BUSINESSWEEK ONLINE : NOVEMBER 20, 2000 ISSUE
CORPORATE SCOREBOARD

Bigger Payroll Bill: Not as Scary as It Seems


Labor costs are by far the largest item on the typical corporate income statement. On average, compensation accounts for two-thirds of a company's expenses, and labor costs in the third quarter grew 4.6% from the previous year, the fastest pace in a decade. Looking out to 2001, will this behemoth start to beat up on profits?

On the surface, the data look scary. Even if economic growth in 2001 slows to 3%, from the expected 5% for this year, labor expenses should bulk up further in the coming year for three reasons. First, growth may not cool enough to loosen up the job markets, so skilled workers will still command big pay raises. Second, higher inflation this year, thanks to pricier oil, will bump up cost-of-living adjustments in 2001. Finally, fatter raises blow up the cost of many benefits such as paid vacations. Total wage, salary, and benefit compensation is expected to rise an additional 5% or so over the next year (chart). And with revenues slowing along with the economy, you'd think the higher payroll tab would squeeze corporate earnings like a vise next year.

TO THE RESCUE. Think again, say economists. Productivity should come to the rescue. As long as workers increase their output during each hour worked, companies can handle bigger wage gains without taking a hit on profits. In the third quarter, for instance, productivity was up 4.9% from the year before. That kept unit labor costs--the cost of producing each unit of product--practically flat.

But slower output next year means that productivity will cool as well, probably to 3% or so, say many economists. If so, can unit costs remain so tame? Stuart Hoffman, chief economist at PNC Bank Corp. ( PNC), thinks so. He says productivity gains of 3% are still enough to offset most of the expected rise in labor costs. ''Labor costs may cause a little squeeze, but not a bear hug,'' he says.

Of course, productivity is not surging across all industries. Efficiency gains are largest at manufacturers, especially those making computers and related equipment. Productivity increases are harder to come by at service industries, such as retailing, entertainment, and food service.

In addition to better productivity, companies may get relief next year from nonlabor costs. A slowdown in Europe should curb demand for materials. And a cooler U.S. economy means the Federal Reserve won't raise short-term interest rates over the next few months. As a result, Hoffman says, ''oil, commodities, interest, and maybe even rent could all grow more slowly next year. That will offset labor-cost gains.''

The danger, from a corporate-cost standpoint, is that the U.S. economy will not maintain its current soft-landing pace. If growth picks up, the job markets will tighten further, lifting pay growth far above productivity. Conversely, if demand slows too much, revenues will plummet before companies can adjust their cost structures. Either way, profits could swoon.

Most economists, though, expect the economy to keep moving at a steady pace. And as long as productivity tools right along, labor costs may get brawnier, but they shouldn't pummel profits.

By Kathleen Madigan in New York

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