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 / Summer 2011 / Issue 63(originally published by Booz & Company)


Retooling Labor Costs

Despite years of cutbacks, many companies’ pay structures are still unbalanced. Here’s a dispassionate, logical way to realign them.

Joe has been a machinist for 25 years at the same company, a steady and reliable worker. Although Joe is a significant asset to his firm, his wages have gone up steadily while his responsibilities have remained largely unchanged. The result is that Joe is significantly overpaid as a machinist compared with co-workers who have been doing the same job for just two years.

Struggling to ride out the worst of the recession and credit crisis intact, Joe’s company has fired dozens of workers — and considering Joe’s salary, he would seem to be a likely candidate for the next round of layoffs. Or maybe not. Joe’s a stellar employee who knows the ins and outs of the organization, the result of his many years on the job. If management let him go, not only would the company lose his wealth of institutional knowledge, but a troubling message would be sent to the other workers — namely, loyalty goes unrewarded. At Joe’s age and tenure, moreover, there could be legal implications to such a move. In short, the company would rather not fire Joe. But what’s the alternative?

For many companies, this is an all-too-common quandary. Over time, compensation policies have gotten woefully out of whack, such that wages for some workers in some jobs greatly exceed what the market says those jobs are worth. Even more troubling is that there’s no single reason for creeping wage disparities. Neglect is one culprit. Workers with many years of service have seen their wages grow in a steady trajectory year after year, fueled by adjustments for inflation as well as annual merit raises that often surpass the rate of inflation, without any increase in responsibilities or required skills. Repeated enough times, these compensation increases can morph into an exorbitant trend.

Equally problematic is the typically inconsistent approach to setting salaries within different parts of the company, or even different parts of a business unit. This can result in huge differences in compensation among similar job categories (and sometimes similar positions) — because line managers, not human resources professionals, are making decisions about wages. Moreover, few companies have an identifiable formula for determining new-hire compensation or subsequent raises.

Many managers have chosen to ignore this emotionally charged issue — especially when business is booming. This attitude is no longer tenable, however, given the pressure that established companies feel today to cut costs wisely in order to keep up with intense competition from both upstarts and emerging markets. In this environment, the gap between high wages and market value must be narrowed, if not closed. To ensure the company’s future as well as Joe’s, it is time to address these kinds of wage disparities.

Simple broad-stroke wage reductions will not do the trick, because they fail to address the structural problems with compensation in most businesses. Companies need to take a more measured and strategic path: retooling labor costs, a multifaceted and tailored program that is less damaging to workers and less risky to companies than typical cost-cutting efforts. With proper execution, net labor savings of 15 to 20 percent are possible, because this approach goes beyond the need for immediate savings and confronts systemic and sometimes dysfunctional wage and salary practices.

After a company completes the retooling exercise, valuable workers like Joe could be trained to do jobs that better match their salaries. But because positions are scarcer in the upper reaches of the organizational pyramid, some of these employees, as well as less-proven individuals, might have to take pay cuts or perhaps a voluntary separation package.

Retooling labor costs requires a company-wide commitment to an ongoing wage strategy made up of analysis, decision making, and implementation. Although the process may be painstaking and difficult, over time the payoff will be as systemic as the problem once was, and most companies will end up with larger and more sustainable improvements in their margins.

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