This is a pure theoretical economic exercise:

Think about the following situation. The following are axiomatic.

1. You have the chance to hire any number of people on Earth - no matter what number you write down, that many people will end up on your payroll with the following terms:

2. they will have a net value of $1 to the company per year (net of every kind of cost, period), starting immediately and with no capital requirements, and no hidden costs of any kind.

What number should you write down? How many people do you need on those terms?

The answer is: even though each person brings a net of $1 per year only, the assumption stated says that there are no capital requirements and you can hire "any number of people on Earth" with no costs of any kind.

There are 7 billion people on Earth: you should write down "7 billion" for the number of people you want on those terms, making $1 from each one.

You now have a company that nets $7 billion per year. By comparison, McDonald's has $5.45 billion in annual net revenue available to common shareholders.

This was an exercise in what your demand should be on the margin with no other costs but only a net value of $1.

Now we move to the real world. In the real world, none of the assumptions listed are correct.

Employees have capital requirements. You only have the ability to hire so many. Luckily, they net you more than $1 each in value.

So, in the real world, we have an interesting situation. We want employees at practically any cost, but could reduce our twenty-person firm to annually netting us just twenty bucks a year, if we pay everyone as much as we still want more people at.

The truth is, we want to pay people as little as possible to retain them. How far above or below their PERSONAL market price (what they can make elsewhere) and how far above or below the market price for the position (how much people will fill your position for) their salary is for, will determine our strategy, and, crucially, how far each of these things is from their net value to you, will determine this strategy.

If a qualified neurosurgeon is working at a McDonald's for whatever reason, then almost no money (e.g. increasing his wage by 8x) will retain him. But presumable an 8x increase in his wage completely eradicates his net value, so it's not even worth considering.

On the other hand, if a qualified CMO is working as your VP of marketing, then presumably a very small increase in wage will bridge the gap between his personal opportunity cost (working elsewhere) and his current wage with you: whether you should do this depends on how much value you are getting from him.

Bottom line: if you are getting huge amounts of value from employees, you should consider paying them their replacement cost if you would rather replace them (McDonald's neurosurgeon example), or, if they are performing better than their replacement would, perhaps a fair strategy is to pay them a portion of their extra net, above their replacement cost.

In other words, if an average VP nets you $300k and this guy nets you $500k then you can pay him an extra $100k over what you would replace him with.

On the other hand, if an avarage VP nets you $10k per year, and this guy is weould be netting the same at the market rate, but is working for $40k less than the VP market rate, and therefore netting you $50k, then almost the entiretly of your net from him comes from his willingness to work for less than your replacement wage.

In this case, I don't think it makes sense to preemmptively give him all your profit.

I guess the correct behavior depends on a number of factors that are not explicitly stated in the article.

The take-home lesson might be "Pay attention to market wages, and how much value each employee is bringing versus what replacing him with someone else would bring."

Bonuses, in my opinion, are a really, really, really good way of dealing with situations where someone is bringing far more net value than their replacement would, and also has a high personal opportunity cost due to their talent.

In this case, by sharing the huge extra revenue, you can increase his wage only in proportion to how much better he is than someone else you would replace him with. This deals with his opportunity cost and retains him, presuming he has enough tools at his disposal to make you as much money as he can make someone else. (The neurosurgeon can't make McDonald's as much money as he can make a hospital, no matter what he does. Therefore, a bonus sharing program won't help that much. On the other hand, a bonus at a hospital would help immensely, if he could also be a director at a different hospital...)

user:	wellthat
created:	November 17, 2012
karma:	8