When running a business, you want to make sure that you're making the best use of your resources because waste directly leads to lost profits.
What is operational efficiency?
Operational efficiency is an accounting metric that compares profits to operational costs. When you get the same output with less input, your efficiency ratio goes up, and so does your bottom line.
That's because income minus costs equals profit.
It's essential to distinguish operational efficiency from productivity. Each focuses on the opposite variable in the same equation. With productivity, instead of changing costs, you try to keep costs the same and improve your output.
An easy way to think about it is a factory that uses all of its machines to produce a specific product. You sell a machine to reduce ongoing operating costs but keep making the same number of products. This is operational efficiency. You're improving productivity while keeping bandwidth the same.
Operational efficiency examples
Operational efficiency can cover many different areas. The most common examples of areas where you can improve operational efficiency come in the cost of goods sold. Still, you may also be able to address other operating expenses.
- Labor hours: Is your workforce fully utilized?
- Material costs: Do you have waste in production, or could you get materials at a lower price?
- Repairs and maintenance: Could proactive maintenance reduce your repair expenses or reduce downtime for machinery?
- Rent: Is your location the right size for your needs, and are you getting a good price?
- Administrative expenses: Other expenses like bank fees, office supplies, and professional services often get ignored but quickly add up.
How to measure operational efficiency
The formula for measuring operational efficiency is
Operating Ratio = (Operating Expenses + Cost of Goods Sold) / Net Sales
You can calculate this ratio in a few different ways.
For your business's overall efficiency, use the numbers from your latest income statement. You can also determine the efficiency of different products or services. To do so, you will need to track what sales and expenses relate to each item you want to track.
For example, let's say a manufacturing company makes shoes and boots. To track the efficiency of each product, it needs to know how many shoes it sold and how many boots it sold to get the net sales for each.
To get the cost of goods sold, it needs to know the cost of materials, machine hours, and labor hours for shoes versus boots.
For operating expenses that don't directly relate to either, it's common to allocate the expenses by net sales. If the factory does 60% of its business in shoes and has $100,000 in overhead, it uses $60,000 for operating expenses when determining the efficiency for shoes.
This sounds complicated, but you can easily set up your financial reporting software to track this information and generate segmented reports that help your decision-making.
How to improve operational efficiency
The key to improving operating efficiency is finding ways to reduce costs that don't affect your outcomes. If you use cheaper materials and lose sales because of returns or declining customer satisfaction, that's not operational efficiency.
Efficiency comes when you get the same materials at a lower cost because you used unused warehouse space to take advantage of a volume discount from your supplier.
There is no set process for improving efficiency. You can take standard steps, but you can work in any order. Some areas might be more cost-effective to address. Others might not be in line with your strategic planning. The end goal is the continuous improvement of your business operations.
- Use benchmarking and business intelligence to determine how your business compares to others. Maybe your cost of goods sold is already lower than average, but your rent is too high.
- Use benchmarking to compare business units. If two of your stores are providing the same service, see if they have similar operating ratios and find out the reasons for any differences.
- Look for bottlenecks in business processes. This often means talking to workers or walking the floor. For example, junior workers might sit idle while waiting for manager approvals that could be skipped or delegated to someone else.
- Find ways to streamline other inefficiencies in workflows. Can process automation replace manual, repetitive tasks? Are employees spending too much time walking between far apart stations that could be rearranged to ensure better routing?
- Bring your entire team in on your initiatives as stakeholders. They might already have ideas from their daily experience. Recognition and bonus incentives for keeping up efficiency can help make sure your team strives to be as efficient as possible.
- Monitor key performance indicators (KPIs) in your accounting dashboards. This gives you a real-time look at whether you're getting results and what other areas you can address.
As you look for ways to improve efficiency, you'll also probably find ways to improve productivity. It would be best to explore any opportunity to improve your profit margins. Your goal is overall optimization regardless of which accounting methodologies get you there.
Operational efficiency KPIs
In addition to measuring overall operational efficiency, you also want to track specific key performance indicators. These KPIs are part of your benchmarking, performance tracking, and discovery of new areas to address.
A good KPI directly relates to your overall goals and the task at hand. The best KPIs to use in your management system vary by your business model and your current needs. These are just samples.
- Accounts receivable turnover and days sales outstanding: These can measure both the performance of your accounts receivable (AR) team and whether your AR processes allow you to collect as efficiently as possible.
- Utilization rate: This tells you how productive employees are. If you have a low utilization rate, you may want to assign them other tasks or explore whether your workforce is the right size.
- Overtime hours: Overtime pay usually means an additional cost for the same work. Overtime is suitable for periods of peak demand, but constant overtime may indicate a need to hire more employees.
- First pass yield: Not getting products right the first time often causes additional expenses to correct the problem, if not outright waste.
- Machine downtime: When machines are down, you're still paying your fixed expenses. This includes planned downtime that you might be able to work around and unplanned downtime that you might be able to reduce with preventive actions.
- Order and picking accuracy: Sending out wrong orders or having pickers make mistakes means wasted labor hours or extra shipping costs.
- Inventory carrying costs: Inventory costs money to store since you need to pay for the space and utilities. Your inventory management needs to balance this with the risk of running out, bulk discounts, and other metrics.
- Warehouse utilization: If you have empty space that you never use, you may want to consider downsizing or finding new uses for that space.
- Cost per acquisition or lead: These are key measures of marketing efficiency. You want to get each customer for the lowest cost possible without losing out on customers.
Again, some of these KPIs may or may not apply to your business. You should use them as a starting point to develop your own KPIs that measure areas you identified for process improvement and to find new ways to improve your operational excellence.
Get started with your financial processes
One of the easiest places to start improving your operational efficiency is your financial processes. Many customers have used BILL to get paid faster and better manage their bills while saving time and money.
Financial controls are one of the biggest bottlenecks for finance and accounting departments, and BILL helps to streamline your controls by making it easier to follow your approvals process while strengthening it at the same time. You can also automate other tasks like automatically recording customer payments and sending reminders to customers who haven't paid.
