Replacing Workers Has Many Costs

Yves here. It takes a lot of time and effort to find good workers. So why does a post with such a seemingly obvious headline as this one’s need to be written?

The reason is a lot of companies nevertheless fire employees all too quickly. That seems far less common in small-ish owner-controlled companies, who know how hard it was to build a good team (small companies find it much more difficult to attract and retain non-flaky workers).

Big companies are far more likely to engage in this type of undisciplined people dumping. For public companies, one big bad incentive is earnings pressure. A second factor with large companies, whether public or private, is diffuse responsibilities, which create yet more bad incentives. One thing that keeps managers busy is hiring new people, after all.

This post focuses on the costs to the party that ought to know better. I’d be curious if readers agree with the estimate of fully-loaded hiring costs. They look a bit light to me.

It goes without saying that the consequences to workers are damaging to catastrophic. Normally, being unemployed for more than six months is a near-insurmountable barrier to getting hired again. Perhaps coronavirus will create a better new normal on this front, of companies taking a more understanding view of crisis-induced resume gaps.

By Cheryl Carleton, Assistant Professor of Economics, Villanova University. Originally published at The Conversation

The labor market is changing rapidly with the onset of the coronavirus pandemic.

Many organizations are laying off almost all of their workers, while others are considering which workers to lay off, which to furlough and which to keep. Alternatively, some are expanding their labor forces.

When the economy starts to open up again, employers will need to consider rehiring or replacing workers, or hiring workers with a different mix of skills. The cost of replacing an employee is high for employers, and being out of work is harmful for workers, who may be replaced with artificial intelligence or contractors and risk losing their skills.

I’m an expert in labor economics, and my work with a colleagueinvestigates the increase in people engaging in alternative work arrangements such as contract or gig work, along with the implications such jobs have for all workers’ well-being.

There is no denying that the U.S. was experiencing a tight labor market and a low rate of unemployment before the coronavirus pandemic took hold. For some fields, particularly health care and services deemed essential by local governments, the labor market continues to be tight.

A sudden massive loss of demand for their goods and services is forcing companies to make quick decisions, and some employers may underestimate the cost to replace good employees. Knowing these costs may encourage them to keep more of their workers on the payroll.

Where Are the Costs?

There are costs involved in losing a worker and replacing them, such as completing paperwork when they leave, advertising the open position, reviewing resumes, interviewing candidates and training the new worker.

Once a new worker is hired, others must also spend time training them, and it will take some time for the new worker to achieve the same level of productivity as the worker who left.

Another cost is the loss in social capital. Social capital is the relationships between individuals at work that take time to build and add to the productivity of the firm.

The Society for Human Resource Management found that departures cost about one-third of a worker’s annual earnings.

The Center for American Progress drilled in deeper. They found the costs of replacing workers who earn less than US$30,000 per year to be 16% of annual salary, or $3,200 for an individual earning $20,000 per year.

For those earning $30,000 to $50,000 per year, it is estimated to cost about 20% of annual salary, or $8,000 for an individual earning $40,000. For highly educated executive positions, replacement costs are estimated to be 213% of annual salary – $213,000 for a CEO earning $100,000 per year.

The much higher cost for replacing CEOs is partly due to the fact that they require higher levels of education, greater training, and firms may lose clients and institutional knowledge with such turnovers.

Employee Alternatives

This high cost of losing and replacing workers has important implications for organizations, consumers and workers, especially now with an estimated 15 million unemployed.

For those workers where the costs to replace them are high, firms will try to accommodate them. Strategies may include maintaining pay, increasing benefits and retraining. These actions are also costly, so firms will weigh them against the costof simply hiring new workers.

This means businesses face high costs to replace workers in the future, and high costs to retain current workers, leading to higher costs for consumers who buy the firms’ goods and services.

While the above consequences might sound great for workers that organizations choose to keep, these are not the only ways in which firms can respond.

The high cost of replacing workers, along with the increased uncertainty about the economy may cause businesses to use more automation and robots. Though such switches may entail a significant upfront cost, once they are made the firms then have more control over their production processes.

Another alternative for firms is to hire fewer permanent employees and turn instead to contract workers. With contract workers, employers are not responsible for benefits, and they can more simply increase or decrease the number of workers as needed.

While this may increase employment for some workers, it will decrease it for others and it has serious implications for the availability of health and pension benefits as well as unemployment benefits, as the current crisis has revealed.

Businesses might also consider limiting the scope of what some workers do to limit the cost of replacing them. If the scope of a worker’s job is limited, then fewer areas will be impacted by the individual leaving, and the costs to train a replacement will be lower. For workers, however, it means fewer opportunities to gain experience.

For example, instead of training workers on several or all parts of the production process, the business may limit them to one specific aspect. It will then be less costly for the firm to replace them and the worker will have less experience to add to their resume. This also means less bargaining power for employees.

Some Win, But Others Lose

The high cost of losing and then hiring new workers along with increased restrictions on hiring nonresidents might mean higher wages and increased benefits for some workers.

However, the high degree of uncertainty in the current labor market, along with the potential increase in contract workers and automation means that some workers will not realize these potential gains, and all of us as consumers will most likely end up paying higher prices for the goods and services we buy.

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  1. PlutoniumKun

    There is another factor with laying off workers too soon – it can cost even more to hire them back.

    Back in 1998 I was working for a large company created to manage and implement a large infrastructural project. It ran into severe funding difficulties, which were likely to be overcome, but would lead to a 4-6 month gap in funding. Initially, experienced staff were put on voluntary gardening leave, but due to pressure from ‘upstairs’ there was pressure to make half the staff redundant. This was fought strongly by the mid manager level who knew well how difficult it would be to get experience staff back, as the economy was pretty good at the time. To no avail, a significant chunk were let go.

    The result? The project got more funding several months later. The organisation found it impossible to staff back up with the type of engineers required. Most of the laid off former staff refused to accept their old jobs back (what’s the point in taking a pensioned job if they can make you redundant on a whim?), instead insisting on fixed term contracts for the remainder of the project at an hourly rate several times what they were originally paid.

    I’ve no idea how much extra this cost them, but I know it was a multiple of what it would have cost to pay those staff just to go on holiday for the downtime.

  2. jackiebass63

    Some businesses get rid of employees because after a trial period they may have to pay benefits. This is especially true for lower paid non skilled workers.

  3. Stephen Gardner

    “CEO earning $100,000 per year.”

    Huh? We seem to be missing at least one order of magnitude. It’s really hard to take any report seriously that talks about CEOs earning $100K.

    1. David Carl Grimes

      This was my reaction too. $100K is like for lower mid-level management.

      A lot of US companies are quick to fire because it temporarily improves their bottom line and the stock market rewards them for it. Notice how stocks move up when layoffs are announced. This, in turn, helps maintain executive compensation levels – the options are no longer underwater.

    2. aleric

      Yes, bizarre on several fronts. How many CEOs get laid off, ever? I agree with the 2x annual salary for the cost of losing experienced engineers or developers, if that’s the sort of person they were actually talking about. 100k is about their median salary, and it takes years for a department to recover from losing one.

      1. False Solace

        Losing an experienced software developer can mean shuttering an entire software system, since there’s no one around who can support it. I’ve seen this many times. After several different rounds of ownership and sizable layoffs each time to pretty up the numbers, there were only 2-3 engineers left who knew how to keep certain systems running. When those engineers departed through normal attrition (or just getting annoyed at ignorant managers) we’ve had to rewrite entire systems from scratch. And it can literally take years to get a usable result. Software develops a layer of cruft over time so it’s not unusual to want to do rewrites, but there are features we lost and never regained.

    3. Craig

      Oh for heaven’s sake. It was an example to show the math.

      FWIW there are CEOs who earn less. Google, Amazon, etc…

    4. periol

      Without going into details, I worked for a CEO for a very large company whose take home salary was $100k. His stock option package amounted to a minimum of $5 million, per year. Looked good talking to the press though, with that $100,000 salary.

  4. Makesi

    Hospital managers fire nurses, techs, and other critical hospital managers to maintain fear and keep themselves busy. They self-select for stupid, ambitious, and an absence of principle. Such people are a gift to organizers. I’ve met many good workers who’ve left management positions having seen that they have no power to make positive changes there, so they “go back to the floor.”

    1. False Solace

      Frequent layoffs are the way the managerial class proves to workers who has the whip hand. It’s a tool they’ll never relinquish. Kalecki might observe they do this simply as a power relation, regardless of the price it imposes on their business.

  5. chuck roast

    “I am an expert in labor economics…” Sorry, that’s when I stopped reading. Have a good day.

    1. Boatwright

      “I am an expert in labor economics…” Sorry, that’s when I stopped reading. Have a good day.

      I suppose you are also with those who think that the doctors and scientists informing us about the pandemic are just a bunch of “experts” perpetuating a hoax. The “Have a good day.” close an extra special passive aggressive touch too.

      1. chuck roast

        My apologies for annoying you. There seem to be experts everywhere these days, and the experts appear more then happy to elbow their way to forefront in this atmosphere of the greatest uncertainty. When a knowledgable person is willing to demonstrate a bit of humility in these circumstances, they are more likely to get my attention. Have a good day.

    2. K teh

      As soon as they say expert, you know its a hold up. They start with an assumed model, to their own end, instead of building one.

      The virus breeds under ghetto conditions, so create ghetto conditions.

      Get out and get oxygen, exercise and sun the best you can.

      Do not stay inside and share stale air.

      Its a respiratory disease for heavens sake. Ventilators are a death sentence for the vast majority, but very, very profitable.

      Vulnerable elderly need to protect themselves.

    3. False Solace

      I’ll agree to the extent that Yves’ preface was more informative than the article — which kept nattering on about replacing workers with AI, robots, and other buzzwords beloved of management.

      1. JBird4049

        Like self driving cars, they are fads and buzzwords, but far too many companies do try, and sometimes carry through, with automation, A.I. and lay-offs even when it does hurt productivity and profits; the fewer pesky employees, and those tend to be the ones with the skills, to deal with and pay shows to investors, stockholders, and others that they have a lean, mean, and (supposedly) profitable company.

        Managers, owners, and investors do not consider people as assets, but as an hindrance they must pay and sometimes listen to. So get the automation and the A.I. because that must be better. It’s groupthink by the people who are running the major companies and who are wealthy. Wealth equals superiority in our society. Not being a good person or running an honest business that actually makes a good product.

  6. Olivier

    Many companies or branches have a macho mentality when it comes to hiring and firing: the oil industry for instance is famous for its boom and bust approach to hiring. I think it must be understood in the context of executive anthropology: these creatures socialize almost exclusively with each other and I wager there are perverse games of one-upmanship played in that milieu: you don’t want to be the odd girly man out. Anything but look weak to your peers: after all they sit on the boards who will decide whether you get that next CEO job.

    1. PlutoniumKun

      It’s not always the case in the oil industry. I worked for one big name contractor to the oil and gas industry and they were surprisingly willing to suffer losses to keep good staff, at least they were back in the 1990’s when I worked for them. They did keep a floating rump of short term contractors to deal with the ebb and flow, but they knew the value of a core of skilled engineers and managers. Mind you, it was a private, not a publicly listed company so they may have had a different attitude.

      A family member is (or was, he’s retired now) an offshore drilling foreman. After very lean years in the 1990’s he found himself head hunted when oil price surged and the Gulf of Mexico became ‘hot’ and they suddenly ran out of experienced techs. Most of his contemporaries negotiated very lucrative contracts, but he held out for longer term contract with guaranteed pension contribution (he learned the hard way that this was vital). So he held a decent job until retirement even when others were let go.

  7. Louis Fyne

    not defending the practice—-but when a business is taking in zero/near zero revenue, the only way to make sure that some employees still get paid is by putting the employees on the unemployment rolls.

    Some businesses have little/no blame for not having a sizeable cash reserve as they might be in a very low-margin industry (see mom-pop restaurants)

    Least bad among a multitude of options. Just saying

    1. JBird4049

      Sometimes a business has to make unpleasant, but necessary choices like firing most of its people. However, the casual firing of people because of some immediate gain or to appear tough regardless of the immediate cost to the workers and long term cost to the company is usually the problem.

  8. K teh

    People with zero work experience making operational leverage decisions, based upon what they were taught in school by experts, who have never worked.

  9. Steve Ruis

    Hey, I’ve got a novel idea. Remember the huge Trump tax cuts that all of these corporations used to buy back their own stock, thus inflating the prices of those stocks to enrich their executives (with options) and shareholders? Hey, sell that stock and use the cash to keep your employees through the pandemic!

    They’ll end off no worse off than before the Trump giveaway and will be ready to surge ahead when the lock down is lifted. And think of the loyalty that their employees will give! Even if they pay have wages for staying at home, the employees will be very grateful.

  10. Susan the other

    Labor economics is a euphemism for cutting costs at the expense of labor. But the points that Ms. Carlton makes are quite good. She’s actually making a good case for a Jobs Guarantee Program or a close version. When our dear congress botched the “paycheck protection program” by cutting it with regulations and making the banks responsible for 20% of all “loan” losses – instead of what was needed: an emergency and ongoing infusion of money to keep businesses going by giving those businesses the money to pay their employees – they screwed the best solution they once had. What genius was that? It sounds like Nancy’s supercilious MO. But who knows? If the government also picked up everyone’s FICA/SS/Medical it would help keep those businesses alive even during a worse downturn. That’s not a bad thing. And the subtle threat about automation and robots is at best suicidal. It might help competition in the very short run but it soon becomes 6s and in the meantime it has killed the golden goose of demand. So think of the PPP as an incipient Jobs Guarantee Program. Or one branch of it. And for god’s sake don’t leave these decisions to congress – they are just way too stupid.

    1. Yves Smith Post author

      That is not correct. Labor economists study things like the impact of minimum wage increases. MBAs are the ones who cut costs at the expense of workers.

  11. Mike Elwin

    Getting back to the main topic, the cost of firing and rehiring … FWIW, employers don’t save much money by hiring through an agency instead of hiring direct. The agency will be paying the workers’ benefits, now, and charging the costs to the employer. It will also be charging its own costs of finding and screening job applicants and charging its other costs and overhead, as well.

    Of course, the agencies’/employers’ costs can be reduced by using contractors instead of employees, but here in California, the new law, AB5, includes a provision that prevents agencies from referring workers as contractors unless the agencies have more of a hands-off relationship with them than agencies normally do.

    So the attraction of agencies is still down to the perceived value of sparing the employing manager the difficult work of selecting new hires. Managers generally believe that agencies only refer qualified people, which of course isn’t true much of the time, but the stress of making the right decision on hires can be overwhelming.

  12. jrkrideau

    I think the author may be underestimating employee knowledge. If you have a fairly complicated technology, you suddenly can find that a lot of “how to do things” or “not how to do things” is in corporate lore or experienced employees. Loss them and the company can crash. Years ago I watched Bell Canada offer early retirement too many senior tech people and then scramble to get them back when mgmt realized they had lost a huge amount of corporate knowledge.

    There seems to be some hints that Boeing cut a lot of experienced (i.e. high cost) engineers a while ago and outsourced. That worked well.

    If the scope of a worker’s job is limited, then fewer areas will be impacted by the individual leaving, and the costs to train a replacement will be lower.

    And 1) you get a bored employee who has no interest in the company and 2) if you need labour flexibility in a crunch or emergency you are toast.

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