High Fixed Workforce Costs: Incompatible with Variable Revenues
In 1974 inflation was 11%. For the next 7 years inflation was 9, 6, 7, 8, 11, 12 and 9%. Based on these rates from 1974 to 1981 the cost of living doubled for those with expenditure patterns that were similar to the market basket used as the inflation measure. Economic growth was stagnant and some saw this as a permanent failure of our economic system. During that same period aggregate pay levels exhibited different rates of change year by year, but during the same period the average increased by slightly less than 100%. This pattern would indicate that organizations felt the need to match inflation rates, in order to keep real wages from dropping. This established an expectation on the part of many employees that they enjoyed “inflation insurance.” Unions extolled their power to keep wages up with inflation as a part of their mantra when organizing, even though their contribution was uncertain.
Over the next 40 years pay budgets increased faster than inflation in every year except 2011, which resulted in aggregated pay exceeding aggregated inflation by over 40%. Did organizations develop charitable instincts? Did they find that increasing real wages benefitted them? Did they adopt a philosophy that employees were more important than investors? Do they now feel obligated to match that largesse?
Workforce cost is for many types of organization the largest controllable operating cost. If all workforce costs are fixed (assuming the staffing level is sustained) downturns in revenue present a problem - affording the workforce.? Base pay (salary; wage) rates and benefits costs cannot be cut without major resistance. Large merit pay increases granted in a year when performance was stellar or inflation was high can increase payroll costs to levels that will be unsustainable when performance declines and indefensible when inflation declines. That is why base pay increases are often called “career annuities.” Increasing benefit levels also creates larger fixed costs unless an employer is brave enough to reduce benefits.?
The incompatibility of workforce costs that are fixed with highly variable revenues should be a concern of all organizations when they formulate their compensation philosophy and strategy. The last three decades have been an era of “Black Swan” events… hugely impactful and not predictable or even imagined. Organizations that expected and prepared for the pandemic are few, if any exist. The magnitude of impact on labor markets, where and how work is done, and inflation did not appear in any of the futurist newsletters or provide advice to organizations. It is likely that the environment will force us to navigate in the future as if we are continuously in whitewater rapids.?An example is Putin's insane war, which can lead the world down an unanticipated path.
Workforce planning has historically been done in a straightforward manner… predict the future and prepare for it. When predictability evaporates a new model is needed. Scenario-based planning is a technique that can help organizations manage in a way that better fits the likely turbulence. Multiple futures can be defined (pessimistic; optimistic; most likely) and alternative strategies created that are robust… they will work reasonably well in whichever future that materializes. By creating a range of possible futures, rather than betting on one, management can develop strategies for coping in advance. Waiting to see what happens and then reacting is rarely a feasible way to succeed. SEAL teams prepare for everything when creating a mission plan and then take the initial action that seems the best. But there is an immediate assessment of the outcome and decisions made about the need to adapt. Act… assess… adapt… act… is their approach. Betting everything on one future is more like a Vegas trip being expected to fund one's retirement, and most outcomes are less than desirable when using that plan.
Events that surprise may serve as a notification that the game has changed… for a time or permanently. It is unlikely that the traditional workforce planning approach will work in the future. New options appear often for TV watchers. Disney adding a streaming service that causes some with small children to alter their packages by replacing another service that is rarely used. When changes can be made easily and at any time costs can be better aligned with changing conditions (e.g., cancelling Disney when the grandkids visit is over). Costs can be more flexible by adopting different strategies.
One of the benefits of outsourcing a project to a contractor is that a staff does not have to be sourced, selected, hired and socialized into the organization. That added staff does not have to removed when the workload subsides. Downsizing can actually increase costs in the short term, since accrued benefits must be settled immediately.? This makes “hiring up” during revenue surges untenable when revenue drops. Treating employees as the most disposable asset rather than the most valuable asset sends a message that will severely impact the employer’s brand.
Today’s Dilemma
Inflation and increased churn in the labor supply have created a dilemma for management. If an organization believes it will lose critical talent unless it grants large base pay increases and/or allows people to work remotely there will be pressure to make those concessions. On the other hand, increasing base pay levels by 6-7% to offset inflation and to serve as counter offers to avoid desertion can be a poor decision in several ways. The first is that it suggests employees are entitled to the higher of the current year inflation rate or current year cost of labor increase in each year. Any organization using that approach will trigger a compounded increase of payroll that will be unsustainable.?
As mentioned earlier, over the last four decades the cost of labor has increased over 40% more than the cost of living. Even though inflation was the higher figure in a handful of years opting for the inflation rate would be a poor choice for workers if they had to pick one of the two rates and stick with it. inflation impacts people differently, based on their lifestyle and their income level. It is also a macro-economic measure that is not controllable by organizations. Even calculating a meaningful inflation rate is subject to debate and policy makers disagree as to the single number they will cite for public consumption. The pandemic had very different economic impacts on different organizations… Amazon and high-tech companies supporting remote communication did very well, while the revenues for other industries were decimated.
The biggest disadvantage of large base pay adjustments is their career annuity effect. It is likely that the higher cost of payroll that is created will be unsustainable for some organizations in the future. The only remedy is staffing reduction, which may result in dissatisfaction because of the impact on people’s workload. Although the employer’s health care costs might be lessened by increasing the percentage of total cost paid by employees it is likely that employees will recognize that as the equivalent to a pay cut.
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Coping With The Challenges
There are variable compensation programs that can enable an organization to better align workforce costs with the resources available for affording the workforce. Profit-sharing plans can pay out contingently, based on economic performance. Project incentive plans can base rewards on outcomes. Equity plans can provide employees with a stake that is valued based on the value of the organization. By communicating the philosophy that contribution resulting in better individual, team or organizational performance will be rewarded it provides motivation for people to extend their best efforts, focus those efforts on organizational objectives and sustain their efforts for as long as they are needed. Once granted a base pay adjustment does not continue to have a motivational impact.
For variable compensation plans to have the desired effect they must be based on the appropriate criteria. If individual incentives are to be effective the organization must define, measure and reward individual performance accurately and appropriately. Employees must accept the plans and believe that they reward job-related performance and provide equitable outcomes. The relationship of rewards across organizational levels must also be viewed as reasonable. U.S. executive compensation levels puzzle people in many other countries. When teaching globally I often field the question “do you Americans really think any executive is worth 400 times what other employees are?”? Cultural orientation explains some of the skepticism… collectivist cultures are less likely to accept that then individualistic cultures such as the one prevailing in the U.S.?
When addressing the “how do we keep employees up with inflation” question I have been advising clients to consider granting one-time “inflation offset” cash awards. By acknowledging the impact of inflation when grocery shopping or filling the gas tank an employer can demonstrate a concern for employee well-being. It can also be explained that the short-term and variable nature of inflation makes responding by fixing costs into the future a poor choice economically. One organization decided to create a pool equal to 2% of payroll, divide that amount by the number of employees and award the same dollar amount to everyone. For employees paid near the average that is in effect an extra week’s pay. It is less than a week’s pay for those paid above average and more for those paid below the average. This was explained by pointing out fifteen gallons of gas costs everyone the same, just as any basket of groceries does.?
The Bottom Line
This is an ideal time to not only act prudently but to invest in well thought out communication programs. Making the “we pay based on cost of labor, not cost of living” philosophy clear can help employees understand this is an economically sound way of managing. It may also be the time to redirect some workforce costs into a variable form. Although some employees might prefer a 2% base pay increase to a 2% cash award, experience shows the cash will be likely to have more impact. You get it all at once, rather than having to work the next year to see it all (and inflation will make the payments later in the year worth less). One client wanted the payout to be an event so the CEO handed out the checks at an all-employee meeting. Having everyone’s check be the same amount avoided the inevitable “I will trade you checks” offered by those cynical about how the organization rewards its people.
Developing variable pay programs to take the pressure off base pay plans can be a tool for not only aligning costs with revenue (realized performance). They can also reinforce the need for the organization to meet specific objectives. An employee who participates in a variable pay plan is recognized as someone who contributes to performance. That is no small deal. Extensive research establishes that paying for performance motivates performance.
About the Author:?Robert Greene, PhD, is CEO at Reward $ystems, Inc., a Consulting Principal at?Pontifex and a faculty member for DePaul University in their MSHR and MBA programs. Greene?speaks and teaches globally? on human resource management. His consulting practice is focused on helping organizations succeed through people. Greene has written 4 books and hundreds of articles about human resource management throughout his career.