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Stop picking employees' pockets
Jeffrey Pfeffer

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December 18, 2007

When large companies fall into financial difficulties, it always amazes me to see where they turn first for help in overcoming their problems -- to their hourly workers and other frontline employees, who are asked to take pay cuts and reductions in benefits such as health insurance and pensions. In 2005, General Motors asked the United Auto Workers union to reopen their contract prior to its expiration in 2007 so the company could reduce health insurance benefits for current and retired employees.

After enduring a four-month strike by Southern California grocery workers, Albertsons, Kroger, and Safeway ultimately managed to freeze the pay scales of existing employees, hire new people at lower wages, and raise health-insurance copayments, all in an effort to meet Wal-Mart's low cost challenge in the grocery business.

But it is perhaps in the airline industry where asking employees to reduce their wages has been most pronounced. Since 2001, US Airways, American, Delta, Northwest, and United have all dug into their employees' pockets, often many times, in an effort to lower costs and survive in an extremely competitive environment.

In the fall of 2004, for instance, US Airways reduced the pay rate for reservation agents by another 21 per cent, taking the pay of Kelly Orr down to $13 an hour from the $25 she once made. The airline also cut the pay of light attendants by an additional 21 per cent, taking the pay of Randy Brooks from the high $40,000 range to the low $30,000 level. Pilots have suffered similar sorts of reductions at most of the major carriers.

But in case you haven't noticed, in spite of the many rounds of wage cuts, the major airlines have continued to lose market share to the discount carriers such as JetBlue and Southwest and have continued to bleed money. Grocery chains have also continued to lose customers to Wal-Mart and Costco on the one hand and to Whole Foods Market on the other, and still face margin pressures and profit problems.

That's because the solution management seized on -- cutting workers' pay -- actually doesn't do very much to make organizations more profitable and competitive or even, in some cases, to reduce costs. Instead, cutting employee wages often worsens company problems.

Hourly rates of pay simply don't do nearly as much as most people seem to believe to determine a company's -- or even a country's -- competitive advantage. That's because wage rates are not the same thing as labor costs, labor costs don't equal total costs, and -- in many instances -- while it is nice to be low cost, low costs and profits aren't perfectly correlated either.

Consider first some surprising facts about the effects of wage rates on the competitiveness of nations. Japan runs a trade surplus with China, even though Japan has higher wages. High-wage, presumably high-cost, countries such as Canada and Germany also run trade surpluses. You might assume that Italy -- another high-wage country and a major manufacturer of clothes and shoes -- would have a difficult time competing in a global market where apparel and footwear are typically made in low-wage locations.

For example, Levi Strauss has closed all of its US plants, and Nike continually fends off critics of worker conditions in the Asian factories where its shoes get made. But Italy, too, boasted a trade surplus, even in shoes, until quite recently. Meanwhile, the United States runs a trade deficit of about $600 billion, even though it has lost its position in the list of high-wage countries. US average employee wages are actually 40 per cent below those in the United Kingdom, 38 per cent below Japan, 23 per cent below the average for Western Europe, and even below the average wage in Ireland.

What's true for countries is also true for companies. The competitive success of airlines such as Southwest, Alaska, and Jet-Blue depends on lots of things besides wage rates. For a start, it's nice to be able to offer customers a product or service offering they actually want to buy. In the airline industry, three of the four US airlines rated the best in terms of the customer experience in 2004 were the so-called low-cost airlines; the only nondiscounter in the top four was Alaska.

According to a study that examined the customer service experience -- on-time performance, number of customer complaints, denied boardings, and mishandled baggage -- there was a performance gap between the legacy carriers and the low-cost carriers, which, although they are supposedly no-frills, actually outperformed their rivals. Virgin Atlantic Airways has consistently pursued a strategy of offering more amenities and better service for both its business-class and economy fares, and has generated a profit when other airlines have struggled.

After further upgrading its business-class seats and service in 2004, the carrier reported a 26 per cent increase in business-class traffic for the fiscal year ending in February 2005. And Singapore Airlines has been one of the most consistently profitable air carriers over the past several decades, in large measure because of its reputation for outstanding customer service. Furthermore, both Singapore and Virgin are able to charge more for trips covering the same routes as competitors, belying the idea that airline service is a commodity and people won't pay more to get more.

In the automobile industry as well, profits depend on more than just costs. Profits also are affected by brand image and product design and quality, all of which affect how much people are willing to pay for a car. While General Motors whines about its cost disadvantage because of its health care expenditures and high, unionized wage rates, Toyota achieved almost $6,000 per vehicle more in net revenue in 2004, according to pay more for each car because it did not have to offer as many rebates, price concessions and financing discounts to get customers to purchase its vehicles.

And even forgetting about the revenue part of the picture and focusing only on costs doesn't change the conclusion that labor rates are overrated as a source of competitive advantage or disadvantage, because labor rates are only imperfectly associated with labor costs. In 2004, it took Ford Motor Company on average almost one-third more labor hours to manufacture a car than it did Toyota. So Ford begins with a cost disadvantage even if its rate of pay is the same.

The problem is that a fixation on labor costs diverts management's attention from other aspects of operations that might provide even more leverage. Take another example: in contract manufacturing, companies such as Solectron will tell you that labor costs constitute at most 25 per cent of total costs, while materials and other costs constitute the rest�and this in an industry with little R&D and marketing.

Not only do labor costs not equate to total costs, even labor costs themselves depend on two things: the rate of pay -- the thing that seems to draw the most management attention -- and employee productivity of the people -- what people actually accomplish on the job. Unfortunately, wage givebacks often alienate employees and reduce their willingness to provide discretionary effort and ideas that can enhance productivity and performance.

Paying less also leads to turnover among the existing workforce -- and turnover costs money -- as well as a competitive disadvantage in the labor market where companies must try to attract the best and the brightest and the most motivated people.

It is difficult to have motivated, committed, and engaged employees when those employees feel as if they have been abused and mistreated, asked for sacrifices not shared by others, and forced to pay for the strategic mistakes of senior management. When companies are facing their greatest competitive challenges is precisely the time when they most need employee loyalty and effort. That's why John Whitney, when he took over a near-bankrupt Pathmark Supermarkets in 1972, actually raised the salaries of store managers. As he told me, the last thing you want during a turnaround is to have your best people heading for the door, worrying about their futures, or not putting forth their best efforts.

Instead of blaming employee salaries for the consequences of every strategic error and management miscue, leaders would be well served to look at the usual suspects -- quality and service -- and focus on fixing those proven ingredients for success. These fixes most often require the efforts of the front-line people, and you don't want to alienate them by picking their pockets.

But most importantly, companies should at least get the facts about the real sources of their poor performance, and avoid the sloppy thinking that equates labor rates with labor costs, labor costs with total costs, and total costs with profits and success. Faulty assumptions lead to bad decisions, which invariably produce lousy business results. You don't have to look further than the US airline and automobile industries to see the truth of that statement.

Excerpted from What Were They Thinking? by Jeffrey Pfeffer.

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Reprinted by permission of Harvard Business School Press.

Copyright 2007. All rights reserved.

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