May 25, 2022

Article 5.12


Do you believe in the "service profit chain" model? Here is a paraphrasing: "retain best employees to improve service. Better service will yield – do it right the first time, lower operational costs; higher service value; better customer retention rates; a base for flexible, value-added services for custom contract customers; and higher, can-do employee morale. These benefits will in turn lead to faster growth rates in both sales and profits, especially in mature, service industries like wholesale distribution."

This sounds pretty good, especially if a slow industry growth rate and the eroding pricing and profit power of our product lines aren’t growing our firms and employees’ futures as well as they used to. But, to adopt the service profit chain model we will have to rethink our business economics around retaining best employees by investing to meet their needs - which are:

  1. A real wage increase every year, if not premium wages for each job niche immediately.
  2. Constant, competitive health care benefits even though health insurance costs are climbing again.
  3. A profit-sharing retirement fund contribution most years.
  4. Sufficient profits reinvested back into the company to finance future job security and growth for all.
  5. Some educational and work tool investments to grow productivity and skill sets.
  6. Jobs that have optimal amounts of challenge and empowerment designed into them, so that everyone can have the possibility of having an interesting job in which they can achieve measurable pride.

How can we afford these fantasies? Total employment costs per employee would have to grow annually by at least 5% in today’s low inflation environment. If our current compensation package isn’t top quintile for our labor market, then the annual increases may have to grow faster for a few years to get to a level that will attract and keep best work ethic employees.

If we don’t make this commitment, won’t our employee recruiting and retention problems persist? Best employees have always had a seller’s market whether they knew it or not, and now they all know that it is a full-employment, seller’s job market. Company loyalty is at an all time low. As job security at big corporations has been fading, the U.S. workforce’s adoption of the free agent mentality has been rising, especially with younger age groups.

Current economic conditions probably won’t float our company boat high enough or fast enough to afford the employee needs list above. The Asian economy’s problems are expected to eventually slow US GNP growth to about 1.5 to 2% and keep the price of tangible goods flat, if not declining in some cases. This could mean no price increase opportunities for most distribution channels and perhaps inventory write-downs for some.

In some channels, big end-users are announcing that because they can’t raise their prices they plan to increase profits by "working with" channel suppliers on an on-going basis to further reduce in-bound "total procurement costs." Margin rate expansion plans on the sell side will be resisted. All of these economic factors add to a possible profit squeeze for the rest of ’98!


The 5%+ increase per year in total people costs is just a starting point in a financial cause and effect cycle that involves the following six ratios:

    1. annual sales / full time equivalent (FTE) employee
    2. annual gross margin dollars / FTE employee
    3. annual, total-employment cost / FTE employee
    4. all, non-people expenses / FTE employee
    5. Profit after tax / FTE employee
    6. Profits reinvested/ FTE employee.

A description of how these factors interrelate is: (#3) Higher employment costs can only be met if we grow (#2) annual gross margin dollars per employee at a similar or faster rate. The margin dollar growth will require similar or better (#1) sales growth that must come substantially out of competitors’ hides. An increase in sales will require an up-front, incremental investment in inventory and receivables. And, the incremental asset increase must be financed first and significantly by company (#6) profits reinvested into the business.

Profits, it turns out, are not only a cost of the shareholders’ investment in the business, but the reinvested portion (#6) is also the cost of the employees’ future. If we have not been consistently making and reinvesting significant annual profits per employee into our business to fuel this entire scenario, what type of recruitment story do we really have?

Graphing the above six ratios over time is also helpful. Make the horizontal axis "years gone by" and the vertical axis "dollars per FTE." Then, plot the data points. We should hope to see 6 parallel lines gently sloping upward from left to right. If all of the lines (except for #4-non-people expenses) have been increasing at a rate in excess of 5% annually, then employee retention probably hasn’t been a problem. All stakeholders – employees, customers, suppliers and shareholders- have been sharing in an ever, improving story. Call it the "everyone wins" model.

If all the ratios have been sloping up except for the profits and profits reinvested lines, then the slope of the debt to equity ratio should also be plotted because it is growing towards a disaster. Private firms can only finance the necessary growth in assets with increasing bank and supplier debt until one or both pull the plug on the business. Then, big layoffs, salary cuts, service deterioration, customer desertion and maybe even a bankruptcy will follow.

The ratio of reinvested profits divided by the equity must equal the sales growth rate if we want the debt to equity ratio to stay constant. If our debt ratio is optimal and profits are exceeding our reinvestment needs, then and only then should we consider splitting the surplus profits between gain-sharing bonuses paid out or put into a retirement fund and dividends above or below the profit line to shareholders.


If this total economic challenge sounds daunting, it has a better chance of succeeding than the odds of the "good old days" coming back. Remember when we used to get lucky and hire some people who didn’t know how good they were? These "achievers" would then work hard for average pay and stay for a long time. They unknowingly, or quietly and resentfully, would subsidize shareholder profits and the least productive employees who were often paid the same as the achiever.

Those days are gone. We need a new "get rich" model. The – "buy low, sell high, collect early, pay late, hire cheap and work hard" – model has become dysfunctional. The "everyone wins" model promises not only better returns for everyone, but it should eventually be more fun and less stressful for managers because all the employees will have to shoulder the responsibility of making it happen.

If we embrace the "everyone wins" model, there are two immediate things to do. First, we will have to invest more money into financing the needs of our best employees because we will need their early, collective commitment and leadership. Then, we must begin the education of and the responsibility transfer to the rest of the employees. We might break the news to them in this order:

  1. Confirm that they would really like to have the 6 employment conditions listed above.
  2. Educate them about the financial cause and effect cycle and the past 5 years of ratio results.
  3. Start tracking these ratios for the last 12 months trailing on a best we can do basis.
  4. Brainstorm about all of the programs that we can do as a team to make all of the ratios start going in the right direction.
  5. Ask for volunteer task teams that will coordinate and pursue these programs.
  6. Point out that if the least productive, least cooperative employee(s) were to leave and not be replaced then ratios would go up and whoever works together to pick up the slack could share some or all of the ex-employee’s wages immediately. This would help some employees move more quickly towards the goal of premium wages for each job category, and it would point out that cross-subsidies between employees isn’t fair.

Because this is a major strategic and philosophical switch, it is, however, reasonable that some passive, dependent employees may choose to eventually leave. At the outset, however, we might want to give everyone the chance to make this new, high performance team.


The "everyone wins" economic model will create all kinds of new problems to solve. Some can be foreseen and others will be surprises. But, the beauty of this new program is that all of the problem solving will be shared equally by all employees. Managers will grow to love being able to say to a complaining employee - "Gee, I don’t have a ready answer. What do you and the rest of the team think? Why don’t you talk it over with everyone and let me know what solution you think will increase the odds of making our ‘people, service, reinvested profits’ plan and target ratios happen."

Merrifield Consulting Group, Inc.