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Learning Corner With Jeffrey Pfeffer: How High Wages Can Pay for Themselves

Jeffrey Pfeffer

Professor of Organizational Behavior, Stanford University

Companies, and even governments, often try to hold down wages in an effort to reduce their labor costs. Following 9/11, when the airline industry experienced mass cancellations, almost all airlines—except forSouthwest—not only had layoffs, but obtained large wage concessions from their workers. When U.S.-based automakers struggled to turn a profit, they negotiated two-tier wage structures where new employees would make less money. The recession of 2008 accelerated this trend: "Pay cuts, sometimes the result of downgrades in rank or shortened workweeks, are occurring more frequently than at any time since the Great Depression," wrote the New York Times in 2009. Pay for the average worker remains constrained today, possibly one explanation for ongoing financial stress and political turbulence.

But contrary to what many company leaders, Wall Street workers and HR professionals seem to believe, employees’ rate of pay is not synonymous with labor costs (which reflect not just the rate of pay but also productivity). Moreover, labor costs have little bearing on competitiveness or profitability. Many companies in Silicon Valley pay very well, but, because of their business models, are extremely profitable. But lower wages do lead to ill health and financial stress, indicators of diminished well-being.

Evidence suggests that if companies paid more, not only would they help their employees, they would actually help themselves. Here’s the logic.

Higher Wages = Higher Profits

In 1914, Henry Ford introduced a $5 per day wage at the Ford Motor Company, more than doubling the prior rate of pay. According to Robert Lacey’s book, Ford: The Men and the Machine, the move aroused the ire of The Wall Street Journal, which accused Ford of "economic blunders if not crimes." The result: diminished turnover, higher quality workers and higher productivity and profits.

About 100 years later, Dan Price, CEO of Gravity Payments,generated mammoth publicity—and skepticism from Fox Business—when he announced a $70,000 annual minimum wage for Gravity’s employees. The much-talked-about move drove customer leads through the roof, and Gravity, a relatively small company of about 200 employees, received thousands of employment inquiries. Profits have never been higher.

These are not just interesting examples. They’re consistent with fundamental ideas in economics. The principle of efficiency wages refers to paying above market to improve workers’ productivity levels. As economist Lawrence Katzexplained, "High wages can help reduce turnover, elicit worker effort, prevent worker collective action [unionization], and attract higher quality employees." Evidence suggests that with more motivated and higher quality workers, less supervision is required because the employees are less likely to shirk responsibilities and are more qualified, thereby saving on supervisory costs.

Because of the profit-enhancing, cost-reducing effects of higher wages, in the end, paying more might actually reduce labor costs. Higher wages can, therefore,actually pay for themselves.

A contemporary illustration of this phenomenon can be seen in University of Colorado professor Wayne Cascio’sdetailed comparison of Costco with Walmart’s Sam’s Club. As Cascio documented, Costco pays higher wages and offers more generous benefits than Sam’s Club, making its labor costs higher. But turnover at Sam’s Club was 44 percent, while it was only 17 percent at Costco, saving literally hundreds of millions of dollars on replacing employees. He went on to explain that, "Costco generated $21,805 in U.S. operating profit per employee, compared to $11,615 at Sam’s Club," meaning that Costco’s more experienced, more productive workforce more than offset its higher cost.

In labor markets, as in many other markets, you get what you pay for.

Minimizing Labor Costs Does Not Equal Increasing Profits

Minimizing labor costs should not be a company’s primary objective. In many instances, even in contract manufacturing, labor costs are a relatively small proportion of total costs. As a senior executive at Levi’s, the clothing company, told me years ago, spending a lot of time trying to reduce costs of something that accounts for a small proportion of total costs—and in apparel manufacturing, labor costs are truly minuscule—is misplaced emphasis.

Companies are much more interested in maximizing their profits, the difference between revenue minus expenses. Profits come from product and service innovation, productivity and outstanding levels of customer service that generate customer loyalty—all things produced by a workforce that is engaged and cares.

So what happens when those factors are missing? The airline industry, with its almost omnipresent wage reductions and conflict with employees, serves as a cautionary example. Joe Sharkey, the former New York Times travel columnistreported that a survey by the Travel Industry Association "found that the consensus among travelers was that air travel was bad and getting worse." As a result, fed-up fliers deferred 12 million business trips and 29 million leisure trips, costing the airlines the revenue from these 41 million foregone journeys.

So What Can HR Do?

HR executives should take the lead in bringing these higher wage arguments and the associated evidence to senior management so that companies can make more sensible decisions concerning pay levels.

It’s also worth noting that the arguments about holding down wages somehow never apply to the C-suite, where the ratio of CEO to average employee pay hassoared over the past few decades. However, the importance of recruiting and retaining talent extends beyond executives to the entire workforce (a notion that HR teams should be championing), which is why paying more can pay off.

To be fair, high pay is only relative (compared to what competitors are offering), which is why if every company tried to put this advice into practice, it wouldn’t work. But given the overwhelming tendency to think that simply reducing labor costs will increase profits, this is not a concern I would worry about. After all, few auto companies followed Ford’s lead, and I don’t see lots of payment processing companies emulating Gravity Payments.

As economic research has reported for decades, paying people more is not just good for those individuals, it means better business. That’s why some of the companies that pay—and treat—their employees wellhave the best financial results.

Image via Twenty20

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