How Companies Are Curbing Labor Costs

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Businesses have always known that profits and labor productivity go hand in hand, but there has never been as much competitive pressure to maintain high productivity, especially amid new labor-saving technologies and abundant sources of foreign labor. Those influences show up in the latest productivity data. During 2008 output per hour worked grew 2.2%. In recessions prior to 2000, productivity typically has fallen. Moreover, based on the March job data, overall hours worked in the first quarter plummeted at an 8.7% annual rate. If the economy contracted about 5% last quarter, as most economist believe, then productivity appears to have posted another sizable gain.

Income Support Programs

With productivity increases offseting the small rise in hourly pay, unit labor costs are up a very tame 1.8% from the year before. That means, even though pricing power is virtually nil, companies at least have been able to limit the impact of the recession on their bottom lines. Government data show that domestic operating profits in the fourth quarter were down 27% from the previous year, but the finance sector accounted for 77% of that loss. While profit margins at nonfinancial companies are down from the past year, they have fallen from record levels, and current readings are still on a par with the high rates achieved in the late 1990s. That means even modest increases in sales will flow much more quickly to the bottom line than in previous post-recession periods.

In the months ahead, with labor markets expected to remain weak, much depends on consumers and the help they will be getting from Washington. In the first quarter consumer spending was showing signs of stabilizing, and economists think it might even post a slight rise after big losses in the prior two quarters. Already several income support programs from the $787 billion stimulus package are starting to kick in. A per-worker tax credit to be paid out via lower withholding beginning Apr. 1 will provide an ongoing rise in pay for many households. A one-time payment to Social Security recipients in May also will boost incomes as will the expansion of unemployment benefits, food stamps, and other income securitiy programs. Adding further to purchasing power is the housing program, which is designed to lower mortgage rates and boost refinancing activity, which in turn will lower mortgage payments.

As the contraction in the economy moderates, so will job losses. Economists at JPMorgan (JPM) note that the worst payroll declines in a recession tend to occur in the quarter following the largest drop in gross domestic product. If so, payroll losses will most likely be less in the second quarter than they were in the first quarter. Nevertheless, as economist Sung Won Sohn at California State University notes, "Even if the economy continues to show signs of improvement, businesses will cut jobs and trim fat to stay lean and mean for the tough times ahead."

Cooper is BusinessWeek's senior editor and senior economist and writes the influential Business Outlook column.