SMB Trends – Bimbos, Twinkies, & Rising Labor Costs

Food manufacturer Hostess ($3 billion sales; 18,500 employees) recently announced plans to liquidate its assets after years of struggling with rising labor costs in an increasingly competitive market space.   Mexican food giant Grupo Bimbo ($11 billion sales; 127,000 employees) is hungry for some of the most valuable Hostess assets including Twinkie.

How did an iconic U.S. brand become prey to a flagship Mexican brand?  Perhaps the answer lies with the labor pool.   Although Grupo Bimbo is not entirely a Mexican company—having some bakeries in the United States and other countries, the overall labor cost structure of the two companies is different.  Unlike Grupo Bimbo, the Hostess compensation structure includes funding expensive pensions, generous medical benefits, and operationally inefficient work rules.  The lesson here is that rising labor costs in a global market are sure to make companies less competitive.

How do the struggles of a large company like Hostess apply to small-to-medium-sized businesses (SMBs)?   Like large companies, labor costs in SMBs are projected to rise for at least two reasons related to the Affordable [Health] Care Act.  First, the cost of employer paid health insurance is projected to rise substantially to pay for a nationwide increased population of insured (some 30 million newly insured).  Second, many employers will be required to cover more employees than they had covered before or face a free rider surcharge of up to $3,000 per employee.

Let’s assume we are owners of a $10 million revenue company with a 10 percent net profit margin.  We have just learned our health care costs are increasing by $50 thousand per annum thereby decreasing our net profit from $1 million to $950 thousand.  Our response will be based on at least four options:

Accept Less Profit – we could choose to accept less profit.  Investments are all about risk and return.  It will be difficult for many business owners to accept less reward for the same amount of toil and sacrifice.  They will seek ways to preserve their profit.  Inflationary cost pressures will not be the only pressure on business owners.  The threat of rising personal income taxes will discourage business owners from accepting less profit inherent with an increased cost structure.

Increase Sales – to overcome a $50 thousand increase in labor costs, the company would need to increase its sales by 5 percent or $500 thousand.  Many SMBs experienced sales downturns several years ago with slight upticks in sales since, but no real recovery.  Revenue growth in many SMBs is currently stagnant.  We expect industry supply chains to raise prices, but those price increases will be passed down the supply chain and have a negligible effect on company cost structures.  Business owners who expect sales increases to pay for rising employee costs are utilizing a risky strategy.

Decrease Employee Wages & Benefits—like Hostess, there will be pressures to lower employee wages and benefits, but these efforts will have mixed results.  The best employees will go elsewhere for better compensation; the worst employees will stay.  After several years of a recessionary environment with frozen pay in the private sector and an increased consumer price index, we think lowering employee compensation will be a difficult, last option.

Leverage Outsourcing Solutions—companies will scour their financial statements for cost savings opportunities.  Eventually, the focus will turn to headcount justification.  Each position will be evaluated for its ability to add value to the business according to three criteria: [1] Are important relationships being nurtured?  [2] Is company-specific intellectual property and / or know-how being developed and preserved?  [3] Are problem-solving skills required to resolve ever-arising, unique problems?  Positions that do not meet these three criteria and instead include highly proceduralized work that includes work papers that can be readily digitized will become candidates for either outsourcing or automation.  These labor categories include human resources, information technology, finance and accounting, legal services, purchasing, and reception.  SMBs that implement these types of outsourcing options may very well realize savings that overcome the costs associated with rising labor costs.

In summary, business owners must proactively respond to the increasing labor cost environment.  As they consider the practicalities associated with increasing sales and decreasing costs, many can and should consider the wide range of outsourcing solutions available on the market.

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