The Paradox of Cheaper European Labor

I was at JPM Healthcare in early January, and as always, there were a lot of conversations about efficiency, cost structure, and where companies should be placing work. A recurring theme, especially from European executives and service providers, was the idea that companies should be outsourcing more work to Europe because labor prices are so much lower.

The argument sounds compelling at first glance as labor in Europe is much cheaper and there is abundant high-skilled talent. But the question I kept coming back to, and the one I want to address here, is a very simple one: “are companies in Europe actually more profitable?”

The answer interestingly in short is NO.

When you look at various business models such as contract research where I have spent a lot of time, the margins of businesses in the US and Europe are largely the same and, in some cases, they are even lower in Europe. That raises a more interesting and much harder question which is “How can companies with dramatically lower labor costs end up just as efficient, and no more profitable, than companies in the US that are paying three times as much for the same level of talent?”

There is a persistent tendency in business to think about labor in purely first-order terms where people look at wages in different geographies and assume that lower wages automatically translate into higher profitability. In some industries, especially capital-light ones, that assumption can hold for a while. In services businesses, and particularly in highly collaborative, knowledge-driven services like contract research, it very often does not.

For example, in the US, a PhD-level scientist will typically cost at least $120,000 per year in salary alone, and much more once benefits and payroll costs are included. In Europe, depending on the country, that same PhD scientist might earn $40,000 per year. If labor represents 40 to 50 percent of total expenses, which it often does in lab services for example, it is easy to convince yourself that moving work to Europe should dramatically improve margins.

That is exactly where many management teams stop thinking as they see the wage differential, build a simple spreadsheet, and make strategic decisions around outsourcing or geographic expansion. When you actually examine the financial performance of European CROs versus US-based CROs, the expected margin advantage is not there. The gross margins and EBITDA are similar despite much lower compensation rates and thus the situation is much more complicated than a first order problem.

There are several reasons for this, and they tend to reinforce one another. The first is labor efficiency, not in the sense of intelligence or effort, but in how time is used in real organizations.

European scientists are highly trained and capable, but Europeans work fewer hours per year than Americans, typically by 15 to 20 percent, and sometimes more depending on the country. There are more vacation days, more holidays, and more formal sick leave within Europe. On its own, that difference does not seem large enough to explain the lack of margin advantage. However, the issue is not the reduction in hours itself but is the compounding effect those reductions have in collaborative environments.

Modern work is not solitary where projects require constant interaction between scientists, project managers, QA, clients, and leadership. When one person is unavailable, progress slows and when different people are unavailable at different times, progress often stops. Anyone who has tried to execute a complex project during August understands this intuitively where a project that should take two weeks turns into two months. Even a modest reduction in annual working hours can lead to a much larger reduction in throughput because of delays, handoffs, and lost continuity.

This is where the math breaks down as a 20 percent reduction in hours does not lead to a 20 percent reduction in output but can actually compound to a much more signficiant reduction in productivity and this alone erases a large portion of the wage advantage.

The second factor is workforce flexibility as service businesses and many businesses live and die by their ability to balance supply and demand. When work increases, you need more people and when work decreases, you need fewer people. In the United States, this flexibility exists as hiring is relatively fast and reductions in force, while painful, are legally straightforward. Companies can respond to demand fluctuations by adjusting headcount and utilization which allows them to run leaner organizations and maintain higher productivity per employee.

In Europe, this flexibility is severely constrained as hiring takes longer and letting people go is difficult, slow, and expensive. Employment protections, notice periods, severance requirements, and regulatory processes make rapid adjustment nearly impossible.

The rational response to this environment is to overstaff and many European businesses tend to hire ahead of demand to avoid being caught short. They build buffers into their organizations because scaling up later is hard but when demand softens, they cannot easily scale down, so utilization falls. This has a subtle but powerful effect on productivity which is that if one unit of work is handled by one person in the US, that same unit of work might be handled by one and a half people in Europe. Once this normalization sets in, it is extremely difficult to reverse and executing 0.75 units of work per person becomes the norm. Asking people to suddenly work faster or handle more output runs directly into cultural expectations and legal constraints within organizations.

The third factor is overhead as European labor laws do not just affect headcount decisions but they increase complexity across the entire organization. Payroll is more complicated, benefits administration is more complicated, legal compliance is more complicated and many European businesses operate across multiple countries, each with its own regulatory framework. This drives up SG&A costs in ways that are easy to underestimate as larger overhead teams are required and country-specific processes proliferate along with additional management layers.

In the United States, labor law is comparatively simple and that simplicity enables more centralized operations, leaner corporate structures, and lower overhead as a percentage of revenue. Taken together, these factors explain why lower labor rates in Europe do not necessarily translate to the bottom line even though it seems as though they should wherein they get converted into lower utilization, slower execution, and higher overhead.

There is another important implication that often gets overlooked. Because scaling up and scaling down is so difficult in Europe, companies there are less resilient to changes in the macro environment. When demand drops, costs do not fall quickly and when demand rises, capacity cannot expand quickly which makes many European businesses more fragile in downturns and less responsive in upswings.

None of this means that outsourcing to Europe is inherently a bad decision as European scientists are excellent, and quality is often very high but it does mean that the secondary and tertiary consequences of outsourcing can outweigh the first order benefits.