Perhaps one of the least understood features of the free enterprise system is how some individuals can become so wealthy and how the people at the top of a company can earn so much more than the entry-level employees. Surely if the CEO is making $10 million, the wages of employees could be raised by $5 per hour, the thinking goes. Surely if a company makes $1 B in profits, they are charging too much or not paying enough in wages, the thinking goes. Surely owners of a company who become billionaires must have taken advantage of customers and workers to get there, right?
In actuality, a seven-figure salary doesn’t have any material effect on the wages of entry-level employees. A company can make billions of dollars in profits while paying fair wages and charging fair prices. People who start and build companies can become billionaires without cheating anyone – in fact they are providing something of great value and charging customers a fair price for the thing that they are providing of they would not have become billionaires. (You might make a few thousand dollars cheating people, but not billions.) A few simple calculations show that the CEOs, the companies, and the owners are making very little profit from each customer and the employees are taking home the majority of the money they are producing. Successful businesses just have a lot of customers and a lot of employees, allowing them to make billions of dollars a few pennies at a time.
A standard remark is that a high CEO salary takes money from workers. Really? Let’s say that the CEO of a large company that has 50,000 employees makes $10 million in salary and bonuses in a given year. What would happen if he forgoes his salary and increases the wages of the employees of the company with the money? How much would wages rise? $5 per hour? $10 per hour? Sadly, no, it is not that simple. If you divide $10 million by 50,000, which is what you would be doing if you took the CEO’s salary and gave it out to the workforce, you get just $200 per employee, or about ten cents an hour. The CEO takes a very small cut from each employee in exchange for running the company and making the decisions that preserve their jobs. He just has a lot of employees. And while $10 million is a lot of money, surely each employee contributing ten cents an hour in exchange for the decisions that keep their company expanding isn’t a great burden.
But what about a company that makes a huge profit? We often hear that greedy companies are making huge profits while their lowest paid employees don’t earn enough to live “in the city.” They also don’t get full healthcare, a few months off for maternity leave, and other benefits. Surely if you took the entire profit and distributed it in salaries and benefits, you could bring wages way up and pay for all of the needs of every employee, right? Again, no. As an example, Wal-mart made $16 billion in profits in 2013. Certainly a lot of money. But if you took the entire profit and divvied it out to its 2.1 million employees, you be giving a raise of … $3.66 per hour, leaving entry level workers with maybe $11.00 per hour. Well below the $15 living wage being bantered about. You would also be taking away all of the profit being earned by the shareholders, givign them no incentive to invest in the company. So an employee working at Wal-Mart makes $7.50 for each hour they work, not including benefits, while Wal-mart (or more accurately, Wal-mart’s shareholders), makes $3.66 per hour. Does that really sound unfair?
The reason that employees aren’t making $15 per hour is that they are not producing $15 per hour worth of wealth. They could make more money if they learned the skills needed to increase the amount of value they create per hour. This requires experience and training – things that entry level employees don’t yet have. Setting their pay artificially to these levels will just eliminate entry level jobs or cause the company to go out of business, in which case everyone loses their jobs. This is simple economics – not greed. If anyone out there can show me how this math could work any differently, please let me know.
Well, is Wal-Mart ripping off their customers? Surely they can’t be making those huge profits without cheating their customers, right? Are they making a hundred percent on each item? Um, no. Wal-mart made $476 billion in revenues in 2013, but again only made $16 billion in profits. This means that they made an average profit of less than 3.5%! Does this sound like an unreasonable profit for finding and buying the goods, shipping them all over the country, and placing them neatly on shelves for consumers to purchase 24 hours a day when they need them? I don’t think so.
So while it may seem like companies are making a lot of money (which they are) and CEOs are getting high salaries (which they are), it doesn’t mean they are abusing either customers or their employees. They are making lots of money, but they are doing it a little at a time from each customer and each employee. The customers get products for just a little over the cost of their production and merchandising. The employees are taking home most of the money that they generate in their jobs and are able to simply report to work and do as they are asked instead of doing all of the planning, marketing, coordination, and selling work that they would need to do if they were running their own businesses. They find it convenient to work for someone else, or feel that they will earn more working for an employer than they would on their own, so they feel it reasonable to give a percent of the value they produce to their employer in exchange for the job. It is only because so many customers are being helped and so many workers are being employed that such big profits are being made.
If someone’s wages are low, it is because they are producing relatively little in doing their jobs. Think about what would happen if instead of checking people out or taking orders, the people in the entry-level jobs were growing their own food on the frontier. If they were at home growing food and putting forth the same amount of effort and employing the same skill level that they do in entry-level jobs, they would not be growing many crops. If they were to put in long hours growing crops, and more importantly, put forth the effort to acquire better tools like a tractor and the knowledge of how to use it effectively, they could grow a lot more crops. Likewise, if they acquire better tools to be more productive at their jobs, and if they put those tools to effective use to produce more things that people need, they can earn a much bigger salary.
Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.