Years ago, I took a class called “Managing With Influence” from Jeffrey Pfeffer, professor of organizational behavior at Stanford University and author of the book subtitled “Profiting from Evidence-Based Management.” During the class, Professor Pfeffer claimed layoffs do not improve financial performance – except in the very short term. He based this on a careful analysis of multiple studies over a wide range of economic environments.
On the surface, it’s not surprising layoffs are correlated with poor corporate performance. After all, when times get tough, most companies react by letting people go. However, the research suggests that downsizing does not improve performance and, in many cases, can compound the issues. This is the downside of downsizing.
Pfeffer summarized the related research in the Valentine 2010 issue of Newsweek. In the article, Pfeffer debunks several myths about layoffs:
- Layoffs do not result in higher stock prices, either immediately or over time.
- Layoffs don’t improve company productivity.
- Layoffs don’t increase profits.
- Layoffs don’t even reliably cut costs.
- Layoffs reduce morale and increase fear in the workplace – even more than companies realize.
Having been through several downsizing events, I can confirm many of these are myths. However, I was a bit surprised by the claim that downsizing doesn’t increase profits. After all, companies almost always focus on profitability as the primary reason for the layoffs.
By what of explanation, Pffefer cites a 122-company study which found layoffs reduced subsequent profitability, even after statistically controlling for prior profitability. The negative consequences of layoffs were even more evident in R&D-intensive industries and in companies that experienced sales growth. Similarly, a Harvard Business Review study showed that companies with no layoffs outperformed those that downsized, even if the comparison companies had similar sales growth rates.
I believe the underlying reason is timing. While the average recession lasts ~11 months, it typically take 3-6 months to recognize a downturn and another 2-3 months to institute layoffs. Once severance packages, temporary declines in productivity and quality, and rehiring/retraining costs are taken into account, companies only earn a financial payback if they don’t replace workers for at least 18 months. Unfortunately, by that time, the recovery is usually in full swing.
So why do companies use layoffs if the evidence is they don’t work? Erik Van Slyke blames greed, noting that cash saved via layoffs can be applied to executive compensation. Art Budros of McMaster University provides a less sinister explanation; a 15-year study suggests firms are just copying the behavior of their peers.
The latter explanation rings true to me. Companies use layoffs to handle difficult environments primarily because they’ve always done so in the past. After all, change is hard and therefore companies (and people) tend to avoid change.
Perhaps the way to avoid the downside of downsizing is to do something different.