(MoneyWatch) Pop quiz: An average performing employee comes to you with evidence that he is underpaid by 5 percent. Your company's budgets are already tight. He makes $50,000 a year. Should you:
A. Offer a 1-2 percent raise; B. Offer nothing. In this economy he's lucky to have a job; C. Offer a 5 percent raise; D. Give him $50 gift card to the local mall.
With job applicants lining up around the block, it might seem like good business sense to let employees quit rather than raising their salaries to be competitive. But a recent study from the Center for American Progress drives home why that isn't so: Employee turnover is expensive.
Turnover costs include productivity losses during training, recruiting and lost work while a position is vacant. For all jobs earning less than $50,000 per year, or more than 40 percent of U.S. jobs, the average cost of replacing an employee amounts to fully 20 percent of the person's annual salary, the liberal-leaning think-tank found in a study that looks at 31 corporate case studies.
So in the above example, choosing to not give even a middling performer a raise may net a temporary cost savings, but if he quits you'll be out 20 percent of his salary. The best option? Bump his pay up 5 percent. Although employee replacement costs are a one-time expense and a salary increase is ongoing, it would take four years of at higher salary to equal the cost of replacing him one time.
High turnover, lower-paying jobs (those under $30,000 a year) are slightly less expensive to replace, at only 16 percent of annual salary, but that still adds up quickly. For instance, 37 percent of hotel/motel and food services employees voluntarily quit a job in 2011. That represents a major expense to businesses already running at the margin.
MIT Sloan business professor Zeynep Ton found that such businesses could reduce their turnover by changing their internal policies. For instance, Wegmans Food Markets, which consistently ranks in Fortune's Top 100 companies to work for (this year it's number No. 4), has a full-time turnover rate of only 4 percent for it's hourly workforce [disclosure: I used to work for Wegmans.] In other words, those same policies that make it a great place to work also lowers turnover costs.
While the costs of losing a "normal" employee are high enough, CAP found that the cost of losing an executive is astronomical -- up to 213 percent of the employee's salary.
CAP also says that offering workers low-cost benefits, such as sick days and a little flexibility, can significantly lower turnover. The upshot is clear: While there is no perfect package of salary and benefits that will stop employees from jumping ship, companies should take turnover costs into account.