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Should You Let People Go, or Keep People and Reduce Salaries?

My friend Derek Cheshire made an interesting observation yesterday:

Tell me if I’m being stupid but after reading about the Greek austerity measures I do wonder why we have to try and make hundreds of public sector employees redundant. Why not just trim pay by say 10%? At least there would be more people with money to help keep the rest of us afloat.

Derek’s question got me thinking.  In general if you’re with a business or government agency and you need to cut labor cost, should you let people go or should you try to keep people employed by cutting everyone’s pay?

First, some perspective
Most businesses and government agencies have gotten more productive over the last twenty years.  For a long time people wondered whether technology really makes a difference, but we’ve come to realize that it indeed makes a huge difference in productivity.  It’s not uncommon for a business to operate with a small fraction of the labor required in the past, and in many cases the quality and customer service is actually better with more technology and fewer employees.

In spite of productivity increases, most businesses didn’t cut their number of employees as productivity grew.  In cases where business volume increased, the productivity gain enabled the business to absorb the increased volume without having to add as many people.  And in cases where business volume remained relatively stable, there wasn’t a big economic incentive to get rid of people.  It was easier to just hold on to the employees you already had than to go through the heartache of reducing your labor force.

Then the economic downturn hit.  Profitability disappeared, and companies had to make hard choices about all of their expenses.  Projects got put on hold.  Travel and training budgets got hit hard.  And eventually the cuts got deeper and layoffs became more common.  Companies realized that they really don’t need all these people since technology has made the remaining employees more productive.  Jobs are being cut that will never be needed again.

Here is the way most businesses look at the problem of reducing labor cost
Businesses look at a workforce reduction logically and unemotionally:

  1. All employees are not equal. In a given job, the difference in output between your best employee and your worst employee is significant.  The actual difference depends a lot on the job, but I would expect a minimum difference of 20%, and I’ve seen differences in programmer productivity of around 1000% (the best programmer can easily have 10 times the output of the worst programmer).
  2. If you reduce your work force, you typically get rid of the lower productivity people first (unless labor or union constraints force you to take a different approach).  It makes sense; if you have to get rid of people, you want to make sure you keep the best ones and get rid of the worst ones.
  3. And for those of you who factor salary or pay rate into the equation, look at it this way: For any given job category, measure output per pay dollar, and get rid of the people who have the lowest output per pay dollar.
  4. So the result of a workforce reduction is not just a reduction in overall labor cost; it’s also an increase in employee productivity.  If you get rid of people who contribute less to overall business output, then your overall business output per employee pay dollar will go up.

Now consider the alternative scenario where you keep all of your employees but cut their pay proportionally to achieve the same reduction in overall labor cost.

  1. As before, all employees are not equal.
  2. When faced with a reduction in pay, a certain percentage of employees will look for employment opportunities in other businesses.  But the higher productivity (“better”) employees are more likely to be able to find jobs in other companies.  So you are more likely to lose higher productivity employees than low productivity employees.
  3. So the result of reducing pay across the board is a decrease in overall employee productivity. If employees leave who contribute more to overall business output, then your overall business output per employee pay dollar will go down.

So from the business viewpoint, it generally makes more sense to reduce the workforce than to keep the workforce and reduce employee salaries.

Important Exceptions
As with any rules, there are exceptions:

1. If you expect that business volume will bounce back soon then you might want to consider a short-term pay reduction which is specifically announced as short-term to keep employees from jumping ship.  This is especially important if your workers require lots of proprietary training and so there is a high cost for a new hire.

2. If your business is the primary employer in a geographic area and so your layoffs will have a large impact on the economy of that geographic area, then you might want to do whatever it takes to keep most of your workforce employed.  In this situation you have such a high degree of dependency on the economy of your geographic area that large layoffs will backfire; the economic disaster you create will be worse for your company than the money you save from reduced labor costs.

3. If the whole culture of your company is based on the team rather than the individual, then doing layoffs might upset the delicate balance of your company.  If labor cost reductions are required, then you should work with the teams themselves to come up with creative solutions.  You may end up with a hybrid approach that eliminates poorly performing workers (even teams recognize deadbeats) and reduces pay for everyone else in return for future benefits to be paid when the business becomes profitable again (stock options are one choice, but there are other possibilities). Using the team to solve your economic problem bridges the management-versus-labor divide and instead includes worker participation in solving the company’s problems.

When faced with the choice between layoffs and reducing salaries across the board, most businesses and governments follow the logic I’ve outlined above, and they go with layoffs. It’s the easy choice, but as I’ve noted in my list of three exceptions, it’s not always the best choice.

And as for the situation in Greece that sparked Derek Cheshire’s original comment, I honestly don’t know.  But I would be willing to bet that unrecognized technology productivity gains were at least part of the rationale behind the decision.  Should Greece have considered exception #2?  Maybe.  Time will tell as we see the impact on the Greek economy.

Comments on this entry are closed.

  • nimai July 6, 2011, 8:36 am

    but businesses aren’t benevolent entities concerned with long term benefits. they generally grab the chance for short term profits and use the fear of job cuts to force employee’s to work longer hours for less pay…in a lot of downsizing situations, it’s not as though the work is going away, the loss of even a moderately decent worker will be borne by their peers. It really boils down to executives at the top working to maximise their bonus by short term boosts to share price, at the expense of long term profitability and employee well being. It’s nice to say bad luck to the people getting fired, they should have been better at their jobs, but realistically, most people will be in the employee’s position, not the director, and any social construct should really be evaluated by how it serves the greater good…but I ramble. good times

  • leon Noone July 6, 2011, 7:29 pm

    G’Day Harwell,
    I’ve worked in and around HR for over 40 years. I’ve run my own consulting business for over 30. There are two main reasons why organizations reduce staff in “tough times.”

    1 Staff are expensive . They’re either the biggest or second biggest expense for most companies. Reducing staff numbers appears to be a quick and easy way to reduce expenses.
    2 Few businesses prepare for “tough times” adequately. When they occur, as they inevitably do, managers look around for a quick fix to save money. Reducing staff is an obvious answer.

    I agree with you about reducing salaries and wages. But in Australia the uproar from unions would be heard in Alaska! In the Great Depression of 1929, salary reduction worked. Employees who accepted wage cuts of up to 50% found themselves relatively better off. The cost of many commodities such as food and clothing reduced by 80-90%.

    Of course, when the ‘Tough times” hit, responses are rooted in emotion not logic. That’s why it helps to prepare in advance.



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