Higher Wages = Higher Profits

Anyone who has ever run a company knows that it is critical to control wage costs. How often have you been discussing a job candidate’s salary request and said, “I think we should pay more than they’re asking”?

In our mind, there is an unwritten rule that says, “Pay people as little as you can get away with.”

But what if that unwritten rule is wrong?

Professor Zeynep Ton of MIT’s Sloan School of Management and the Good Jobs Institute argues that, contrary to conventional business wisdom, paying higher wages is good for business.

In her recent HBR article, “Equality in the U.S. Starts with Better Jobs“, Zeynep shares the research on what happens with low and high wages:

“What we often fail to see is that wages are not just a neutral market valuation of what a job is worth. The wages themselves affect the quality of that work and therefore the worker’s productive value and career prospects. Put a capable person in a position where she must work two low-wage jobs — with uncertainty about her schedule, fear that she will not make rent, and little or no support from management to do a really good job — and she will likely resign herself to mediocre or poor performance.”

Think of all the deadweight losses generated by paying penurious wages. An employee in a precarious financial position will suffer anxiety and become less productive. This lowers per-employee productivity to the point where paying lower wages might actually increase labor costs. This approach also tends to produce higher job turnover, which also decreases productivity. Nearly all employees take time to ramp up to full effectiveness when switching to a new job; high turnover makes the average employee less productive, which is another way that lower wages increase labor costs. This isn’t a zero-sum game, it’s a negative-sum game!

“This vicious cycle can be reversed. We already observe that where the minimum wage increases, workers’ well-being improves — with no negative effect on employment. Workers have fewer unmet medical needs, better nutrition, less smoking, less child neglect, fewer low-birth-weight babies, and fewer teen births. With more income, they spend more money and rely less on government benefits — all positives for the economy. What’s more, my colleague Hazhir Rahmandad and I find that even in low-cost service settings, paying higher wages and treating workers with respect and dignity can be profit-maximizing. Good jobs also create a competitive advantage by enabling firms to differentiate and to adapt better to change.”

As a die-hard capitalist and fan of economics, I have historically opposed minimum wages. In the pristine, perfect world of supply-and-demand curves, there is no reason to introduce such distortions. But Zeynep’s work, and her focus on how low wages harm employee productivity, explains that we don’t live in that pristine world. We live in a world where people worry about paying their rent and feeding their families; that worry has a real cost for employee and employer.

Since I’m not an academic, I don’t need to worry about finding perfect evidence to pass peer review. Instead, I can rely on anecdote and common sense, and let my readers tell me if I’m off my rocker.

I looked up the FY2018 SEC filings for Costco and Walmart, and added in their reported number of employees and average hourly wage. Costco provides its employee turnover rate (6% of hourly employees who have been working at the company for over a year–a remarkably low rate that is reflected in the fact that I can still recognize checkers at my local Costco who were working there when I first started shopping there in 2000), and I combined Walmart’s long-standing 44% turnover rate (which, remarkably enough, is better than average in its industry) with a reported 10% reduction to arrive at a figure of 34%. Finally, I assumed that the average worker at both companies worked 2,000 hours per year. Here is the tale of the tape:

CostcoWalmart
Avg Hourly Wage$23$14.26
Rev/Employee$1,089,046$227,429
Ann Wage/Employee$46,000$28,520
Wages/Rev4.22%12.54%
(FY 2018)

While Costco clearly has higher per-employee wage costs, its Wages/Revenue ratio is nearly 2/3rd lower than Walmart. Costco employees are simply much more productive than Walmart employees.

Some of this can be chalked up to the difference in business model; the warehouse shopping model is designed for lower overhead. But if that model is so superior, what is stopping Walmart from emulating it?

The numbers aren’t publicly available, but Trader Joe’s likely looks more like Costco than Walmart: Highly productive, highly-paid, low-turnover employees who are a relative bargain because their wages make up a much smaller percentage of costs.

This flies in the face of our instincts. If you pay your employees more, you can lower your labor costs.

But what has following our instincts gotten us? Unprecedented levels of income inequality? 40% of Americans who can’t cover an expected $400 bill?

As Albert Einstein never said (the quote actually comes from an Al-Anon meeting in 1981):

“Insanity is doing the same thing over and over again and expecting different results.”

It’s time to stop the insanity and start realizing that paying employees more is a great way to make our businesses more profitable. (And it’s pretty good for society as well.)

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