiency over time.
As useful as it is, the operational efficiency ratio isn’t the only way to measure operational efficiency. Nor does it paint a full picture of your organization’s performance (for example, it doesn’t show interest repayments on debt), so it needs to be used alongside other KPIs.
The ratio above is just one metric to measure how effectively your business operates. In service-based businesses, there are other useful metrics that can help you measure and improve your operational efficiency.
If your business delivers projects and professional services for clients, your COGS will be heavily biased towards resource costs - salaries and wages of the knowledge workers delivering your projects. So it is in your interests to optimize how you use these resources - enabling your employees to deliver more work within the same amount of time/cost to the business.
A useful metric to measure, monitor, and seek to improve is therefore your resource utilization.
Calculating your utilization rate tells you how much time your employees spend working. You can calculate this overall (all work delivered) or by billable work only (work that adds direct value to your business). It is useful to understand both.
Overall resource utilization is the time your team spends working on everything needed to deliver business success — this includes billable and non-billable client work, internal projects, training, workshops, and conferences. It's expressed in percentage terms that show the amount of time that resources are being productive.
(Total registered hours / Total hours available) x 100 = Overall resource utilization
Billable utilization only considers the time spent on billable and revenue-generating work. In other words, it's the time someone actually spends on projects. Calculating your billable utilization rate shows how much time resources are being productive AND generating revenue for your business.
(Total registered billable hours / Total hours available) x 100 = Billable utilization rate
In an ideal world, every resource in a business would be productively utilized 100% of the time. However, this is neither possible nor realistic. Non-billable hours are necessary to get work done, and team members need to work at a comfortable pace to be productive and avoid burnout. [Check out this article on billable vs non-billable work for more info.]
Experts recommend the following targets for resource utilization:
By collecting and monitoring these figures, you can identify opportunities to improve resource utilization and therefore operational efficiency. You can also use them as a target for project planning, to improve the accuracy of your budget projections.
Speaking of projections, this can be another useful set of metrics to track. You should be measuring how your actual use of resources compares to projections. Discrepancies can indicate problems in your planning processes, which could suggest operational inefficiency.
If this sounds too time-consuming, it doesn’t have to be. Resource planning software can help you measure resource utilization with just a few clicks - and allocate and reallocate resources to projects equally easily.
You should also be measuring and monitoring profitability as an indicator of operational efficiency.
In a project-based business - assuming your project processes are standardized and your projection methods are accurate - if projects go to plan, you should be able to achieve a fairly consistent level of profit across different projects.
According to Inc, agencies typically make between 25% and 40% profit on projects. If you experience significant variation in project profitability, this could indicate issues with operational efficiency.
To compare profitability between projects, you need to calculate each project’s profit margin. It’s a simple sum.
(Total project cost - total expenses) / Total project cost x 100
So, for the example below, the margin is 35%. If you track the profit margins on different projects and find some are netting >40% and others are limping along at 10% or less, you might have a problem.
Variability in project profit margins could indicate a range of issues - all of which are worth addressing.
Inconsistent/inefficient practices - It could be that your project teams are using different approaches, which result in different levels of efficiency. In which case, you could identify and share best practice to help increase performance across the board.
Poor profit planning/tracking - Profit planning means planning your projects with the profit margin in mind, and then tracking progress against this goal. This approach lets your PM take corrective action if your profit margin is under threat - and ensures operational efficiency is front-of-mind in project delivery. Variability could result from this not being implemented consistently across all projects.
Lack of automation - Perhaps your teams have different levels of uptake of technology. If some teams are harnessing the power of automation, and others are burdened with excessively labour-intensive manual processes, this could account for the difference. Consider using appropriate software to take the strain out of resource planning, allocation and management.
Read how to increase profit margins next if you want to learn more.
Quantitative data isn’t everything when it comes to operational efficiency. Qualitative measures are also important.
To understand how efficient your operations are, it’s helpful to get on the ground and get a feel for things. Do processes FEEL efficient? Are your staff operating as part of a well-oiled machine? Are they empowered to work at an optimal level?
Or do processes feel inconvenient and clunky? Are staff slowed down and feeling frustrated? Do they duplicate work because teams and tools don’t talk to one another? Are they working long hours to meet deadlines and risking burnout?
What about your customers? Are they happy with your product or service? Or do they complain about lead times, processes, and deliverables?
Be alert to signs of poor operational efficiency day-to-day. And commit to a regular operational efficiency audit to ensure your processes - and people - are working optimally.
Here are some signs of operational inefficiency to look out for:
Measuring and monitoring operational efficiency is the first step to improving it. We hope we’ve given you some actionable advice on how to get started.
If you want to measure resource utilization and project profitability without wasting time poring over spreadsheets - not operationally efficient 😉 - try Runn.
Runn is resource planning software that makes it infinitely easier to plan, manage, monitor, and optimize how you use your resources - for happier employees and higher operational efficiency.
And you can start your 14-day free trial today - no credit card needed!
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