(FORTUNE Magazine) – Pop quiz, department of ethical dilemmas:

Say you are in the garment business, and you discover that two of your sewing subcontractors in Bangladesh are using child labor. You also determine that if the kids lose their jobs, some of them may be driven into prostitution. What's the right thing to do? Lay the children off, or keep them working in the factory?

When privately held Levi Strauss & Co. confronted this problem in 1992, it came up with a solution that wouldn't occur to many companies: Take the children out of the factory; continue paying their wages on condition they attend school full time; and guarantee them factory jobs upon reaching 14, the local age of maturity.

The gesture was classic Levi Strauss. This is a company that was paying a lot of attention to issues of worker loyalty and trust long before it became fashionable to do so. In the Great Depression, then-CEO Walter Haas Sr. kept his people employed laying new floors at the Valencia Street plant in San Francisco, while waiting for Levi's business to revive.

These days almost every company faces the same conundrum: businesses have alienated their employees through layoffs and other brutalities, just as the shift to an information economy vastly increases the value of human input. How to win deep commitment from employees? Far more than most enterprises of its size, Levi's has seemed to find solutions. At Levi's U.S. sewing plants, the average length of service is over a decade, while turnover among managers at San Francisco headquarters is just 1.5% annually. In Germany, two openings for management trainees recently attracted 600 candidates.

At the same time, Levi's has been a champion wealth creator. The marketer of 501 button-fly blue jeans and Dockers khaki pants is the global leader in branded apparel and ranks No. 15 among FORTUNE's most admired corporations. Under Robert Haas, chief executive since 1984 and great-great-grandnephew of the company's founder, Levi's shares rose from $2.53, adjusted for stock splits, to $265 last year (the value reported to the SEC as part of a 1996 recapitalization). To give a sense of scale, albeit on an apples-to-oranges basis, that 105-fold increase compares with Microsoft's 122-fold stock price increase since it went public in 1986.

The happy combination of outstanding business performance and conspicuous decency has made Levi's a model for other companies struggling to manage big work forces in an age of unraveling relationships. So it was a nasty jolt indeed when Levi Strauss in February joined the ranks of companies announcing layoffs amid great profitability: The company told employees it plans to slash $80 million from the bloated overhead of its U.S. unit by eliminating 1,000 salaried jobs.

Employees were distressed and confused by the announcement-- Levi's makes no promise of job security, but in practice, says Lindsay Webbe, who recently retired as head of the Asia/Pacific division, "somebody had to be pretty deserving to lose a job." More broadly, the prospect of layoffs cast a cold light on Levi's unusual way of doing things: Are its many innovations actually effective ways to run a business, or are they the indulgences of a wealthy private company whose owners want their virtue to be noticed? As Levi Strauss struggles to get its costs back in line, observers may decide once and for all whether this company's widely admired values and culture are vanity items or templates for success.

Robert Haas is clear about why layoffs are needed: "The remarkable growth of the past decade had some undesirable consequences," he told FORTUNE. "Our focus became diffused. We became less attentive in our hiring, staffing, and cost-control efforts. Management, including myself, all share responsibility."

But Haas insists that the problems have been ones of execution; he has no intention of throwing out the company's unusual philosophy. "Everyone looks at the wrong end of the telescope, as if profits drive the business," he says. "Financial reporting doesn't get to the real stuff--employee morale, turnover, consumer satisfaction, on-time delivery, consumer attitudes, perceptions of the brand, purchase intentions--that drives financial results. I believe that if you create an environment that your people identify with, that is responsive to their sense of values, justice, fairness, ethics, compassion, and appreciation, they will help you be successful. There's no guarantee--but I will stake all my chips on this vision."

He placed his biggest bet so far in April 1996, when the moneyed jeansmaker paid out $4.3 billion to some shareholders in an LBO-style recapitalization, Levi's second leveraged buyout under Haas. Stockholders who sold out got cash, and plenty of it. The cost of buying back nearly one-third of the company's shares added $3.3 billion of corporate debt, which sobered Levi's managers and contributed to, among other things, the recently announced job cuts. With that kind of debt load, says board member Warren Hellmann with impish understatement, "decisions are crisper."

Instead of cashing in, Haas consolidated power and enshrined his management ideas in law. The unusual transaction transferred total control over the company's governance to a four-man voting trust: Haas, his uncle Peter Haas Sr., cousin Peter Haas Jr., and Hellmann, a distant relation who is a partner in Hellmann & Friedman, a San Francisco investment banking firm. The trustees' collective right to stewardship is backed by their families' ownership of over 60% of the company's remaining stock. Haas's personal stake is probably worth more than $900 million today, a big chunk of Levi Strauss's post-LBO market value, estimated at $10 billion.

The SEC document describing the transaction states that those who choose to remain shareholders must "make an explicit commitment to the values currently articulated and practiced by the company." Furthermore, it stipulates that the voting trust "will permit management to run the Company in a manner consistent with the Company's Mission and Aspirations Statement and Business Vision."

The Aspirations Statement to which the document refers is not in itself all that different from what you find in the standard corporate catechism. It stresses commonsense goals, the kind that are usually observed in the breach: teamwork, trust, diversity, recognition, ethics, openness, empowerment, and so on.

What's remarkable at Levi's is the degree to which the company puts its money where its mouth is. Says Peter Jacobi, Levi's brash, bearded president: "We have told our people around the world what we value, and they will hold us accountable. Once you do that, it's like letting the genie out of the bottle: You can't go back."

For instance: Managers' bonus pay, which can be two-thirds of their total compensation, is tied explicitly to their "aspirational behavior"--as measured in twice-annual 360-degree appraisals by subordinates and others. Another expensive gesture of commitment is Levi's new gain-sharing plan. In last year's LBO, the company retired its employee stock ownership plan. To compensate, Levi Strauss promised roughly an extra year's pay to each of its 37,000 workers if the business meets cash-flow goals between now and 2001. That would be a significant transfer of wealth: some $750 million in cash, on top of already handsome base and incentive pay. The plan doubles as an education scheme, enticing workers to learn how their behavior relates to business results.

As you might expect, the combination of extraordinary financial success and obsessive focus on matters of principle can become an enormous pain in the neck. Political correctness and insufferable smugness both flourish at Levi's. The Levi Strauss foundation, funded with 2.5% of the corporation's pretax profits, stopped supporting the Boy Scouts on the grounds that they discriminate against atheists and gays.

"Sometimes I get frustrated with Bob Haas," says Jacobi. "I don't think he's clear enough with the organization about why we want what we want. I think of the aspirations as a business strategy, pure and simple. We can't run this global organization from San Francisco, so we need to create an empowered organization. That's why we work on teamwork and trust and the other aspirations--it supports the way we do business. But I don't know if we have done a good enough job of defining what our values are. We're not in business to create world peace."

Levi's employees, as a rule, seem to buy into the company's self-image. Says Clive Smith, a cutter at Levi's new plant near Cape Town, South Africa: "I worked at another company for ten years. They treated their dogs better than they treated me. When we tell people what it's like working here, they think we're lying. Here, I can talk to the facility manager, the managing director--anyone. You'll have to fish the cops to get me out of here." Across the world in San Francisco, associate general counsel Ruth Meyler expresses similar feelings: "The company where I worked before partook of the classic dog-eat-dog ethos," she says. "When you got dressed in the morning, metaphorically speaking, you had to put on your breastplate and helmet and have your musket loaded. At Levi Strauss, you are the same person at the office and at home. I find that extraordinarily important."

So morale is good, and the company functions cooperatively, more like a guild than an army. But which way does the chain of causation actually go? Does "aspirational" conduct increase the company's profits? Or is it that great wealth, derived from the happy accident of owning a mythic brand, permits the luxury of genteel behavior?

It's possible to make the case that Levi Strauss, with 1996 revenues of $7.1 billion, has been the luckiest company on earth. The company's first big break came in San Francisco in 1873, when Levi Strauss, a bewhiskered, unmarried, German-born dry-goods wholesaler there, was approached by Jacob Davis, a Nevada tailor. Davis needed $68 to file a patent for his big idea: work pants with pockets reinforced by metal rivets to prevent ripping when laborers such as gold miners filled them with rocks and other crude stuff. Strauss provided the cash. Together the partners introduced what they called "waist-high overalls," the shapeless, saggy progenitor of the modern blue jeans.

The second big break occurred in 1969, on Max Yasgur's farm in upstate New York. By then, Levi's comfortable, durable pants, long favored by hard-working proletarians west of the Rockies, had become a symbol of class rebellion. The ultimate flowering of the trend took place at the Woodstock festival, where a sea of jeans demonstrated that baby-boomers had adopted denim pants as the uniform of their generation. Levi's jeans, distinguished by their status as the original blue jeans--and by prominently visible trademarks, such as the bow-shaped stitching on rear pockets--benefited most. Before long, "Levi's" became virtually a synonym for "blue jeans." Says Steve Goldstein, the vice president in charge of American brand marketing: "That was a gift from God that had absolutely nothing to do with our marketing acumen."

According to Leo Isotalo, Levi's third major stroke of luck was its competition. Isotalo ran several overseas operating groups during a 13-year stint that ended in 1989. "A fair amount of the current success of Levi Strauss," he says, "is attributable to the ineffectiveness of their branded competition."

Levi's principal competitor in blue jeans is VF Corp., the $5.1-billion-a-year diversified apparel business behind the Lee and Wrangler brands. In the U.S., VF's 27% share of jeans unit sales is higher than Levi's, but on a worldwide basis Levi Strauss rules. Whereas the San Francisco company discovered the magic of brand marketing, VF fought back with superior manufacturing and distribution. Result: VF boasts lower costs and replenishes stock more efficiently, but consumers happily pay more for Levi Strauss pants. Financially, that gives Levi's the long end of the stick: At the end of 1995, the last year Levi Strauss & Co. reported its financial results to the SEC, its gross profit margin of over 40% exceeded VF's by more than ten percentage points, a superiority that translates into mountains of spendable cash.

Lucky Levi Strauss has been, but luck does not begin to explain its performance. By April of last year the company had increased its total market value roughly 14-fold since 1984, when Bob Haas took over--far more than VF, far more than the booming stock market itself, and nearly as much as Coca-Cola, an all-star value creator. Granted, the financial engineering in Levi's two LBOs greatly enhanced results, what with buyout premiums and leverage. The retirement of millions of shares of stock--some 30% of the total outstanding--in the recent LBO increased the amount of Levi's corporate wealth attributable to each share that remained, dramatically boosting per share returns. At the same time, the deal reduced the total value of Levi Strauss by the $4 billion that was paid out in cash to shareholders. But plain, old-fashioned net income has multiplied by a very handsome 18 times during Haas's tenure, to $735 million by the end of 1995. By the end of 1996, revenue, that supreme measure of creativity and customer satisfaction, had tripled under Haas.

Furthermore, there is no doubt that Levi Strauss's mythic business was in flames by the time Haas took charge. Cashing in on what must have seemed like limitless growth in blue jeans, Levi's family shareholders had taken the company public in 1971. Under CEO Walter Haas Jr., Bob's father, and successor Robert Grohman, an outsider CEO hired from Playtex, Levi Strauss gradually shed the paternalistic ways it had cultivated for generations. It tried to behave like a normal public company, responding to Wall Street's demands. The outcome was disaster.

Chasing demand, Levi's added factories to make more denim and corduroy pants. To please security analysts, it diversified into hats, rainwear, and men's suits. Thinking strategically, it extended the Levi Strauss brand into skiwear. All three gambits failed. Employees, scattered throughout fieflike operating divisions, were consumed by infighting. Numbers mattered more than people, and by most accounts, the caring Levi Strauss culture was crushed. By 1984, net income had plunged more than 80% from the peak four years earlier. Levi's shuttered or sold one-quarter of its U.S. factories and reduced its work force by 15,000 people, nearly one-third of total employment.

By the time he succeeded Grohman, Bob Haas says, he was "deeply troubled" by what Levi Strauss had become. He describes the debacle in terms that resonate today: "The trust in the company and its leadership in particular was shattered," he says. "Unfortunately, the reason was that we in management had screwed up. I was part of that."

Haas had arrived at Levi Strauss in 1973 as an executive demanding enough to earn the nickname "Z.D.," short for "zero defects." He had set out in life with an inheritance of some $10 million but soon established a record of achievement: valedictorian at Berkeley, a Baker scholar at Harvard's business school, a White House Fellow under L.B.J., and a consultant at McKinsey & Co. He also marched for civil rights and served in the Peace Corps in West Africa's Ivory Coast.

Today, at age 55, Levi's highbrowed CEO is deliberate and meticulously thoughtful, with sad, basset-hound eyes behind hip glasses, and the stooped posture of a tall guy who would prefer not to stand out. He strictly limits his activities to work, family, and philanthropy, arriving at the office around 7 a.m., leaving around 5:30 p.m., and falling asleep by 9 p.m. He keeps an AIDS ribbon taped to his office computer.

Haas sometimes seems like a study in counterphobia, the psychological term for doing what you fear most. He's obviously shy, for instance, but pushes himself to mingle with workers. At Employee Appreciation Day last year, the self-conscious Haas showed up in a ridiculous western outfit that included leather chaps and a holstered six-gun. As a manager, he has spent his career letting go of the control he once cherished. Says Tom Tusher, 55, who long served as president of Levi's and is Haas's most intimate business counselor: "Bob had a change of heart while working under Grohman."

Yet Haas's steely side still shows. "I'm very good at saying no," he says. When some family shareholders proposed taking the company public again last year, the CEO quietly warned he'd quit. Instead, his own plan prevailed, creating the voting trust that now allows Haas to wield power delicately from a position of unassailable strength.

When Haas took charge in 1984, he set about making Levi Strauss more like the family business it had been. One of his first moves was to take the troubled company private in a $1.7 billion LBO, briefly the biggest in history. Another was to take his top managers offsite and tell them, "I don't have the answers, and you don't either. We've got to listen, be open to influence."

Haas's theory was simple: In their relationships with employers, people crave the same basic qualities that make other human relationships succeed.To overhaul the way the company went about its business, Levi's published the aspirations statement in 1987. It fizzled. "Basically, nothing happened for a couple of years," Haas concedes. The situation began to change only after the company supported its aspirations with a curriculum of courses. Since 1989, Levi's has trained half the company's employees and most of its managers in three required courses: leadership, diversity, and ethical decision-making. For managers, each course lasts a full week.

The courses contain a good measure of personal confrontation. During leadership week, participants are challenged by feedback that rates them on personal qualities such as credibility and fairness. Diversity training focuses on different issues from country to country: In male-dominated Japan, the training emphasizes the role of women, while in the Czech Republic, the effort is to get people to work with what one local manager called "those dirty Gypsies." The ethics course teaches a method of decision-making that tries to consider every relevant point of view. In practice, it produces surprising results, such as the decision to pay Bangladeshi children to attend school until they are old enough to work.

Lots of companies, from Motorola to Sears Roebuck, provide excellent training. What made Levi's courses particularly effective is less the course content than a simple device tacked on at the end: Each compulsory training program concludes with a request for feedback on the gap between stated ideals and the actual practice at students' workplaces.

Not surprisingly, the first reported gaps concerned compensation. Middle managers noticed that senior executives got more than their share of rewards, and that aspirational behavior was not rewarded as well as shipping lots of pants. The company responded by expanding eligibility for the bonus pool from 400 to 10,000 employees. Then it devised a new appraisal system that linked those rewards to performance in four categories, one of which is aspirational behavior. To collect any bonus at all, a manager must score well in all four categories. "At first we thought the aspirations were the flavor of the month, but that got our attention," says Waddell Blackwell, a Levi's veteran who runs the company's South African unit.

Gradually the company created linkages between values, training, gap analysis, and employee appraisal and compensation that add up to an integrated, systematic approach to management. Rank-and-file Levi's workers have learned to depend on the published aspirations as a standard of behavior that is enforceable within Levi Strauss. The quality of enforceability is what distinguishes Levi's approach. The difference is not an intellectual breakthrough but a matter of commitment and perseverance.

Says Haas: "What I like is the idea of transparency. Everybody knows that people are watching. Our values are really our conscience. The fact that people realize that the outside world and our own employees are watching forces them to be thoughtful about the consequences of their actions."

What does this mean for day-to-day management? Task forces. Lots of them. Of course, this is a horrifically time-consuming way to run a company: Tom Tusher, Levi's former president, says he spent roughly a full day each week in management meetings. But devotees insist that collaboration ultimately saves time. Argues Carl von Buskirk, head of Levi's European operations: "It might take longer to get to the decision, but the buy-in, support, and implementation of that decision happens much more rapidly."

And whatever you think of management by committee, the results for Levi's generally have been superb. After Haas took over, Levi Strauss changed its business focus from manufacturing to marketing. Within marketing, its concentration on the very center of the target has been maniacal. Although the company sells baggy, zippered, and wide-leg pants to customers of all ages, it aims its advertising relentlessly at kids ages 15 to 19, and usually promotes just the 501 jean that is the direct descendant of the waist-high overall. Virtually unknown outside the American West before 1984, 501s now account for an estimated one-third of Levi's U.S. jeans sales.

Overseas, Levi Strauss pushed from a small base in Europe into more than 40 countries, pitching its trousers as icons of an idealized America. The strategy took guts, considering that non-U.S. operations had been bleeding during the early 1980s. The gamble paid off: Overseas markets have since produced most of Levi's revenue growth.

To recapture the wandering interest of boomers as they mutated from rebels into golfers, Levi Strauss created the Dockers line of casual cotton pants. The company had failed before with a similar gambit in branded sportswear. This time the reward was huge: Dockers became the market leader, with annual sales approaching $1 billion. In late 1996, Levi's added another brand for conservative boomers, a line of men's dress slacks called Slates. With Slates already a winner in high-end department stores, Levi's seems to be hoping for another billion-dollar brand.

But the management approach responsible for these triumphs also led to some major goof-ups, and ultimately to the destruction of 1,000 jobs. Of these mistakes, the biggest was a well-intentioned but wildly overambitious effort to improve the service Levi's provides to U.S. retailers--a case study in reengineering gone wrong.

Brilliant at pleasing the consumers who wear its pants, Levi Strauss & Co. had often annoyed its actual customers, retail stores. Orders took as long as 60 days to ship, resulting in empty shelves and lost sales. The troubled reengineering project began with the modest goal of creating electronic-data links with Levi's biggest customers. Like the army of mops in the "Sorcerer's Apprentice" section of Fantasia, the plan expanded until it became a cosmic rethinking of the company's U.S. supply chain. Haas's dream was to leapfrog to industry leader in service.

The cost of this huge, complex, technology-intensive project swelled from $500 million to $850 million, amid vast disruption and stress. The plan called for state-of-the-art automated distribution centers, and computer systems that went beyond the state of the art, leading to investments of hundreds of millions of dollars developing new software and systems. In reengineering war rooms, walls got covered with process maps and colored charts--green for no problems, yellow for some problems, red for stoppers. Yellow and red became the colors of the day. Eventually, says Tom Kasten, vice president for reengineering, "it became clear to us that what we were trying to achieve was not doable."

In 1994, Levi's board rebelled after a presentation in which Kasten tried to justify a budget that already had ballooned to $800 million. Eventually the chastened reengineering group added years to its ambitious schedules. Reflects Hellmann: "This has been extremely painful. Had this begun in 1986 or 1987 or 1988, the board and management would have been much more critical much earlier. We would have had less of the atmosphere of 'Well, we've got a lot of cash, the business is doing wonderfully, we can spend our way through this thing.' We were too casual at the outset."

Levi's collaborative management system may not have caused the problem but certainly didn't avert it. Group discussions are most fruitful when they tap knowledge previously locked up in individuals. But when a bunch of highly aspirational pants experts try to envision the inventory-forecasting software of the future, their openness and honesty and respect for one another's opinions cannot alter the fact that none of them really know what they are talking about. Says an observer: "There's a tendency not to say that the emperor has no clothes." Management inattention also played a role. Haas, an early proponent of the reengineering, was criticized in his 1996 performance review for his distance from Kasten's project.

Once the leveraged buyout transaction closed, however, a tidal wave of debt compelled financial discipline. "You can get real sloppy," concedes Jacobi. "The debt has given us an increased sense of urgency. We're taking a second look at things."

Not a minute too soon: competitors are starting to gain at Levi's expense. In the U.S., growth in denim pants is fastest at the high and low ends of the market, where Levi Strauss faces tough competition from pricey fashion pants such as Tommy Hilfiger's and inexpensive store brands such as Sears Roebuck's Canyon River Blues or J.C. Penney's $1-billion-a-year Arizona line.

The layoffs are more a cultural crisis than a sign of serious trouble in the pants business. For a $7.1-billion-a-year corporation, cuts of $80 million amount to a fleabite. Early retirements should take care of roughly one-quarter of the 1,000 jobs Levi's plans to eliminate, so probably no more than 750 people, just 2% of total employees, are at risk. And no one doubts that the company will treat the victims with its usual compassion and generosity.

No, the potential danger here is in the minds and hearts of Levi's employees. The company's aspiration statement is mute on the question of job security, but the company's behavior has given workers ample reason to expect it. Despite the temptation of much cheaper labor overseas, Levi Strauss has struggled to maintain its U.S. manufacturing base, which still provides nearly 18,000 jobs. Similarly, the company recently avoided layoffs at its South African plant, despite a temporary decline in local sales so steep that unsold inventory was stacked in the employee cafeteria.

Squeamishness was part of the mix. Karl Slacik, Levi's chief financial officer during the early 1980s, learned his trade under ITT's famously cold-blooded Harold Geneen. He says that while "cleaning up" Levi's finance department, he once fired a longtime employee he regarded as lazy and insubordinate. "It was a very traumatic experience for the whole company," Slacik recalls. From then on, he used gentler methods--and eight years later, he says, he was still cleaning up.

There's nothing wrong with compassion, heaven knows, but Levi's reluctance to expose workers to market forces gradually weakened personal accountability and robbed the company's guiding principles of their clarity. Wealthy and magnanimous, Levi Strauss allowed its employees to forget one of the great economic lessons of our age: that job security is dead and gone.

This is a company that needed a kick in the pants and got one. Now it's time for Levi Strauss to distinguish between its juicy management ideas and the peach fuzz that surrounds them. If Haas and his colleagues can manage that, other companies may be emboldened to learn what Levi Strauss can teach about earning workers' loyalty and trust.

REPORTER ASSOCIATE Jeanne C. Lee