How does replacing an existing worker with a cheaper, newer worker affect a company's bottom line? Labor costs are indeed reduced. But Value Created is also reduced, usually by an amount that dwarfs the labor savings. We can measure Value over Replacement Personnel--VORP--by comparing the difference in both Value Created and Labor Costs for a typical employee and her replacement. First, some definitions:
Value Created is Sales less Materials Costs and represents the value the marketplace places on the fruits of a worker's labor.
Loaded Labor Cost is the amount an employer spends on that employee--wages, benefits, taxes, unworked pay, workers comp, etc.
Net Value Created is Value Created less Loaded Labor Costs. This amount is used to pay rent, insurance, utilities, and other overhead; marketing, research, and development expenses; professional fees, taxes, interest, reinvestments in corporate sustainability and any other fixed costs. A company is profitable when Net Value Created exceeds these fixed costs.
Net Value Created is not Gross Profit. Gross Profit is a metric used by MBAs and CPAs that allocates some fixed expenses to labor and materials costs for tax purposes. It takes what could be a black and white calculation and turns it into arbitrary hocus pocus that leads to bad decision making by management.
Value Created is reduced when existing workers are replaced with cheaper, new workers because overall productivity suffers for almost a year. Unfortunately, sweatshops are prevalent in the garment industry because of the widespread belief that garment workers are “unskilled laborers”. Entry level workers are quickly as productive as veterans, but are willing to work for less. Sweatshop owners believe conditions and policies that encourage high employee turnover keep labor costs low without penalty.
It may be easy to train employees to sew as fast as a veteran in front of an engineer with a stopwatch, but there is a big productivity difference between rookies and veterans—because the veterans spend much more time creating value. Veterans know where the thread is, where the scissors are, how to fix the needle, how to read the work instructions, what to do when an order doesn’t seem right, what to do when the manager isn’t there, what work to do next, how to avoid injuries, how to stop an order with a quality problem, etc. Rookies can sew fast on the cheap but can’t do anything when the work runs out until an expensive manager or mechanic comes over and tells them what to do next.
We have a team incentive program based on the number of minutes worked by a group of sewers. For 90 days, new employees (and we only hire experienced sewers) only count half of the minutes they worked toward the bonus. For the next 90 days the employee counts 75% of her minutes. They don’t sew any slower than the veterans, but they produce half as much because they spend so much less time creating value. This progression from 50% to 100% has proven pretty accurate—bonuses remain static when a new team member is hired, and the team leaders neither complain about nor fight over new employees, which they would if a newbie made bonuses less likely or more likely.
So, by the end of year one, one average new employee has produced 81% of what a veteran employee has. However, a veteran is never replaced by one average employee. Because another skill that separates these so-called "unskilled laborers" is the ability to show up for work on time, every day, stay healthy, keep their personal problems out of the work place and play well with others. After 90 days the team leaders have to decide whether this employee is a keeper. For every employee we keep, one lasts about six weeks, and one lasts 90 days. Which means after one year, the 3 replacement employees produces 62% of what a veteran employee produces (45 days, 90 days, and 90 days at 50%, 90 days at 75%, and 45 days at 100%).
We'll call this 62% Productivity Loss. You need a few other variables to calculate your company's VORP: Average loaded wage, Entry level loaded wage, and loaded labor costs as a percentage of value created ((labor costs) / (sales - materials costs)).
Value Created Per Hour for your company is simply:
(Average Loaded Wage / Labor as a percent of Value Created)
With an entry level employee Value Created Per Hour would be 62% of that figure. However, labor costs would be reduced by (Average Loaded Wage less Entry Level Wage).
So at the bottom of the blackboard, we get:
VORP = (1-Productivity Loss) x (Average Loaded Wage / Labor as a percent of Value Created) less (Average Loaded Wage less Entry Level Wage).
Lets try it with a company with where labor is 40% of Value Created, employees cost $15 per hour, and entry level employees cost $10 per hour.
The company's average employees create $15/.4= $37.50 per hour of value. Entry level employees would create 62% x 37.50 = $23.25 per hour. But the entry level employee would save that employer $15-$10=$5 per hour in labor. You just saved $5 an hour in labor. Congratulations, Einstein! You just cost your company ($37.50-$23.25)=$14.25 in lost Value Created.
The "VORP", or difference in Net Value Created between and existing and an entry level employee, is (1-.62)($15/.4)-($15-$10)=$9.
Next: How did the Garment Industry get this SO WRONG?
