The Department of Labor announced in late June a proposed change to the threshold annual salary for overtime-exempt employees from the current $23,660 to $50,400. This change will greatly affect small businesses.
One thing politicians seem to forget is that when they change the rules to try to force higher pay, the money has to come from somewhere. There are only three places from which it can come: the profits of the business (or perhaps the owner’s compensation), the customers or the employees themselves.
We’ll explore each, using this example: A company with approximately $5,000,000 of annual revenue with 15 employees who are currently classified as exempt from overtime and make an average of $35,000 per year and work approximately 50 hours per week.
1. The profits of the business
One approach is to divide the employee’s salary by the standard number of straight-time work hours in a year (2,080 hours) and make this their new hourly compensation. For the employees that make an average of $35,000 per year, this would be $16.83 per hour.
If these employees work an average of 50 hours per week, the employer would have to pay 10 hours per week of overtime. Given our example of 15 employees making this amount and assuming that the employer will pay overtime 46 weeks out of the year (because of vacations and holidays, the employer won’t pay overtime for six weeks out of the year), the costs will increase by $174,191 per year ($16.83 an hour times 10 hours a week times 1.5 times 46 weeks with overtime times 15 employees).
In effect, each employee will get an $11,613 per year raise ($174,191 divided by 15 employees). This will represent a 33 percent pay increase for these employees. If the employer does nothing else, he or she will have to survive with $174,000 less per year in profit. Many small businesses couldn’t survive that. Therefore, we don’t think many small businesses will choose this option.
2. The customers
Employers could try to pass this cost increase onto customers in the form of a price increase. In our example, that would be about a 3.5 percent increase ($174,191 out of $5,000,000). This may work if all of the employer’s competitors increase prices as well. If not, it is likely that the price increase will result in a loss of sales volume. This would of course reduce profit, so the employer would still be funding, at least a portion, of the cost increase out of his or her pocket.
By the way, depending on the amount of volume the business loses, it may find that it needs to reduce its costs by laying off some of the very employees the new rules were intended to help -- another example of the law of unintended consequences.
3. The employees
Finally, the employees themselves may be called on to fund the changes. One way this could happen is to set an hourly pay rate that will mean that they work about the same number of hours per year they are currently working and make about the same total compensation they are currently making.
For this example, let’s assume that the employees will be paid straight time for 2,080 hours each year (40 hours a week times 52 weeks a year). The employer will also pay each employee 460 hours of overtime (46 weeks a year times 10 hours a week). Because overtime is paid at time and a half, the 460 hours of overtime would be the equivalent of 690 straight time hours (1.5 times 460). This means that the employees will be paid the equivalent of 2,770 straight-time hours per year (2,080 plus 690).
If the employees were paid $12.64 per hour, they would make approximately the same thing they are currently making: $35,013 ($12.64 a hour times 40 hours a week times 52 weeks a year plus 10 overtime hours a week times 46 weeks with overtime times $12.64 times 1.5). This keeps the employer whole and has the advantage of leaving his or her employees whole -- they work the same number of hours and make the same thing as before the change.
A second way that employees might be called on to fund the change is through increased productivity. Many employers allow salaried employees considerable flexibility. For example, they might be able to take a longer lunch break to run errands. Watercooler chat with colleagues is accepted. Checking Facebook or personal email is allowed. All of these things are fine because the salary is fixed and the job has to get done. Time spent on other activities during the day simply means working later to get the job done. Once employees become hourly, employers would be reasonable to demand an end to these types of activities.
Another option would be to hire additional employees to do the work on straight time and keep the business whole. In this case, the employer would determine the straight time hourly wage by dividing current compensation by the total number of hours worked.
In our example, $35,000 divided by (2,080 plus 460) equals $13.78 per hour. Employees would then be limited to working 40 hours per week. To make up the slack the business would hire three additional people at the same rate (460 formerly overtime hours times 15 people divided by 2,080 hours per year per person). This business would still be a third of an employee short, but could make this up with increased productivity or by hiring a part-time person.
The employer’s costs would remain unchanged. The employees would work fewer hours, but would actually see their compensation decline to $28,662 (an 18 percent pay reduction) -- another example of the law of unintended consequences.
The new regulations are coming and businesses will have to comply. Employers have options, but will need to put a plan together before the new rules take effect.