How Companies Are Curbing Labor Costs

With the job cuts and rise in productivity, companies have been able to limit the impact of the recession on their bottom lines

By James C. Cooper

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In times of economic weakness, U.S. businesses have learned that slash and burn is the quickest way back to profitability. And in a recession as bad as this one, the massive cutbacks companies are making in their payrolls, inventories, and capital spending should come as no surprise. But with these cuts, businesses are rapidly putting themselves into a position to respond quickly to any spur on demand that's already on its way from Washington, increasing the chances that the economy can return to at least modest growth in the second half.

Of course, labor is most companies' biggest cost, and based on the March employment report, cost-cutting is still in high gear. Nonfarm payrolls fell by 663,000 in March, only a shade below the 691,000 average loss in the three previous months. The size and distribution of the March declines were similar to those in February, with manufacturing shedding an additional 161,000 jobs, construction losing 126,000, and the service sector down 358,000.

Payroll losses pushed the unemployment rate to 8.5% last month, up from 8.1% in February and up 2.3 percentage points from six months before. There's so much slack in the labor markets that increases in hourly pay have become significantly smaller. Over the past three months, average hourly earnings rose at only a 2.2% annual rate, about half the 4.2% pace during the previous three months.

Attention to costs in a recession is nothing new, but what's different now is the speed at which companies have moved in response to the ups and downs in demand. They actually began their current round of cost cutting more than a year ago, just as the economy was beginning to labor under the initial effects of tight credit conditions. Companies began trimming their payrolls in January 2008, and job losses now total 5.1 million.

Rapid Inventory Response

But it's not just labor costs. Businesses reduced their outlays for new equipment in each quarter of 2008, and they have whittled down their inventory levels for five quarters in a row. The pace of cost cutting since the economic paralysis following the Lehman Brothers bankruptcy has been stunning. More than 70% of payroll reductions have occurred in only the past six months, and in the fourth quarter of last year companies slashed their equipment outlays by 28%, the most in 50 years, with another big decline expected in the first quarter.

Businesses' reaction times are faster now partly because intense global competition has increased shareholder pressure on companies to protect profitability and partly because technology allows a faster response. For example, systems that offer real-time order tracking and inventory control promote rapid adjustment of production schedules. The result: fewer excess buildup that, in the past, led to drawn-out adjustments to inventories, production capacity, and payrolls, prolonging recessions.

In particular, the latest job numbers imply that service-sector industries, which account for more than 80% of private-sector jobs, have shown much more flexibility in paring back their labor costs compared with past recessions. Manufacturing and construction have accounted for a big share of job losses, but these declines have not been out of line with past recession experience. On the other hand, service jobs have fallen much more than past trends would have predicted, given the strong support service payrolls have received from the health-care and education industries. Over the past six months, private service-sector employment has fallen at a 4.2% annual rate, the steepest such decline in the history of the data, which go back to 1947.