Getting Ahead of Rising Labor Costs

Widespread labor shortages and rising labor costs over the past two years have been blamed on short-run factors associated with the pandemic: government assistance and workers’ reluctance to go back to jobs where they still face health risks. But what if something bigger is at play here that is indicative of longer-term changes in the labor market that would require a fundamental rethinking of compensation strategy?

A survey of trends in labor costs and business model transformation over recent decades shows that we may be at a tipping point in terms of workers’ preferences and willingness to act according to those preferences to achieve the pay and working conditions they believe they deserve. If leaders want to maintain competitive advantage in the coming months and years, they may need to seriously consider fundamentally changing their approach to front-line compensation, job design, and career paths.

A Long Time Coming

Many telltale signs of the trends toward rising labor costs and increased employee demands for better working conditions were apparent before the pandemic. In the retail industry, entry-level wages started to increase substantially at bellwether companies such as Target, Amazon, and Costco in recent years.

Going back half a century, labor market trends laid the foundation for what we’re seeing today. In the 1970s, wages and employment opportunities in manufacturing were eroded when jobs were shipped to lower-cost locales in developing countries. The next transformation wave started in the 1990s: The internet enabled the transfer of high-cost knowledge work to lower-cost locales. The simultaneous era of business transformation saw massive gains in productivity, returns to capital, and a falling share of the total national income that goes to labor.1

A separate trend that has been well documented in the research literature but less well covered in business and political commentary is growing within-group wage inequality.2 This trend predated the internet revolution and was likely caused by the business model transformations of the 1970s and 1980s. These new models spawned a winners-versus-losers dynamic within occupations that previously offered much clearer career paths toward the middle class. In many of those occupations, including law, accounting, and finance, it used to be the case that getting a university degree and dedicating yourself to a career in that field provided financial security. Yet, over the years, companies got better at selecting jobs that contributed more to profits and productivity, which enabled them to reward those individuals by paying more while leaving out everyone else — including peers working in similar roles in the same organization or those at other organizations doing very similar work. That trend greatly increased financial insecurity for most people who traditionally worked in these front-line roles for large parts or all of their prime working years.

The Rising Gap Between Compensation and Front-Line Job Demands

The economic and managerial trends discussed above coincided with an era of low inflation that started in the 1980s and persisted for four decades. During that time, traditional approaches to setting compensation in front-line jobs produced predictable results: low macroeconomic wage growth in the economy and within job classes, ensuring that average wages within job families grew very slowly. This is the flip side to the growing share of capital in national income: Shareholders captured more and more of the gains from increased profits, because compensation was kept low by strategies designed to minimize worker pay gains.

It’s worth noting that the big macroeconomic savings on compensation came from balancing the books on the backs of the largest segment of workers who account for the bulk of labor costs in most industries: front-line employees in traditional blue-collar and service roles. The “war for talent” that McKinsey identified in the late 1990s continues to this day. Yet that battle was around attraction and retention only for managerial-level roles and certain technical and professional positions, which have always had greater status, compensation, decision-making, and autonomy than front-line roles.

Traditionally, compensation for front-line roles has been set by comparing a job to other, comparable jobs in the (local) labor market. If the compensation for comparable jobs is depressed because of macroeconomic trends such as low inflation and meager sharing of the gains from rising profits, it appears as if corporate leaders can keep compensation low because the workers lack better options elsewhere that offer more pay.

The problem with that approach is the growing gap between compensation and job demands. Just because it appears that you can get away with paying less does not mean it is a smart strategy to pursue. I first ran into this phenomenon in the early 2000s, working with a leading consumer products company on its compensation philosophy and pay levels for one of its most important front-line roles. Over time, the company had let compensation for this role fall behind the job demands, because it kept benchmarking pay at similar jobs in other companies, where the comparable jobs’ compensation barely kept up with inflation. A key difference was that this particular company kept increasing the productivity demands for these critical front-line roles in ways that made the jobs harder to perform than many of the apparently comparable jobs. Those productivity demands increased its margins and cash flow in ways that made Wall Street happy but also created a substantial hidden risk.

What leadership missed in their analysis using traditional benchmarking was that their business model was successful precisely because their front-line employees could keep delivering on the higher productivity demands compared with those in similar roles at other companies. The real threat arose from the fact that those very same employees could vote with their feet by leaving for easier work elsewhere or, more perniciously, by sandbagging their performance in ways that didn’t get them fired but threatened the corporate productivity goals.

The only solution was to increase pay faster than the compensation benchmarking suggested was necessary. This motivated workers to accept the increased job demands and enabled the company to continue increasing productivity. As a result, profitability also increased but at a slower rate than the original compensation benchmarking approach would have predicted.

Reinterpreting What We’re Seeing Today

It’s instructive to compare the experience of the company in the previous example with the widespread coverage of the so-called Great Resignation today, where companies across many industries are scrambling to fill open jobs.3 The same scenario is now playing out on a national scale across different industries: The package of job demands and compensation are not good enough to attract and retain enough workers in many key front-line roles.

For many front-line workers, the pandemic has brought into sharp relief the risks of continuing to do marginally acceptable work for marginally acceptable pay. Pre-pandemic, many people struggled to make ends meet while working extra-long hours and/or multiple jobs. Then, once the pandemic hit, job demands suddenly increased because of new safety protocols (such as cleaning, masking, and social distancing), increased workloads (having to take more steps to complete tasks, or experiencing greater absences among colleagues and unfilled job openings, for instance), and increased health risks (becoming infected with COVID-19). This large pool of employees may never again be willing to go back to those same jobs for the same pay, even once COVID-19 becomes endemic and no longer presents an immediate health threat.

For many people who previously worked in these front-line roles, the time away from their jobs due to the economic shutdowns in 2020 gave them space to rethink what they want from work and explore other options. Many decided to retire early.4 Others are trying their hands at self-employment. And the largest segment, I suspect, is rethinking what they want to do in terms of work, either while remaining on the sidelines (the rate of labor force participation remains below its pre-pandemic levels) or while trying out other types of work. The bottom line is that it doesn’t take more than 5% to 10% of workers in an industry segment to withdraw their labor for there to be massive effects on job openings and business models, which certainly seems to be what’s happening for many key front-line roles across varied industries. The immediate implication is that working conditions, pay, and benefits may need to change in fundamental ways to ensure a long-run labor supply and stable business models.5

For a current example, consider the experience of UPS versus FedEx in the past two years. For years, “experts” have predicted that FedEx’s nonunion, contractor strategy would give it a clear leg up on UPS’s more expensive, unionized business model. Yet it is FedEx that is currently struggling with performance and quality issues, while UPS has been outperforming its rival during the pandemic.

What Leaders Need to Do

For years, companies like UPS and Costco have pursued a strategy of paying their employees based on the perceived value of their work rather than on the cheapest compensation in comparable markets. These companies have often been treated as the anomalies, but they may become models for building more resilient competitive advantage.

What I argue for is related to the “good jobs” debate around lower-paying front-line roles — a debate that has raged for over a century.6 Many people who advocate for different job designs focus not just on the front-line jobs themselves but more broadly on the opportunities for advancement, either within the organization where they are working or at jobs in other companies, along well-defined career paths. However, although providing career advancement sounds great, I believe framing the issue in such terms restricts how we should think about the quality of front-line roles.

Many people are content to work in front-line roles for years and even their entire working lives. Think about call center representatives, garbage truck drivers, construction workers, flight attendants, and mechanics, for example. While many people who start in these roles later move into management positions, the vast majority do not. It’s not economically desirable for the companies or the economy for most of them to enter management. This is why, in recent decades, we have seen new options emerge, such as technical job ladders, which provide some front-line employees with a clear path to increased compensation and responsibility without entering management. The real challenge — and opportunity — is to make all front-line roles attractive to work in day to day, month to month, and for years on end, not just those with well-defined technical job ladders.

In an era of rising prices, what’s going to distinguish your business with its customers is service and quality — the overall value for the price. To deliver that value, like UPS and Costco, you often need to pay premium compensation to attract, retain, and motivate your people to deliver industry-leading service and quality, and you need to invest in designing front-line jobs to be attractive to work in for the long term. If this means raising prices faster than you would otherwise, so be it. The macroeconomic environment of rising prices will provide cover for those price increases, signaling to your customers that you are investing in the capabilities needed to meet their expectations. You may have lower profit margins, but you will have better operational performance, greater customer loyalty, faster growth, and more durable market share and competitive advantage.