The Headcount Solution : How to Cut Compensation Costs and Keep Your Best People

The last resort to reducing operating costs is a layoff. The manager thinks about what can be accomplished. “Clearly, if I lay an employee off, we get the benefit of the reduction in cost of employment (compensation, benefits). But what if I lay the wrong person off? What if we lose talent we need and suffer loss of business as a result?”

These considerations force the manager to look at the consequences of layoffs in terms of four basic areas. As Table 5-4 shows, the term costs can refer to short- and long-term savings, a benefit to the company, and to the short- and long-term costs that need to be incurred to achieve the savings. The latter reflect what the company will have to spend to achieve cost savings.

Most companies usually concentrate on only one of the four elements in Table 5-4: cost savings in the short term. However, such a narrow focus is fraught with peril.

Short-Term Cost Savings

The first cost category consists of the costs saved when an employee is laid off. Such cost reduction provides an immediate benefit to the firm and is the category most managers focus on when making layoff decisions. The category consists of the following elements:

• Salary

• Benefits (e.g., health insurance, life insurance, pension contributions, etc.) that can amount to an additional 40 percent above the employee’s salary

• Incentives and bonuses

The division manager identifies an employee whose cost of employment is $77,000 per year (including a base salary of $55,000 and other costs, including benefits that amount to $22,000). If he finds 100 of these people, the company can get immediate relief in the form of a $7.70 million reduction in annual payroll costs.

Short-Term Costs Incurred

Unfortunately, it’s not that easy. Companies conducting a layoff find that there is a price to pay in the short run for getting costs out by actions such as layoffs. These costs are listed in Table 5-5. They find that there are still a number of obligations due the employee being severed:

• Accrued vacation. A majority of employers offer paid vacation each year, and in most cases the vacation benefit accrues throughout the year. An employee who is terminated during a year may have several days of paid vacation coming, and this obligation must be met even if the company separates the employee.

• Cost of outplacement services. Many companies have adopted a policy of providing a terminated employee with the services of specialists who can assist in finding new employment. Such services include counseling, coaching, resume preparation, the use of office facilities, and other support. These costs can range from several hundred to several thousand dollars per employee.

• Severance salary and benefit continuation. Most employers have policies of continuing salary and benefits (e.g., health insurance coverage) for a period of time, often several weeks or more, at the company’s expense. The number of weeks offered is based on the employee’s length of service with the organization. This represents a benefit beyond the requirements of the COBRA law of 1985 that requires employers to offer group health plans to terminated employees for 18 months (at the employee’s expense).

  Table 5-5: The Real Cost of a Layoff (Short-Term Costs Incurred)

  Cost Item

  Accrued paid vacation Outplacement services Severance salary Total cost per employee separated (total of 1, 2, and 3)

The division manager builds a quick spreadsheet to assess the real cost of a layoff. He enters the number of employees to be laid off and their average salary employment cost. He also makes estimates of short- term costs per employee based on company history and experience. The output looks like the analysis in Table 5-6.

“So, I’m going to have to spend $1.99 million or so to save about $9.63 million. The net cost savings will be $7.64 million for the first year,” he concludes. “Okay. Let’s see where we are,” he examines further. “I’ve taken out $5.77 million in Round 1, another $2.57 million in Round 2, and this round will add another $7.64 million in costs for a total of $15.98 million. I’ve just beaten the goal of $15.95 million.”

The manager’s thinking has not yet reached the long-term cost consequences of cost cutting and layoffs. The company fully intends to be around 5 years from now and longer. All too often in the heat of the crisis, leaders focus on the obvious benefit (reducing short-run costs.) However, they lose sight of less obvious longer term costs that may come back to haunt them in the future. What are some of these longer term economic consequences?

*Actual numbers are rounded for this example.

Long-Term Cost Savings

A layoff results in reduced employment costs in the long term. The benefit will last as long as the company doesn’t need to rehire the employees. But what has actual experience been? The majority of companies that lay off employees find themselves back to prelayoff employment levels within 18 months.

What happens? When the cost crisis is over, excessive employment cost has been diminished as a prime issue. Management’s attention now focuses on growing revenues, and it is very willing to spend on employment costs to achieve that objective. The reality is that most companies that lay off employees do not experience a long-term benefit from employment cost reduction.

Long-Term Costs Incurred

The information systems division manager in this narrative is concerned with losing skills and competencies the company will need now and in the future if he lets his best people or the wrong people go. His fears are real. They speak to the equally real but less tangible costs a company incurs when it loses valuable human capital. “If I let Sam go,” the manager ponders, “he probably won’t be available a year or two from now to rehire. That means I lose all of Sam’s know-how.” He’s right; the company has lost the investment (selection, orientation, formal training, and informal job experience) it made in Sam. These are skills and competencies that must be built all over again when Sam’s replacement is hired. The manager lists the hidden costs the company will face when it rehires:

• Market premium for attracting the separated employee’s eventual replacement. This means the company may find that it has to pay a market premium to attract a replacement, a figure higher than the salary of the severed employee.

• The cost of recruiting and screening candidates for the job to be refilled. Most companies that lay off people find themselves recruiting to refill the position within 18 months after the termination. Ads need to be placed, recruiters hired, and even search firms engaged to develop a set of applicants from whom to screen. The selection process also costs money, for example, to conduct interviews, administer tests, follow up with references, conduct physical examinations, and perform other screenings. Such costs would not have been incurred if the company had not laid off staff in the first place. These costs can easily amount to 5 percent of the first year’s salary for each candidate screened. A company might spend $12,500 ($2500 each) to screen five candidates to fill a position that pays $50,000 per year.

• The cost of orienting the replacement. The new hire can’t just pick up where the laid-off employee left off. The new person will need to be oriented to the job and the organization. He or she will have to learn all that is unique about the company, its culture, and its industry. Many organizations provide formal orientation, which adds to costs.

• The cost of the additional guidance and supervision required during the replacement’s initial period of employment. The new employee costs the company in nonproductive hours while climbing the learning curve on a new job. He or she also requires more guidance, mentoring, and attention than a seasoned veteran. Somebody has to provide the supervision, and that takes time away from other tasks.

• The lost productivity while the replacement learns the ropes. Finally , there is an economic opportunity cost incurred. This is the difference between the productivity the company would have enjoyed had it retained the laid-off employee and the productivity of the replacement while he or she is learning the job. How many times have customers patiently waited to be served while a new salesperson was learning the software system? How many times have customers wished they had drawn the seasoned employee?

• Costs can run up to an amount equal to two or three times the annual compensation of the person laid off and is a cost above and beyond the annual salary of the replacement.

The division manager builds a second spreadsheet to estimate the long-term costs the company will incur to achieve whatever long-term cost reduction is realized. The output looks like that presented in Table 5-7. All of the elements in Table 5-7 will be incurred as soon as the company replaces the employees it laid off.

Time becomes a critical factor when considering long-term costs savings and long-term costs expended. Most companies laying off staff are back to prelayoff employment levels within 18 months. The longer the time of reduced employment, the better the economics because of the recurring long-term costs savings. But let’s say that this company experiences rehires within a year of the layoffs. Now the company has spent $20.6 million in long-term cost incurred to save $7.52 million for a year (see Table 5-6). And that calculation does not take into account less tangible costs that exist, and are just as real:

• Low morale and survivors’ syndrome

• Lost innovation

• Fear

• Angry customers

• Lost market share

  Table 5-7: The Real Cost of Layoff (Long-Term Costs Incurred)

  Cost Item	Amount per Employee
  1. Recruitment,selection,and orientation expended on the employee who was laid off ($12,500 to screen applicants,$7500 to orient)	$20,000
  2. Training investment (based on 5 years’ service @ $3000 for training each year)	$15,000
  3. Recruitment,selection,and orientation of the new hire as a replacement ($12,500 to screen applicants,$7500 to orient)	$20,000
  4. Market premium paid to attract the replacement (assuming the company will bid $60,000 to replace the $55,000 person laid off)	$5000
  5. Estimate of the cost of additional supervision during replacement’s first year	$5000
  6. Economic opportunity cost of lower productivity during the first year (based on the replacement working at 75% of the veteran employee)	$100,000
  7. Total long-term cost per replacement (total of 1–6)	$165,000
  8. Total long-term cost for replacing 125 layoffs	$20,625,000

Smart decision making demands the manager to consider all four benefit/cost categories just described. Focusing only on the short-term cost reductions can lead to bad decisions such as laying off the wrong people and spending even more to replace them a short time later. The discipline of considering the plusses and minuses represented by all four categories will lead to the right decisions about whom and how many to lay off and whom to retain.

Managers should take the following steps:

1. Consider how all four cost categories apply to the organization and the particular situation.

2. Recognize that even in the short run, there’s no free lunch. It will cost to lay off staff.

3. Don’t discount or underestimate the long-term costs associated with layoff actions.

4. Be careful about timing; consider how long the period will be before rehiring. The shorter this period of time, the more you should avoid taking layoff actions.

If these steps are taken:

• Fewer people probably will be laid off.

• Mission-critical people who need to be retained will be identified.

• The negative impact will be minimized, including costs in the short and long run, which provides the opportunity to recover quickly and inexpensively.