Six Dangerous Myths About Pay

In the “Harvard Business Review on Managing People”, an article by Jeffrey Pfeffer states that businesspeople are adopting wrongheaded notions about how to pay people and why. In particular businesspeople are under six dangerous myths about pay. Here, I present you my understandings of that research paper.

Myth #1: Labor rates are the same as labor costs.
Myth #2: Cutting labor rates will lower labor costs.
Myth #3: Labor costs represent a large portion of a company’s total costs.
Myth #4: Keeping labor costs low creates a substantial competitive edge.
Myth #5: Individual incentive pay improves performance.
Myth #6: People work primarily for the money.

Explanation of Myth #1 and Myth #2: A labor rate is total salary paid to the labor force divided by total time worked by them. But, labor costs take productivity into account, besides the total amount paid to the labor force. Thus, labor rates and labor costs are different. For example, consider two companies X and Y that are in the same business and produce the same products.

Case 1: Company X pays $10 per-hour to 100 employees for producing Z units of a product in 50 hours.

So, Labor Rate = (total salary paid to the labor force)/ (total time worked) = $(10*100*50)/ (50 hours) = $1000/hour
Labor Cost = $50000

Case 2: Company Y pays $15 per-hour to 100 employees for producing Z units of the same product as Y does in 30 hours.

So, Labor Rate = (total salary paid to the labor force)/ (total time worked) =
$(15*100*30)/ (30 hours) = $1500/hour
Labor Cost = $45000

Now, see, although Labor Rate at company Y, $1500/hour, is higher than the Labor Rate at company X, $1000/hour, but, still, Labor Cost at Y, $45000, is lower than the Labor Cost at X, $50000.

How is this possible? This is possible simply because of higher productivity demonstrated at company Y than that at company X. The labor force at Y finished the same job in lesser number of hours than did the labor force at X, keeping the quality of work the same. And, this theory of productivity is true in, almost, all the fields of businesses.

Case #1 and Case #2, mentioned above, also explain Myth #2 – just by lowering the labor rate, it’s not possible to reduce the labor cost. Productivity is something that should not be overlooked. In order to remain competitive in the market, a company cannot afford to live with these two myths.

Explanation of Myth #3: Managers who mix up labor rates and labor costs also tend to accept Myth #3 that labor costs are a significant portion of total costs. Sometimes, that’s true. It is, for example, at Accounting and Consulting firms. But, the ratio of labor costs to total costs varies widely in different industries and companies. And even where it is true, it’s not as important as many managers believe. One of the reasons why the confusion over costs and rates persists is that labor rates are a convenient target for managers who want to make an impact. Labor rates are highly visible, and it’s easy to compare the rates you pay with those paid by competitors or with those paid in other parts of the world. Moreover, labor rates often appear to be a company’s most malleable financial variable. It seems a lot quicker and easier to cut wages than to control costs in other ways, like reconfiguring manufacturing processes, changing corporate culture, or altering product design.

Explanation of Myth #4: Those who swallow this myth may neglect other more effective ways of competing strategies, such as through quality, service, delivery, and innovation. In reality, low labor costs are a slippery way to compete and perhaps the least sustainable competitive advantage there is.

Explanation of Myth #5: Individual incentive pay has been shown to undermine teamwork, encourage employees to focus on the short term, and lead people to link compensation to political skills and ingratiating personalities rather than to performance. Instead of individual incentive pay companies should opt for group-oriented compensation system. Some people might refute group-oriented pay-system on the basis that it induces “free riding” attitude in the team members. But, this is incorrect, because individuals do not make decisions about how much effort to expend in a social vacuum. Moreover, employees are influenced by peer pressure and the social relations they have with their workmates. Plus, sometimes, individual pay schemes go so far as to affect customers. For example, salespeople might piss the customers off by pestering them to buy the services or products that they are selling - in order to meet their targets. Another good reason is that in the typical individual-based merit pay system, the boss works with a raise budget that’s some percentage of the total salary budget for the unit. It’s inherently a zero-sum process: the more I get in my raise, the less is left for my colleagues. So, the worse my workmates perform, the happier I am because I know I will look better by comparison. This discourages people from sharing best practices and learning from other employees.

Explanation of Myth #6: People do work for money – but they work even more for meaning in their lives. In fact, they work to have fun. Companies that ignore this fact are essentially bribing their employees and will pay the price in a lack of loyalty and commitment.