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Talent Management Column

How Accounting Affects Hiring

There's a big difference between a dollar spent on a robot and one spent on a worker. And this difference helps explain investors' and employers' general reluctance to invest in employees.

Tuesday, February 21, 2017
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One thing my father always told me to do was take accounting in college. Of course, I never did, which was probably too bad because, as we all know, we only manage what gets measured, and accounting drives what gets measured.

I was reminded of this again in a radio conversation with my colleague Ann Harrison, who studies offshoring and has just edited a book about the future of manufacturing jobs. In the conversation, she noted that increasing productivity has been the big driver of the decline of manufacturing employment in the United States, and that we really should be trying to create incentives for manufacturing businesses to make use of employees.

That brings us to accounting. We all know investors call the tune in the private sector, and they look to the financial accounting of the firms in which they invest to decide whether to buy or sell them. As a result, executives of those companies do everything they can to make their financial numbers look good. What constitutes good? Profit, of course, which is revenue minus costs. But how we calculate revenue is tricky, and how we calculate costs is even harder.

Consider, for example, the difference between buying a robot and hiring a worker. Both are costs, but they are treated very differently by accounting, with big implications for investors. A dollar spent on a robot counts as an asset, with assets sitting across the balance sheet from costs and helping to cancel them out. A dollar spent on employees, in contrast, counts as an expense. That's true even if the spending is on training, which an untutored person would think sounds like an investment.

It gets worse for employees because there is no place in accounting to recognize investments in them. That spending is parked along with "administrative expenses," which includes such things as office furniture, pencils and paper. Investors want to see administrative expenses be as small as possible because it seems to indicate that the business is efficient.

It gets worse for hiring and investments in employees. Of all the expenses that aren't "assets," investors hate employee costs the most. The reason is they count them as "fixed" costs that can't easily be cut if business declines. That puts future profits at risk, and if there is anything investors hate as much as expenses, it is risk because it makes an asset less valuable.

I always thought that idea of labor being a fixed cost was a bit strange, given how quickly most companies get rid of excess workers when business declines. It's far harder to get rid of a capital investment such as a robot when business turns downward. We call them "assets" in accounting, but go ahead and try to unload those robots from your assembly line on Craigslist when you don't need them.

For all those reasons, businesses have a big financial incentive to spend on capital rather than labor and to invest in capital -- machines, robots, even information technology -- to replace labor, even if that swap wouldn't otherwise have made sense. When you run those incentives out over company after company, we see one big reason why capital spending is up and employment is down. (Yes, it's true that, in some situations, equipment is just way more cost-effective than labor, but in others, the accounting issues are enough to keep employers from hiring and then training workers to improve productivity.)

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Accounting throws one more wrench into hiring decisions. Most accounting systems create incentives to engage contractors and temp workers, even for long periods of time, rather than hire regular employees. The reason is that contract work, spending on temps and other ways of engaging workers without hiring them don't appear on balance sheets as "employment" expenses with all the negative baggage of fixed costs. They show up elsewhere, typically as "services." That doesn't look as bad to investors as does hiring the equivalent number of employees, even when they stay just as long as regular employees do and even if the total expenses of engaging contractors or temps is greater than the cost of an equivalent number of direct hires. (It usually costs 25 percent to 30 percent more.)

All this is worth bearing in mind when we think about where the good jobs have gone and what we can do to bring them back.

Peter Cappelli is the George W. Taylor Professor of Management and director of the Center for Human Resources at The Wharton School of the University of Pennsylvania in Philadelphia. His latest book is "Will College Pay Off? A Guide to the Most Important Financial Decision You'll Ever Make."

 

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