Wal-Mart, AT&T, and Goldman Sachs are giants in their respective industries and routinely rank among the world’s most profitable companies. In the last four quarters for which information is available as of the date of this post, Wal-Mart earned net income of $15.1B, AT&T earned $12.8B, and Goldman Sachs earned $10.3B. Each of these numbers is staggering, but consider another few morsels of data. Wal-Mart reports having 2,100,000 full-time employees. AT&T, 267,720; Goldman Sachs, 38,900. If you’re looking for a quick answer as to why employees of Goldman Sachs so well-paid, whereas Wal-Mart is often accused of squeezing its ‘associates’ at every turn – divide the figures above. On a per-employee basis, Wal-Mart earns roughly $7,200; AT&T, $48,000; and Goldman Sachs, over $260,000. And these profits are calculated even after taking into account the cost of compensating employees! The reality is that the average employee of Goldman Sachs generates more profits for shareholders than does an employee of Wal-Mart by a factor of 35. Forgetting about questions of justice and merit for a moment: should it be so surprising that the pay of an average employee of Goldman Sachs is many multiples greater than that of an employee of Wal-Mart?
My former colleagues at McKinsey argue that profit per employee is a meaningful measure of corporate performance; in particular, of how effectively firms in knowledge-intensive sectors leverage their intellectual capital. (Didn’t that sound so consultant-esque? Full disclosure: I contributed to the research cited in the link.) My choice of companies for the purpose of this comparison is meant to make a similar point.
- Wal-Mart’s business model is highly labor and capital-intensive; it’s a logistical masterpiece that sells many goods, on impossibly thin margins, at prices competitors can’t match. The competitive advantages of Wal-Mart include its size, lean-ness, and omnipresence. Only a small percentage of employees are truly critical to this equation.
- AT&T generates its income through a combination of labor- and capital-intensive, traditional telecom business lines; and higher-margin business lines (such as wireless), which include some deliciously rich opportunities to generate almost free money from roaming charges and ringtone downloads. Certain populations of employees are largely fungible in terms of the overall business plan of AT&T, e.g., those in customer service; others, perhaps highly skilled engineers who come up with the grand designs for the next wave of wireless infrastructure, can directly influence huge successes or failures of the enterprise.
- Goldman Sachs… well, most people probably have no idea how Goldman Sachs makes money, beyond the suspicion that it must be nefarious. Truthfully, many of Goldman Sachs’ employees are not as critical to the enterprise as they might like to believe, but theirs is also a lean organization in which the costs of unwanted staff turnover can be significant. Almost any business function, from big-ticket deal-making to trade reconciliation, carries meaningful economic consequences for success or failure. It is up to the firm’s employees to create ways to profit from the firm’s financial capital and other intangible assets (e.g., intellectual capital and privileged relationships).
To take the argument to an extreme: why do certain hedge fund founders earn billions of dollars? Because hedge fund management companies are contractually entitled to a percentage of the dollar profits that investors realize; and hedge fund founders typically own the lion’s share of the economic interests in the management company. This is a thoroughly ridiculous arrangement that the market seems to tolerate; I will come back to this another time. But, indulging for a moment: it is not unreasonable to assume that a hedge fund management company may run $5B with a staff of, say, 100. In a year where their investments are up 20%, they will generate $1B in gross profits, of which investors might receive $800M and the company receives $200M. In other words, the average employee ‘earns’ the company two million dollars, roughly a factor of 8 greater than our Goldman Sachs superstars, and over 275x the employees of Wal-Mart. And people wonder why Goldman Sachs gets jealous about hedge fund compensation!
Defenders of Wall Street pay practices often make tone-deaf arguments about how hard their professionals work, and how the pay is necessary to “retain top talent.” Many people toil in unglamorous roles and if ‘working hard’ were a meaningful criterion for determining pay, there would be many more millionaires coming out of slaughterhouses and classrooms.
A more intellectually honest argument (which I am going to make in a tone-deaf way, just to be clear) is that Wall Street is one of the few sectors of the economy in which a significant proportion of workers are not individually irrelevant to the success of the enterprise. Wal-Mart may have some extraordinarily competent and diligent minimum-wage staffers in its stores, but the consequences of their exceptional performance is virtually invisible in the results of the enterprise. However, the departure of just one senior investment banker and her small team could cost Goldman Sachs millions of dollars in annual revenue. When the performance of a specific individual is so closely tied to the economic results of the enterprise (particularly if it is tied in a measurable way) it is obvious that such an individual will be positioned to capture a significant share of the value they create for shareholders.
This observation holds across other sectors with professionals who are generally paid well, and where some individuals receive shockingly high compensation: law, technology, medicine, media, sports, etc. It is tempting to draw the wrong conclusion that these salaries are a justified consequence of individuals’ effort and educational attainment (e.g., in law or medicine) or of individuals’ innate talents (e.g., among celebrities and star athletes). Those may matter, but they are nothing without a context in which they belong to someone who has measurable individual influence over the success of a commercial enterprise. Many talented athletes will never play professionally. Many exceptionally smart and highly-educated people will not have (or seek) the opportunity to become a partner at a white-shoe law firm.
A much better question to ask with respect to compensation, particularly on Wall Street, is: why are certain roles (and the people who fill them) so critical to the success of the enterprise? The head of a major trading desk is in a unique position among human worker bees: he or she can make or lose millions (in some cases, billions!) of dollars. Billions of other humans will never have that chance – but of course, at least three billion people out there would be better than average at it. To put a less facetious point on it: why is there rarely an attempt to normalize for the conditions that enable certain individuals (by virtue of their institutional roles as well as their innate abilities) to exert significant individual influence over the results of the enterprise? I will explore this question next time.
Some house-keeping notes on the above:
- Any company data cited above were pulled from Yahoo! Finance on 1/20/2011 and pertain to the most recently available SEC filings as of the date of this post
- One can quibble over how to appropriately measure profitability; I choose GAAP net income here because it’s consistent, but I would argue that the choice is immaterial to my argument
- AT&T reported an $8.3B increase to its Q3 2010 net income as the result of a one-time tax settlement with the IRS, which I subtract from the reported GAAP net income to arrive at the figure I report above; again, I claim this is immaterial to my argument