Why Margins May Be Ready to Move Higher

What will get corporate profits out of their six-quarter slide? With rising energy costs, higher outlays for security, and a strong dollar weighing down corporate earnings, business executives are turning to their biggest expense, labor, as the primary way to rescue their ailing bottom lines.

That doesn't always mean layoffs, either. Businesses are boosting productivity not only with improved technology but by becoming more flexible in deploying their workers. The result? In the first quarter of 2002, output per hour worked surged at an annual rate of 8.6%, pushing unit labor costs down at a 5.4% pace. That drop followed a 3.1% decline in the fourth quarter, according to the Labor Dept. Without those back-to-back drops in unit costs--the largest in 20 years--the Scoreboard profit declines in the last quarter of 2001 and the first quarter of 2002 would likely have been even greater.

Federal Reserve Chairman Alan Greenspan recognized the importance of productivity in a speech to Congress in mid-April. He said then that "a lack of pressures in labor markets and increases in productivity are holding labor costs in check, resulting in rising profit margins even with inflation remaining low." In other words, as long as companies can cut the cost of what they make--through improved technology, lower labor costs, or both--they will increase profits even if prices and sales volume hold steady. Joseph T. Abate, senior economist at Lehman Brothers Inc., believes that an increase in labor productivity alone could cause such a steep decline in costs that profits throughout the economy could increase by 20% in 2002, compared to an 18% drop in 2001.

How do companies rein in labor costs, especially without layoffs? Navistar International Corp. designed new work schedules to meet seasonal swings in its school-bus assembly plant in Tulsa, where orders are high before school starts but plummet by Christmas. Chairman and CEO John R. Horne says: "We designed the operating process at the Tulsa plant so that the basic workweek is four 10-hour days. Then you can add any part of Friday and any number of Fridays depending on demand." In this way, says Horne, "you can follow the market very easily with a 25% capacity swing, [workers] still got their 40 hours of pay, and none of their friends got laid off." That flexibility helps the company find and deploy extra labor when it's needed.

Over at heavy-machinery maker Caterpillar Inc., temps will be hired to meet any increase in orders this year. Also, Caterpillar is now using overtime to fill orders. Investor Relations Director James W. Anderson says the advantage of temp workers and overtime is that if demand slumps, "those costs can be taken out pretty quickly."

Of course, productivity gains rely on new technology, such as robotics or computers. So as capital spending rises, workers will get the equipment they need to work more efficiently.

Higher productivity also comes with a nice economic perk: It allows companies to hand out pay raises that outpace inflation. In the first quarter, total wages and salaries rose 3.5% from a year ago, much better than the 1% increase in prices. And as workers spend that cash, it helps revive overall demand, which leads to new hiring. In April, nonfarm payrolls actually grew by a small 43,000. In the long run, slimming labor costs just may be the key to revving up profits again.

By Kathleen Madigan in New York, with Michael Arndt in Chicago

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