MLB's Labor and R&D Formula

Last Updated Aug 19, 2008 1:01 PM EDT

MLB's biggest single expense is player salaries. To the average fan scanning headlines on the sports page, superstar salaries may appear absurd. However, player salaries are determined by market forces, just like any paid position. In fact, MLB's basic labor structure, in place for more than 30 years now, keeps players from charging the full amount their skills would draw on the open market for at least six years, allowing savvy teams to get young talent on the cheap. Indeed, for any successful ball club, understanding labor costs is as important as understanding the basics of the suicide squeeze. Here's how the pros do it.

Why Players Are Most Likely Underpaid

Highest Paid Players in 2007:

  • 1. Alex Rodriguez (New York Yankees): $27,708,525
  • 2. Jason Giambi (New York Yankees): $23,428,571
  • 3. Derek Jeter (New York Yankees): $21,600,000
  • 4. Manny Ramirez (Boston Red Sox): $17,016,381
  • 5. Todd Helton (Colorado Rockies): $16,600,000

Biggest Multiyear Deals:

  • 1. Alex Rodriguez (New York Yankees): 10 years, $275 million
  • 2. Derek Jeter (New York Yankees): 10 years, $189 million
  • 3. Manny Ramirez (Boston Red Sox): 8 years, $160 million
  • 4. Todd Helton (Colorado Rockies): 11 years, $141.5 million
  • 5. Miguel Cabrera (Detroit Tigers): 8 years, $152.3 million

See also: “Passan’s All-Overpaid and All-Underpaid Teams” by Jeff Passan, Yahoo Sports.

This year, 434 players on MLB active rosters will earn $1 million or more, and 85 guys will make $10 million or more. Average pay on opening day 2008 topped $3 million for the first time ever.

Of course, baseball players are professionals with an extremely unique skill set who have reached the pinnacle of their profession — similar to Fortune 1000 CEOs. The average player spends several years in the minor leagues and then another six years in the majors before he can sell his skills for their full value as a so-called “free agent” on the open market. If that still sounds like a short apprenticeship compared to the corporate world, here’s the catch: A study of almost 6,000 players (excluding pitchers) who made it to the majors from 1902 to 1993 found that, even in the modern era (since 1969), an average rookie can expect to play 6.85 years. In other words, the average player’s career is ending just about the time that he’s free to sell his skills to the highest bidder.

The median MLB salary actually has remained at $1 million for three consecutive seasons despite a $600 million jump (10.5 percent) in revenue during that period. In fact, in recent years opening day payrolls as a percentage of MLB’s gross revenues have declined from 55.6 percent in 2002, to 41 percent last year. An analysis by Forbes found that during the past five years, player costs fell from 66 percent to 56 percent of team revenues. The Sports Business Journal reported that the percentage of MLB revenue going to players fell to between 51 and 55 percent in recent seasons.

How MLB Keeps Salaries Low (for the First Six Years)

How is baseball, which doesn’t have a salary cap like the NFL and NBA, managing to rein in its biggest single expense? The answer lays in its unique labor system. For its first century, pro players were locked into annual deals with a single team; then, in the 1970s, the players’ union won the right to free agency, allowing players who had been in the majors for six years and were not under a current contract to sell their skills to the highest bidder. Except for a period in the 1980s when the owners colluded not to sign free agents, average pay has risen ever since, notes Andrew Zimbalist in May the Best Team Win.

In one last attempt to put the genie back in the bottle, MLB tried in 1994 to impose a salary cap that offered players 50 percent of revenues. The ensuing labor dispute led to a 232-day strike that cancelled the World Series for the first time in 90 years.

Still, under a longstanding element of their collective bargaining agreement, teams can severely limit younger players’ pay and negotiating leverage versus the talent market. For his first three years in the majors, a so-called “reserved” player can only play for the team that initially signed him and can be limited to MLB’s minimum wage. Granted, this season, it’s a highly survivable $390,000 — but that’s no matter how many millions of dollars the player’s skills generate in ticket sales and TV ratings.

In The Baseball Economist: The Real Game Exposed, economist J.C. Bradbury finds that reserved position players in 2005 made a median difference of 89 percent less than their estimated marginal revenue product — that is, the dollar value of their contribution to helping their team win.

In his fourth through sixth year, a player still can’t sell his services on the open market, but he is eligible for arbitration of salary disputes. While paid much more than the minimum, arbitration players still make a median difference of 77 percent less than if they were fully compensated for their contributions to team revenues, writes Bradbury.

Just as pharmaceutical companies have 20 years after patenting a drug to bring it to market and lock in profits before generic competition kicks in, Bradbury notes that MLB teams have six years to profit from underpriced-to-market players they’ve discovered and developed before free agency sends the price of their talent soaring. In some cases, teams lock in the future price of their most promising young talent by giving big long-term contracts to players before they approach free agency.

One of the ultimate examples of such payroll management was seen in 2001 with the Oakland A’s, a small-market, low-revenue team that won 102 games (the second most that year) with a lineup that was 62 percent reserved players, 28 percent arbitration eligible, and 10 percent free agents — for a second-lowest payroll of $34 million, notes author Vince Gennaro in Diamond Dollars: The Economics of Winning in Baseball. If the A’s had had the average MLB mix of 35 percent restricted, 23 percent arbitration eligible, and 42 percent free agents, salaries would have cost $104 million that year, writes Gennaro, and the team would have hemorrhaged red ink instead of enjoying EBITDA operating income of $16.3 million, per Forbes — nearly matching the Yankees’ $18.7 million.

The Minor Leagues: 10 Percent on R&D

Unlike the NFL and NBA, which have most of their player development done for them by big university programs, each MLB team spends about $20 million a year to find, sign and develop talent in its affiliated minor leagues. That’s $600 million a year, or 10 percent of last year’s revenues, to support the five-tier minor league system of (from bottom to top) rookie, Low-A, High-A, Double-A, and Triple-A leagues.

While minor-league teams like the Toledo (Ohio) Mud Hens and the Lehigh Valley (Pennsylvania) IronPigs drew a record 42.8 million fans to smaller town ballparks last year, it’s their affiliated major-league teams who assign the players and managers, then foot the bill for salaries, per diem cash, and even part of the cost of bats and balls.

While the pay scale is low ($31,250 minimum for a first-year player with a major-league contract, even less for thousands of others), the MLB teams fork it over for years on end — even for top draft picks to whom they also pay huge upfront bonuses. An analysis by Gennaro of first-rounders from 1995 to 1998 found that it takes an average of 3.4 years to reach the majors — 4.1 years for high school draftees and 2.7 years for players coming out of college. And that’s if they make it at all.

Also, the traditional signing bonuses to lock up first-round prospects averaged nearly $2.1 million in 2007. The Tampa Bay Rays, picking first this year and last, shelled out a combined $11.75 million in bonuses for a shortstop and a young southpaw pitcher, equal to 27 percent of their opening day 2008 payroll. But most bonus babies will fail to pan out; only one out of four first-rounders becomes an MLB regular player.

See also: MLB draft signing bonuses for 2007.

Like a well-performing portfolio of junk bonds, the superstars more than compensate for the flops. An analysis by researchers at the Sellinger School of Business and Management looks at Chipper Jones, drafted by the Atlanta Braves in 1990 and signed with a bonus of $275,000. After making it to the majors in 1995, his contribution to the team in his first year was worth $6.1 million. Meanwhile, his pay was about the rookie minimum: $120,000. During the next five seasons, his play was worth an average of $8.4 million a year to the Braves — then perennial NL contenders — while his pay, under arbitration, reached $4.6 million in 2000.

But Is That Guy Really Worth That Much?

As oddball as some salary outcomes may seem, with the stakes now running to so many millions of dollars, baseball has probably never been more rational or sophisticated in evaluating and valuing talent. In recent years, an increasing number of teams are turning toward the use of sabermetrics, a rigorous analysis of what exactly each player contributes to his team.

Thanks to sabermetrics, teams now can see at a relative glance how well a given player is performing using a stat called Value Over Replacement Player, or VORP. VORP compares a player’s offensive contributions to a theoretical player who hits about 80 percent as well as an average major leaguer. Pitchers can be similarly analyzed and given a VORP for their prowess at preventing runs. Factor in defensive skills for position players, and you get WARP or Wins Above Replacement Player.

See also: Baseball Prospectus’s glossary of sabermetric terms.

Wins mean money for teams in the form of tickets and merchandise sold, sponsorships, and television ratings. Thus, the contribution to wins a player generates with his bat or pitching arm can be given a dollar value.

By way of example, Gennaro in Diamond Dollars cites outfielder Vladimir Guerrero’s 2005 dollar value to his employer, the Los Angeles Angels of Anaheim, Calif. Based on his WARP value, Guerrero’s potent bat (batting average: .317, 32 home runs, 108 runs batted in) generated 8.2 of the Angels 95 wins that year. Based on the size of the Angels’ market and the team’s division-topping record, writes Gennaro, those wins added $10 million in revenue to the team from such factors as a 653,800-person increase in attendance. And with those additional wins, the team made the post-season, which generates millions of dollars in current and future ticket sales — to which Gennaro assigns a net present value accruing to Guerrero of $7 million. That makes Guerrero’s total impact on the Angels in that year more than $17 million, making him well worth the eye-popping five-year, $70 million deal he signed in 2004, which paid $11.5 million in 2005.