The Value of Labor

FOR MANY in the truck equipment industry, this last decade was one of tremendous growth for their businesses. But it also was one of many challenges.

For most of my contacts, the biggest issue was attracting and retaining qualified installation and production personnel. This was the case especially during the latter part of the decade. With unemployment near 3% for this period, it created many problems for some truck equipment distributors.

Quite often the following scenario was played out in their business:

1. Compensation systems at the truck equipment distributors were outdated and did not reflect the competitive wages of their region.

2. With unemployment this low, it was an employees' job market. Many skilled personnel left for other industries that could use their transferable skills.

3. When trying to backfill the void, most companies found that the pool of unemployed, highly skilled personnel was non-existent.

4. Hiring highly skilled personnel from other industries was not possible within the current compensation structures of most truck equipment distributor shops.

5. The employees that were available had limited skills or experience, or worse yet, had personal baggage that included poor attendance or shoddy work habits.

6. Because the distributor's compensation system was not current with the market, it was difficult to attract new employees. Therefore, the companies were almost always short of personnel.

7. To attract new employees, the companies were forced to pay new employees more than their current employees exhibiting the same skillsets.

8. Once this became known among other shop employees, the company was forced to increase wages for this select group of existing employees.

Many truck equipment distributors have still not dealt with the underlying problem in the scenario above and are caught in the same vicious circle. They have not kept pace with the local job market and need to overhaul their compensation system in order to become competitive. There are many reasons why this is an important issue for the truck equipment industry, including:

1. Training: Many companies have very broad product lines and offer everything from ladder racks to large truck-mounted aerial devices with custom line bodies. In this environment, it takes many years for an employee to learn all of these products and become productive. By then the company has a great investment in training him. For this reason, once fully trained, it is important to retain that employee.

2. Productivity: In order to remain competitive, distributors must often resell purchased components at low margins. They must then make the majority of their profits on the value-added labor. Therefore, creating and managing a productive work environment is critical to profitable operations.

3. Quality: Rework costs are often very high for distributors. Personnel that can perform the job correctly the first time are critical to retain both from a cost control and a customer relation's standpoint.

Objectives of a Compensation System

A structured compensation system has three main objectives. They are:

1. Employee procurement and retention.
2. Consistency in application of the system.
3. Reinforcement of positive behaviors.

In order to support the first objective, the compensation system must be competitive within the local employment area. Regional manufacturing and business associations will often share wage and benefit information for the sole purpose of establishing what changes are occurring in the local market. Armed with this information, a distributor can review how their wages and benefits compare and make the required changes.

Uniformity is the second important objective. Once a system is established, the supervisors must be trained and held accountable to manage the process consistently. This training would focus on effectively carrying out performance evaluations and wage reviews. In addition, one senior manager must be accountable to insure company wide consistency in the administration of these tasks. One of the major causes of union activity is brought on by disparity in wages, reviews, and other supervisory actions. A disciplined approach in creating and managing an effective compensation system will prevent most union activity.

Let's review the following situation that is prevalent in many companies and build a case for the last objective. Often the highest-paid production personnel are the most senior, not necessarily the most productive. In general, the most productive employees have five to ten years of seniority, know all the products, and consistently demonstrate the highest levels of productivity.

Unfortunately, they are often paid substantially less than the more senior employees because the compensation system has not been responsive to this group of personnel. In this instance, the compensation system implies seniority is the most important behavior of an employee, not work habits and productivity. As I have witnessed many times, this situation is a key driver in turnover in the highly productive group with less seniority. This is not the message employees should receive.

Therefore, in my mind, the most important objective of the compensation system is to encourage and reward positive employee behaviors. Once a good basic system is established, further steps can be taken to enhance the effectiveness of the system and fulfill the third objective. Used together or as stand-alone tactics, the programs listed below are strategies that will reinforce desired behaviors.

1. Pay-for-Skill Programs. Compensation systems can be modified to pay a premium to employees that learn and apply new skillsets. These premiums are a small percentage of total wages but are often of more significance to the employee because of the personal recognition they receive.

2. Work Team Programs. These programs create a rich environment for assimilating new employees, crosstraining, and reinforcing improvements in quality and productivity. Pay-for-Skill and incentive programs are very successful when directed at the work team level.

3. Lead Programs. The addition of floor leadership can yield tremendous financial benefits at very little cost. Again, these individuals are more often motivated by the personal recognition than by the pay premium. These programs also play a key role in the success of work teams.

4. Incentive Programs. These can be awarded to individuals, work teams, or on a plant-wide basis. Incentives can be developed for quality, productivity, rework, etc, to create desired changes in behaviors.

A Financial Perspective

Profits are often won or lost on the production floor, and skilled personnel are the means of winning that battle. Business managers need to broaden their perspective on compensation programs and consider employee costs in light of what they produce, instead of what their hourly wages are.

For example, in the example that follows, we will consider the costs and outputs of three employees with different levels of experience and compensation.

The analysis in the table fairly represents different businesses I have recently seen in the truck equipment industry. For example, a $10.00-an-hour, entry-level wage was quite common for many businesses in recent years. These entry-level individuals may have had some mechanical or welding training but lacked the experience to use their skills effectively within this industry. In many cases, it would take years of in-house training to bring them up to the same skill levels as the senior employees. Therefore, the mismatch between the high entry-level wages and the corresponding lower levels of productivity created a cost problem for the businesses.

As I am using the term here, productivity is a measurement of the percent of time it takes for a specific employee to complete a defined task compared to an average, fully trained and skilled employee. There are many ways to measure productivity, but this simple understanding will suffice for our discussion.

Our analysis will look at the impact of pay rates and productivity and see how understanding this concept better may provide added incentives to make improvements to compensation systems. We will dissect the contents of the table above in detail to highlight the cost problems facing a business.

True Costs and Marginal Costs

Looking at Columns A and B in the table, we see three representative employees with different wages and corresponding differences in productivity. These differences impact the actual cost required to complete a quoted hour of labor. Listed below are the main points we can see in Columns A through D:

The high-skilled employee has a productivity rate of 100%, and he is able to complete one hour's equivalent work in one hour. Therefore, his adjusted labor cost per hour would be the same as his actual labor cost of $15.00 per hour.

The medium-skilled employee has a productivity of 75%, so it requires 33% more time for him to complete one hour of quoted work than the high-skilled employee. Because it takes him 1.33 hours to produce one hour of work, it will cost his employer $16.67 in labor cost to complete the quoted hour of work.

For the same reasons, the low-skilled employee with 50% productivity would require 2.00 hours to complete the work, and his actual labor cost would be $20.00 for the one hour of quoted work.

For the business owner, this means that he will lose either $1.67 or $5.00 per quoted hour of labor for every hour he uses these two lower-skilled employees rather than the skilled employee.

Effective Hourly Revenue and Margins

Let's assume the quoted shop rate at this distributor is $50.00 per hour. The revenue and margins generated by each employee each hour are different because of their productivity differences. This impact is shown in Columns E and F. The following conclusions are evident:

1. The lower the productivity of the employee, the greater time it takes.

2. Lower productivity reduces the effective revenue rate per hour. As seen in Column E, the low-skilled employee uses two hours to produce an hour of quoted work. Therefore, the revenue he generates is only $25.00 per hour.

Taking the difference between the labor cost per hour of output and the effective revenue rate, an effective hourly margin is generated for each employee. We can easily see the major differences in margin for the three employees in Column F.

Opportunity Costs for the Business

Of greater concern to the business is that there are many opportunity costs. These costs include loss of margins and shop capacity. With respect to shop capacity in our example, there is up to a 50% loss because of the additional time that floorspace and shop equipment is committed to each job when the less-skilled employees do the work. These opportunity costs can be quantified in several ways as shown below:

Let's take the numbers in Column G and view this difference over 2000 hours a year. Compared with the top employee, the $12.50-per-hour employee costs the company $20,000 in annual margin, while the cost of the $10.00-per-hour employee is $40,000. This opportunity cost in the hourly rate is significant, and it is easy to visualize the huge impact on financial performance if a business has many employees in these lower-skilled categories.

On a job-bidding basis, lower-skilled employees also have a large impact on gross margins. Columns H through J show a typical ten-hour job bid at $500.00 that is completed by each of the three employees and factors in their productivity. This analysis shows the opportunity cost as a difference in margins generated by the job. There is a difference of up to 10% in margins from top to bottom. Of course, distributors can compensate for the differences in productivity and can add more hours on the quote. Unfortunately, this can often mean not getting the business at all.

Capacity losses will create opportunity costs. If lower-skilled employees are used and no additional capacity is made available, the business will generate less sales revenue. The corresponding loss of margin will be an opportunity cost.

Another approach taken is to increase capacity and make up for the lost production throughput. Additional equipment, personnel, and floorspace will be needed to have the same production throughput while using the lower-skilled employees. Because it takes longer and requires more floorspace to produce a product, it will also mean having additional in-process inventory — which is an expensive byproduct of this approach. In total, the increases in capital assets and inventory will create greater demands for cash and exclude the use of this cash for other business opportunities.

This simple illustration can be viewed in many different ways. But the point I want to make is that there can be a significant difference in outputs generated by various employees, and this output per employee hour is what is important. Hourly wages need to be competitive and applied consistently. In addition, the business must factor in what kind of employee it is attracting and retaining with its compensation systems. The financial and opportunity costs associated with less productive employees far outweigh the costs of attracting and retaining qualified personnel. Based on the analysis shown above, the more productive employee is a much better investment for the business.

Bringing it Home

In closing, establishing an effective compensation system can dramatically reduce turnover and, of more significance, reinforce desirable behaviors. My experience has shown that the productivity improvements far outweigh the minute costs of these programs. Once basic wages are competitive, these complementary programs add notable reward to employees by meeting their higher psychological needs — a much greater personal motivator than money alone. In turn, employees respond with higher productivity, less rework, less attrition, and generate greater profits for the business.

It makes business sense for distributors to measure their compensation systems against the three objectives in the article and then make the appropriate modifications. The bottom line is that spending a little more on the front end on a good compensation system can insure higher productivity, reduced cash needs, and greater profits for a business.