How do we take the economy into account… again?

Nearly ever week I get asked the question “how should we take the economy into account when evaluating our pay structure?”  The fact that this question was actually asked means that there is a fundamental lack of understanding about the way pay structures are designed, assuming of course that the structure in question was designed correctly.  It also reflects a failure to look at the broader picture, in which cost savings are better found not in squeezing blood from a stone, but from making processes more efficient and cost-effective.

If a pay structure is created using accurate and current labor market data, the state of the economy is already taken into account.  Labor market data represents the cost that employers incur in paying for employees to provide certain services.  If the structure uses current market data, it presents an accurate representation of the cost of labor, analogous to the cost of any other product or service.  If an organization adjusts a structure (presumably downward), or fails to respond to structure changes because of “the economy,” it is making an adjustment that is not warranted by either good business sense or the reality of the economy.

For some reason, employers erroneously believe that the cost of “people” is more under their control than the cost of goods or services.  By setting budgets for payroll increases in reference not to the market, but to their choice of how to allocate available funds, an organization expresses an unwarranted degree of arrogance.  For a labor intensive organization, which likely has a significant part of its budget dedicated to labor, a mistake of even one percent can result in excessive turnover-related costs and a failure to provide necessary services to customers.

Organizations need to understand, conceptually, how people are much more like commodities than they may have believed.  As an analogy, consider how an organization responds to the price of a basic commodity such as copier paper.  To determine how much to budget for paper, an organization assesses the amount of paper it uses, researches the price (including estimates of potential price increases), and calculates a total.  The key to this analysis is the price of the paper;  no competent financial analyst would say “our budget is based on our desire to pay 3% more for paper for 2013.”  In fact, that sort of comment would be laughed at as being somewhat absurd — we don’t choose how much to pay for paper, we pay whatever the price is.

Assuming that we currently buy paper at $35 a case at Staples, we will continue to pay $35 until the price changes.  We won’t voluntarily pay $36.05/case ($35 + 3% budgeted increase).  If the price goes up to say, $39 a case, we have to make a choice.  We can pay the $39 a case at Staples, we can search out another supplier to provide the same quality of paper at a lower price, or we can purchase a lower quality paper.  All of those choices will have consequences:

  • Paying more means we pay more — and we respond to that by finding a way to increase our revenue, or shifting from another line item in the budget.
  • Switching suppliers may reduce the cost, but we may lose customer service, preferential terms or other advantages gained from long-term working relationships.
  • Buying lower quality paper may seem like a good short-term solution, but it may also mean more paper jams, damage to our machines, and productivity losses because of down time.

Some will argue that people are not like paper.  In some ways, employers have leverage over people — they need us and may willingly stay even when we don’t pay them what they are worth.  Of course, everyone knows that when leverage is applied to a person, there will be an equal and opposite reaction, even if it can’t be quantified.  It is also a baseless assumption to suggest that simply because there is high unemployment there is a wide supply of the skills needed for particular jobs.  Highly skilled employees are always sought after, and always have options, and failing to recognize this is a mistake.  One of the biggest frustrations any employer has today is finding the combination of skill and work ethic to function in its environment.  This is the case no less in times of high unemployment than in times less favorable to employers.  Voluntarily giving up a known quantity for a speculative product at a lower price is just not good business sense.

While in individual situations the fact that we’re considering animate objects instead of commodities may matter, in a larger sense, those situations are the exception.  In many ways, overall, people are like paper, and the reaction to a change in the pay structure (our analogy to the new Staples catalog) will be similar:

  • If we pay the new price, we retain products that are a know quantity — we are familiar with them, they meet our expectations and we can count on them.  Giving them increases that reflect their value reinforces their commitment to us and keeps their morale up.
  • If we switch employees, we voluntarily give up years of experience and expertise and understanding of our own circumstances and peculiarities, and we lose our “known quantities.”  We may have a momentary reduction in cost, which will last until our new employee realizes his or her value in the market.  However, with the temporary saving in cost we will also experience lost productivity while the position is unfilled; costs of recruiting, hiring, training and acclimating new employees; lowered productivity during the training and ramp-up period; and the costs of other employees’ productivity while they cover for what we’ve lost.  Any experienced accountant will tell you that the cost of turnover, whether or not it appears on a P&L, is much greater than the cost of paying market value for current employees.
  • If we switch to employees at a lower cost, with commensurate lower levels of skills, we should expect, and will get, lower levels of productivity and quality.  In short, we run the risk that our new employees will be like poor quality paper — they jam up the machine that is your existing workforce and cause others to be ineffective.

If a proposed pay structure is calculated with accurate labor market data, it already accounts for the economy.  The answer to the question “how do we account for the economy” is answered with “we already did.”  The right response to the question is not “how do we adjust the structure” but “how do we use less labor so that our costs do not increase.”

Continuing the use of the paper analogy, consider the other as yet not discussed variable, the amount of paper used.  If the price of paper goes up, we have a very viable alternative — figure out how to use less paper.  When price is not an object, there is a lot of waste; we print out drafts instead of editing on the screen, we print out extra copies of reports “just in case” and we have paper copies in the files in addition to the electronic copies stored on our servers.  The increased price of labor provides an opportunity to examine not just the cost of business, but the way in which you conduct your business.

Nearly even organization has opportunities to reduce labor waste.  Labor waste grows over time, and the experience of those organizations who have laid off significant portions of their workforce but yet continue to provide quality goods and services without significantly increasing the remaining employees’ workload proves it.

The bottom line is that your pay structure tells you what your reality is, and how you react should be an exercise in good management.  Accept and understand your costs, and you have an opportunity to re-examine your processes and retain your best assets.  Pretend that you don’t have to accept reality, and you can expect to spend a lot of hours waiting for the copy guy to come by and clear your paper jams.

About Edmund B. Ura

Edmund B. Ura, MAIR, JD, works with governing boards, executives and human resources staff to develop methodologies for ensuring fair and equitable compensation programs that support achievement of organizations' missions. Contact Ed at ebura@mercesconsulting.com.

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