Do the Math

Will the health care bill help or hurt small business owners? That mainly depends on one factor: whether or not they already offer health insurance.

If you own a small business that presently offers health care, the health care bill will obviously help your profitability. A central feature of all the proposals is the creation of a national risk pool, which would eliminate the penalty small businesses face because of their tiny risk pools. This would enable small businesses to compete for labor with larger businesses, and it may even bring rates down.

Macroeconomics dictates what will happen next: the marketplace will reward employers who have already been offering health insurance. Your competitors who do not presently offer health insurance will see their costs increase at the same time yours decreases. They will respond by providing the absolute bare minimum necessary to comply with the health law, then raising prices while yours remain constant. This will result in greater market share for you, which will result in your needing to hire more employees, with benefits that exceed the bare minimum.

US Small Businesses will not become less competitive, because we already can't compete with countries that have lower labor costs. An 8% increase in labor costs will not make us less likely to take business away from a factory in China where workers earn $40 per month. US Small Businesses compete with each other--and if they all have to offer health insurance nothing will change except that their workers, and our economy, will be healthier. A recent government imposition of health regulation that was bitterly fought by small business may provide a glimpse into the future: when New York City banned smoking in bars and restaurants, their owners predicted the end of Manhattan nightlife. Guess what--people adjusted. Quickly. Given no choice, people gave up smoking inside but not drinking. The model has proliferated nationwide.

If you don't offer health care to your employees, that means one of three things:

1) You are bad at math: your employees are paying for their own health care with after-tax money. Which means you have to pay them at least $1200 (which costs you a minimum of $1400 after employer taxes and workers comp) for them to be able to afford an $800 per month policy. In the short run, your expenses will increase--but you will be able to adjust income for new hires and your existing employees will end up having far more discretionary income at no extra cost to you. Unfortunately, you didn't understand what I just said, and that blonde lady on Fox say "health care bill bad".

2) You are great at math: your employees are on Medicare or some other form of public assistance--which means other businesses are paying for your workers' health insurance. That's a great deal that I can't blame small businesses for fighting to keep. Unfortunately, the present system will bankrupt our country in the near future. You will likely find a way to punish your workers for this, but since you are probably paying minimum wage it will take a while for you to recoup these funds. You know exactly what you are fighting against, and your employees are also fighting against this bill because they see it as a battle between the Medicare they already have, and the hurt The Man will bring down on them if he has to pay for your insurance.

3) You see your employees as unskilled and replaceable. That might actually be the case--because the employees you'd want to retain are working at some other company that offers health insurance. But that is never the case with "the job"--as I've learned owning a small business, showing up for work on time, the ability to be trained and improve on your own, and working well with others is a skill that is increasingly rare in America. Or, you are the only game in town--most likely a small town in the Southeast. Either way your employees have no health insurance. They come to work sick, or miss more work than they need to, or switch jobs as soon as they need health insurance. Short term bad, long term good.

It might help to understand why businesses began offering health insurance in the first place. Back in the day of The Organization Man, when tax rates for executives exceeded 50%, health insurance was a non taxable perk that actually paid for itself by keeping key men healthy. When tax rates began falling, company provided health care was taken for granted as a perk necessary to attract talent. So health was a white collar tax shelter. Blue collar workers got their insurance courtesy of labor unions. Health insurance is still a privilege of white collar workers and unionized blue collar workers. This bill will benefit non union, blue collar workers and their families more than any other demographic. It will also hurt their employers in the short run. They'll get over it.
 

The executive branch has always had the power to redefine words to serve their interests.  Reagan's USDA reclassified "ketchup" as a vegetable so school lunches could meet both budgetary and nutritional requirements.  George W.'s DOJ redefined "torture" so as not to violate international agreements, and Bill Clinton himself took a stab at redefining the meaning of "is" with reference to another sort of violation. 

Now Obama's Department of Homeland Security has redefined the word "domestic" to include products made in Mexico and Canada in order to reconcile the "Buy American" provisions of the Stimulus Package with NAFTA.  

So the Kissell Amendment, which was intended to give USA manufacturers an edge, has actually handed the edge to Mexico, which is now allowed to bid on "domestic" contracts but is exempt from any of the Workers Rights provisions of the Federal Acquisition Regulations regarding workplace safety, overtime, child labor, and other abuses. There is just one problem: the Kissell Amendment does not use the word “domestic".  It specifically requires that TSA Uniforms be produced "in the United States".

But redefining the meaning of "in the United States" to include Mexico would torpedo another Homeland Security Program: E-Verify. On the same day that the Transportation Safety Administration released their uniform program featuring the new definition of "domestic" the Senate passed the "E-Verify Amendment", an attempt to legislate George Bush's executive order that federal contractors use none other than the Department of Homeland Security's electronic system verify the legal status of their workers for work performed "in the United States". 

As the Senate's "E-Verify Amendment" Sponsor, Jeff Sessions said, "Our unemployment rate is now at 9.5 percent, the highest in 25 years. E-Verify is a critical tool to ensuring that jobs go to lawful, taxpaying, American workers -- which, in the current recession, is more important than ever before. I am pleased that the Senate has agreed that federal contractors benefiting from the stimulus should be required to use the program in the future."  He did not add, "or they will have to manufacture their products in Mexico" at the end but he could have to make the statement more accurate.

Something’s gotta give here.  If “Buy American” violates the anti-protectionism procurement laws of the World Trade Organization, wouldn’t a law requiring that American Citizens work on federal contracts violate the same laws?   If Homeland Security redefines "produced in the United States" as it sees fit for its own contracts does it have to hold other federal agencies to the same standard?

In 1992, Ross Perot foretold of NAFTA causing a grand migration of jobs to Mexico to emit a "giant sucking sound." I started Unionwear the month Perot made that famous prediction and spent the next few years second guessing my career choice.

Q. So why don't I ever see apparel labelled "Made in Mexico?"

Step 1: The law of supply and demand met the law of unintended consequences

Legend has it that immediately after the passage of NAFTA, US agribusinesses began flooding the Mexican market with cheap corn and other farm products. This drove Mexican farmers out of business, and North in search of factory jobs faster than American maquiladoras could be deployed along the US-Mexico border. The supply of cheap labor outpaced the demand for it, and real wages began shrinking. Desperate, Mexicans began illegally crossing the border where they were able to find work building and maintaining the houses built during the real estate bubble and filling entry level positions in the burgeoning service economy.

Step 2: Natural selection meets adverse selection

In 1995 I was kibitzing with Milty, an avuncular garmento across the aisle at M.A.G.I.C., a Las Vegas Menswear Convention. He had just pulled the plug on his Mexico operations and decided to move it to China. "Mexicans are not like Americans. They worked until they made $200 then they would quit and go back to their villages. We could never get any momentum." An agrarian worker content with seasonal employment must have seemed odd to Milty. His grandparents probably uprooted their lives at the turn of the century in order to escape a permanent struggle with survival. They came to America and contributed to a gene pool already wired to chase dreams. As we broke down our booths, Uncle Milty tossed me a sample shirt I had been eyeing. "Do yourself a favor. Don't wash the f:)kin' thing."

When manufacturers began deploying maquiladoras right on the US border they begged for what the health insurance industry terms "adverse selection" in their labor pool. The $10 per hour US jobs across the border attracted Mexicans with the drive to go there, the planning and stamina necessary to get there, the skills to stay there, and the persistence to return if necessary. Those left behind toiled in miserable, unsafe sweatshops for $1 per hour or less and left as soon as they got the chance.

So you know what these maquiladoras got for $1 per hour? Labor that was worth... $1 per hour. This didn't last long. Whole factories and industries started disappearing to Asia, where employers didn't have to compete with the American Dream next door or contend with pesky labor laws or monitors.

Q. Now jobs appear to be returning to Mexico from China. Is this good for the US economy?

Mexico is "local" compared to China. Tijuana is certainly more local to Los Angeles than New York is. Local means more oversight, less environmental damage, and a more direct connection between labor and consumer. Opportunities in Mexico at a time of little opportunity here explains why undocumented workers are returning to Mexico. Manufacturers in Mexico are more likely to use US made parts, particularly under NAFTA. Rebuilding Mexico's supply chain infrastructure after it was gutted by companies relocating to China will also help US manufacturers who import parts.

A "lean" US manufacturer can compete with Mexican manufacturers as long as a weak immigration policy continues to result in adverse selection of Mexican labor. We can't, however, compete with an economy like China's with a low wage workforce, held at gunpoint, that grows by 30 million annually. The original intent of NAFTA was to bring wages in Mexico up to the level of America's wages, and develop a true, viable trading partner and net buyer of our exports. That is a lot more likely to happen now.

And when that happens, work -- not workers -- will be returning to El Norte. 

Free trade is defined as the ability for a buyer and seller to conduct business without government interference.    So when the government is the buyer why can't it freely choose who to buy from without incumbent sellers claiming interference with free trade?

I have a solution to this loophole-infected quagmire: Scrap protectionist language and simply require sellers to the US, state and local governments to comply with US labor law regardless of where the goods are made. 

A recent NY Times Editorial about the "Buy American" bill is a perfect example of how easily the razzle of "Free Trade" can dazzle the journalistic integrity of our last great voice of skepticism.

Looking for some good economic news? Look no further than US Manufacturing.  China's advantages in manufacturing have all but eroded  according to Business Week.    The US Trade Deficit sank to a ten year low.  And all sorts of indeces are pointing to an impending expansion in domestic manufacturing ahead of the rest of the economy.  This is such positive news I'm hesitant to even mention it.  At this point my grandma would chide me for begging the evil eye to come and knock my optimism down a peg, and attempt to ward it off with a medieval Yiddish spell ("kinna hurra").  What's happening and why?

Legislation Levels the Playing Field

Red state laborers will finally make as much as their blue state counterparts next month, when the Federal Minimum Wage is raised to $7.25. Most of the blue states, ours included, had already raised their legal minimums to that level years ago, but a map of the states still slumming it at the Federal Minimum Wage is basically identical to the 2008 map of states won by John McCain, proving once again that the more someone needed a change, the less likely they were to vote for it. What IS the matter with Kansas?

Before the break up of Ma Bell in 1986, long distance phone calls used to cost a fortune.  Then competition like Sprint and MCI drove down the cost of long distance, and by the 1990s long distance calls were less expensive than local calls.  But that is still news to my grandmother, who to this day will not talk on the phone to another area code for more than 59 seconds.

Our former plant manager was similarly phobic towards overtime pay, prohibiting it under any circumstances. And I never questioned him--after all, with our labor costs so high to begin with, how could we possibly make any money paying 50% more for the same work?  A year after he retired, we faced a tremendous temporary surge in business--providing both 2008 presidential candidates with hats and bags.  We had to make a quick decision--do we hire 20 more sewing operators, or give 80 of our operators the chance to (voluntarily) work an extra 10 hours a week at time and a half?  I don't know what drove me to "do the math"--on the surface it seemed that hiring the cheaper new operators would be a no brainer--but the answer actually astonished me.

The first thing I noticed was that our regular time was actually costing us more than time and a half.  Besides the 11% federal employer portion of taxes, we had 3% for workers comp, 3% on our pension contribution, and 1% on city taxes--an 18% vig to the system.  Then there was 25 days of unworked pay: 10 holidays, 10 vacation days, and 5 personal and sick days, all subject to the 18% vig. When amortized over the other 236 weekdays in the year it meant 12.5% of every dollar of regular pay went to fund unworked pay. Finally, our health insurance costs worked out to $2.22 per regular hour worked, or 22% of a $10.00 wage. We also gave production bonuses averaging $.75 per hour, or 7.5%.

So regular pay was costing us 60% more than the gross wage. How does that compare to overtime?  The health insurance, unworked pay, and pension were all paid for by regular time--they don't increase with overtime. We don't give production bonuses on overtime hours, and in our state workers comp is not charged to overtime hours. That just leaves the 12% in payroll taxes, plus the "and a half" premium (also subject to 12%)--a total of 68%.  

So all things being equal, overtime was costing just 5% more (168%/160%) than regular time per hour for the same employee.  But all things are not equal--because when overtime is necessary, the alternative is hiring a new employee, training them, replacing them, training their replacement, then letting them go when demand goes back down before they reach their full potential. They may be a couple of dollars cheaper, but for the first few months they add so much less value and require so much more high labor cost supervision.

Another argument against overtime is that it fatigues the workers. What we discovered was that a number of our workers had second jobs that they gave up because they were making more in ten hours of overtime than they were in twenty hours of their part time second jobs.  One of the great benefits of voluntary overtime pay is that so much more of the payroll costs ends up the employees pockets. If an employee is making a just over a living wage, overtime can multiply their discretionary income many times over.

In this recession I regularly read about companies who cut back hours to save labor costs. In the scenario above, a $10 worker costs the company around $16 per hour whether they are working regular time or undertime.  However, if their hours are cut back to 32 hours per week, that means that health insurance and unworked pay are amortized over 20% fewer hours--so labor costs per hour increase significantly.  Employees may be sacrificing to share the pain, but both companies and employees always lose out when workers don't work at least 40 hours.

So the bottom line--don't fear overtime--it doesn't cost a company any more than regular time, and it may cost a lot less.

It seems so obvious: if you don't pay employees enough to live on, you will have low morale and high turnover, lowering productivity and creating less value. The reduction in value created will always exceed the labor costs saved. So if sweatshop owners are really "greedy", why don't they see this when they look at their labor force, factory, and financial statements? Because they can't, for two reasons:

--Piece rate work does not create value and commoditizes laborers--to the factory owner's detriment.

--Archaic, irrelevant labor costing techniques developed before spreadsheets and exported overseas become dangerous agents of poor decision making in the hands of managers who don't understand the underlying math.

First, a wiki-sized history of the garment industry. Mass communications and the growth of department stores and catalogs made mass merchandising of fashion possible. However, the difficulties in predicting fashion success coupled with long lead times required to produce a clothing line made conventional financing difficult. Investors wanted a piece of the profits--but profits in this shady business too often fell victim to a bookkeeper's eraser, the back of a wise guy's truck, extravagant garment district overheads, or a foolhardy position in a fabrication with fleeting fame. So investors settled on more predictable metrics: Labor costs could be based on negotiated piece rates and materials costs on yields. Overhead could be controlled by limiting expenses to 40 or 50% of labor costs, a benchmark at the time. If overhead were higher than that the investors' share of the profits would come out of the manufacturers' pockets.

This model lasted for a while, but profits were still elusive (because piece rates produce pieces, not garments, but more on that later). The industry moved to a licensing model which just ignored profits and took fees off of sales--now Calvin Klein doesn't produce a thing and just gets a royalty check based on sales from the vertical conglomerate that manufactures the clothing.

But the piece rates and overhead multipliers survived in the costing departments like nipples on men. Factory owners and industrial engineers measured labor costs one way: with a clipboard and a stopwatch, meticulously timing production of every step multiple times for accuracy, then increasing it by some divine multiplier like 40% to account for overhead: The industrial engineering equivalent of ordering a bacon double cheeseburger with a diet coke. Garment factories shipped these metrics to Asia along with their equipment and systems of work and they exist, unquestioned, to this day.

The problem with piece rates is that they encourage workers to produce pieces--not garments. If a worker is paid by the collar they sew, you'll end up with a ton of collars, but you may not get a ton of shirts. Collars have no value--you can't sell them. The reason garment factories rarely achieved profitability in piece rate systems was that the profits ended up on the floor, in piles of work-in-process. Sure, value was created--someone would eventually make and buy a jacket, but imagine all that gratuitous effort in the name of productivity!

If a worker only sews collars, she is going to go from novice to expert in a short period of time and make the better paid veteran sitting next to her start to look expensive. This commoditizes the laborer and makes it difficult to see who has the know how and experience to create value. So when times got tough, it made perfect sense to cut labor costs by squeezing out higher paid veterans. And, because the workers were focused on producing parts rather than the whole to begin with, value creation probably didn't suffer much.

The overhead multiplier used in the garment industry became a weapon of mass destruction when Excel was introduced to the schmata trade. That overhead is 40%-50% of labor in garment manufacturing was as accepted a benchmark as the keystone markup is in retail. But using this benchmark in financial modeling and decision making without regard to its origins or the underlying math will lead to some terrible decisions.

Keep in mind that in financial statements, labor is only charged when a product is sold. All other expenses--such as the labor invested in work in process that is not made into garments--gets put into inventory. So when a spreadsheet uses 40% of labor costs to calculate overhead rather than trying to predict the actual overhead, overhead--representing "fixed" expenses--appears to fluctuate with labor costs. If you lower your labor costs, your overhead will be appear to be reduced, when in reality it stays the same and probably increases because of the need for additional management. If you increase your labor costs, or add more laborers and expand within the same facility, or you create more value and sell more units using the same workers, your overhead will appear to increase, when in reality it stays the same and actually decreases on a unit basis.

And when you tag an artificial expense onto your labor costs, you obscure your true unit profitability. In other words--YOU CANNOT SEE HOW MUCH MONEY YOUR WORKERS ARE MAKING FOR YOU, which marginalizes the impact of better workers, further commoditizing them.

One of my favorite quotes was from a one time garment magnate whose company was insolvent and we were negotiating to buy his assets. His calculations used the overhead multiplier, and mine used actual labor costs and actual overhead costs. Of course his calculations showed his company should still be in business, because they neglected the eighteen 40-yard dumpsters of obsolete work-in-process we had to remove after the deal closed. Our calculations showed much lower profitability. He said to me, "With the way you calculate profits, I can't understand how you make any money." He--and his generation of "garmentos"--would never understand that value can't be created with a calculator.

This distinction is critical to the the fight against sweatshops. There appears to be a battle within the left about whether to boycott sweatshops, police sweatshops, or just ignore them, because in many environments a job in a sweatshop is far better than the alternative. I believe in a fourth way: co-operation. There are practices in every sweatshop that hurt both workers and management, and whose elimination would help both labor and management, but management knows no alternative. They just know the clipboard, the stopwatch, and the piles of work in process showing that everyone has plenty of work. If we could just show sweatshop management how to create more value by converting that waste into wages, those factories would become more competitive, and the race to the bottom might start to reverse itself.

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:

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)=$9.25. That means existing employees are worth $14.25 per hour more than an entry level employee, or $9.25 after the labor savings are considered... and those were real numbers from a union shop.  The formula goes nuts in sweatshops, where labor costs are tiny percentage of the value created and the difference between veteran and rookie pay is miniscule.  In a sweatshop where labor is 10% of the value added and veterans make $.10 more than rookies a veteran sewer creates four times as much net value as a rookie... DO THE MATH! 

Next:  How did the Garment Industry get this SO WRONG?