Higher Labor Costs Cometh

Marx wrote that “the production of too many useful things results in too many useless people.” If you watch Downton Abbey, you can see that tension playing out through the British class system of the early 20th century.

Fast forward to today, and the story is far more complex. Yes, there are too many qualified people who cannot find steady employment, but there are also many companies that can’t find the talent they seek. 

Fear of inflation and commodity costs abound, but should it change a company’s outlook? Maybe not. But what about labor costs? For many companies, the answer is yes. I have summarized four points below to help business owners, casual economists, and investors make sense of the current business environment. 

• Pricing power and profits do not always go hand-in-hand. Profits depend on relative pricing power (growth in prices relative to unit costs). Rising profits, therefore, imply that selling prices are improving relative to production costs. With high unemployment rates and unprecedented productivity, costs have been low for many companies. But they are rising alongside demand for scarce talent, as well as commodity costs.

• There is usually a temporary profit spike early in recoveries when there is a surge in productivity growth and a slowdown in compensation costs, but that doesn’t tend to last as labor costs pick up. Don’t assume that growth rates will be even, and watch for rising labor costs. 

• The rule of thumb for developed economies is that labor costs dominate business input costs. While the costs of energy and other raw materials are significant, labor costs are the largest business costs. In the nonfinancial corporate business sector, labor costs are roughly three times more significant than non-labor costs, according to Merrill Lynch. Factor in expected pay raises and hiring costs, looking at the supply and demand for the labor you seek. For startups, this may mean that locking in full-time talent may be less costly now than in the near future, even though labor costs are often your riskiest investment.
  
   
• Rising commodity prices will not hit companies as hard as many pundits believe, but some companies may feel the pain of consumer restraint. Watch commodity prices, but know that they don’t necessarily spell inflation. It may be a good time to revisit your supply chain costs and find a more efficient distribution model. 

Further reading:
Planning for Change, As the World Turns from stepwise 
Five misconceptions about productivity from McKinsey Quarterly

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