The Effect of Labor on Profitability: The Role of Quality
Executive Summary — Determining staffing levels is an important decision in retail operations. In 2006, retailers spent $393 billion on employee wages, more than 10 percent of their revenue that year and more than their inventory holding costs. Hence, staffing levels have a major impact on retailers' costs. But at the same time, staffing levels affect conformance quality—how well employees execute prescribed processes—and service quality—the extent to which customers have a positive service experience at the stores. While there is overwhelming evidence that conformance quality and service quality improve sales, both generally and in retail settings, their effect on profitability is not clear. To examine how the amount of labor at a store affects profitability through its impact on conformance quality and service quality, Zeynep Ton analyzed extensive data from stores of a large retailer. Key concepts include:
- How well employees execute prescribed processes is an important driver of financial performance.
- It is important to design processes that are simple and easy to follow, especially when there is high employee turnover, as in the retail industry and when offering a self-service environment.
- Good process design needs to be backed up with an organizational culture that emphasizes conformance to these processes.
- Too much corporate emphasis on payroll management may motivate managers to operate their stores with insufficient labor capacity that, in turn, degrades financial performance.
- Emphasis on payroll management can also degrade employee morale.
Determining staffing levels is an important decision in retail operations. While the costs of increasing labor are obvious and easy to measure, the benefits are often indirect and not immediately felt. One benefit of increased labor is improved quality. The objective of this paper is to examine the effect of labor on profitability through its impact on quality. Since employees at retail stores perform both production-related activities and customer-service activities, I examine both conformance quality and service quality. Using longitudinal data from stores of a large retailer, I find that increasing the amount of labor at a store is associated with an increase in profitability through its impact on conformance quality but not its impact on service quality. While increasing labor is associated with an increase in service quality, in this setting there is no significant relationship between service quality and profitability. My findings highlight the importance of attending to process discipline in certain service settings. They also show that too much corporate emphasis on payroll management may motivate managers to operate with insufficient labor levels, which, in turn, degrades profitability.