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STRATEGY

How Paying Employees More Can Make You More Profitable

MIT Professor Zeynep Ton says the relationship between wages, productivity, and profits is not as clear-cut as most of us think.

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It seems like simple math: The more you pay your employees, the lower your profits.

How then, to explain companies such as Costco? Costco pays higher wages than any other warehouse company; a 2006 study by Wayne Cascio, a professor of management at the University of Colorado, Denver, found that its wages are 40 percent higher than those of Sam's Club. Yet Costco is still profitable. Bill Durling, the head of corporate communications for Sam's Club, says the study is "likely outdated" and points out that unlike Costco, Sam's Club has stores in many rural locations.

Costco is not the only one to pay generously and still show a healthy profit: Trader Joe's, Spanish supermarket chain Marcadona, and the convenience store company QuikTrip all follow a similar pattern. To some extent, they all compete on price.

This is the dilemma that fascinated Zeynep Ton, an adjunct associate professor at Massachusetts Institute of Technology's Sloan School of Management and author of the recently published The Good Jobs Strategy. After years of research, she determined that the answer lies partly in how management looks at their employees: Are workers mostly costs that detract from profitability, or are they engines that drive revenue growth? Ton's research suggests, counterintuitively, that companies such as Costco are more profitable precisely because of relatively high employee wages--not in spite of them.

"This is not a hypothetical thing," says Ton. "And it's so much better for everybody."

Travelling globally, getting lost locally

Ton's interest in the subject began with a four-year study of Borders bookstores. She was looking at a problem familiar to any shopper: The item the customer wants is listed as "in stock" by the store's inventory system, but no one has any idea where it is. "Think about it," says Ton. "Some guy in supply chain management got that thing all the way from China, and now no one can find it!"

This is not a small problem: Ton found that so-called "phantom stock" was eating up a whopping 25 percent of Borders' profits. When she presented her findings to an audience of CEOs and managers in retail, she says, "everyone raised their hand" when asked if this was happening at their companies.

There was a clue: The Borders stores with the highest turnover, and the least employee training, had the biggest problems with phantom stock. So Ton started to look at the effects of investment in employees -- in the form of training and pay-- on profitability. She soon found a group of companies that invested in their employees, paid them relatively well, yet were more profitable than their peers.

Of course, you can't just pay employees more and hope it will all work out for the best. There are four strategies, Ton says, that turn employees into revenue-generators rather than mere costs. Paying more is one of them, but they all work together.

1. Offer less

At first, this might not make sense. But the typical supermarket, says Ton, stocks about 40,000 unique items, or stock-keeping units (SKUs). How can any employee, no matter how well-trained, know where everything is? Or offer a customer a substitute if the desired item isn't there? Trader Joe's, by contrast, stocks about 4,000 SKUs. That lets their employees be truly informed about the store's merchandise, bringing sales receipts higher.

There are other ways to offer less. Costco doesn't provide shopping bags, making check-outs faster. It only accepts American Express and debit cards. QuikTrip, which runs a chain of convenience stores, eschews customization, selling the same merchandise and using the same store layout no matter where it does business. That makes it easy for employees to move between stores.

2. Combine standardization with empowerment

At QuikTrip, says Ton, there is only one way to get merchandise off a truck. There is only one way to check out a customer. That might smack of micromanagement, but it makes employees more efficient. When it makes sense, employees have great latitude. The store manager doesn't place the order for out-of-stock items -- individual employees do.

Ton says this is the retail equivalent of the "thinking production system" championed by Toyota. In this system, an employee who notices a problem can pull a so-called andon cord to stop the assembly line. They can then take the time to fix the problem and also fix whatever caused the problem in the first place.

At one assembly line Ton visited, the company had installed an andon cord, but workers obviously didn't feel empowered to pull it. When one worker noticed a dent in the back panel of a car, Ton expected him to pull the cord. Instead, he grabbed a mallet and banged out the dent.

You can't just tell workers they need to improve, says Ton. You need to make sure they're comfortable calling everything to a halt in order to do it.

3. Invest in employees

This is especially important in service companies, says Ton. It comes in two forms -- pay and cross-training. She says it's unrealistic to expect employees to do a great job at work, and to provide great service, if their salaries are so low that they're worried about buying groceries. And if employees are properly cross-trained, they can find useful things to do when they're not working directly with customers. If employees are cross-trained, you won't have people sitting around twiddling their thumbs, it's more efficient, and employees feel more competent and find their jobs more interesting.

4. Operate with slack

Most companies would rather have too few employees than too many, says Ton. That's a mistake.

Again, think about an assembly line. A line that's running at 120 percent capacity may sound impressive, but it's trouble waiting to happen: Things are more likely to go wrong, and when they do, it's really hard to find a break in the action to fix them.

Given a choice, says Ton, you want more employees. That way, when you identify a problem, you have time to fix it. And if workers are properly cross-trained and empowered (see above) they'll find something useful to do even if it seems like there are "too many" of them.

A new old-fashioned mindset

"These choices work well when you invest in your people," says Ton. "If you invest in your employees, they're more productive. It's not that the employees at QuikTrip get you the perfect donut, personalized just for you. It's that they get the right donut to the right place at the right time."

These strategies are easier to follow if you're just starting out or if your company is private, Ton says. It's easier for entrepreneurs in the same way that it's often easier to build a house from scratch than to attempt a massive renovation. This is a long-term strategy, so it's easier to commit to it if you're not always hustling to meet the expectations of Wall Street analysts.

No matter how you approach it, says Ton, start with a mentality: "All decisions should be good for employees, good for customers, and good for investors. It creates a virtuous cycle. And if you make these four choices, the business will improve over time."

IMAGE: courtesy of Zeynep Ton
Last updated: Jan 17, 2014

KIMBERLY WEISUL is editor-at-large at Inc. and co-founder of One Thing New, the digital media startup that is rebooting women's content. She was previously a senior editor at BusinessWeek.
@weisul




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