The Downside of Downsizing

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.

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13 Responses to The Downside of Downsizing

  1. Jeff Stiles March 14, 2010 at 7:37 pm #

    Your ending paragraphs present perhaps the strongest argument overall. It is hard — but possible — to drive meaningful organizational organizational change.

  2. Mike Mankowski March 15, 2010 at 7:05 am #

    Layoffs appear to be the “easiest” solution, even though you note that they don’t really impact profitability. I agree with Jeff that the last line is spot on – layoffs for the sake of the past. Not sure this myopic behavior will change anytime soon.

  3. nmarks March 15, 2010 at 10:29 am #

    I believe layoffs only work when they are the result of a re-examination and re-working of the organization, its strategies, goals, priorities, processes, and organization. There may be a need to combine people restructuring with capital program changes – and even enhancements, to replace manual with automated processes.

    An across the board do-what-everybody-else-does program costs money and rarely results in retention of customer loyalty, opportunities for growth, improved innovation, and efficiency.

    I believe people do it because it is expected and an easy answer.

  4. Aiaz Kazi March 15, 2010 at 10:30 pm #

    Interesting article. A few comments

    I agree with the overall premise that more often than not layoffs have more of a downside and fail to deliver any real benefits. I also agree that the timing of a layoff matters and that layoffs create uncertainty and doubt in the workplace beyond what is expected.

    The point about historical precedent is valid but does not completely explain the behavior of companies laying off employees for the first time. For public companies I do believe there is a combination of historical precedents at play here – the first of the layoffs in the industry the company is in, and the second of how Wall Street has rewarded those layoffs in the short and medium term. This the point nmarks makes in his last sentence “I believe people do it because it is expected and an easy answer.”

    Finally, layoffs possibly work under 2 scenarios – an honest re-evaluation of the business (nmarks captures this well) and the other one where companies engage in periodic and controlled catharsis to trim the fat, but the latter scenario only works if “trimming the fat” has been established as an ongoing practice in the company.

  5. Robert E March 16, 2010 at 2:56 pm #

    Layoffs are sometimes unavoidable. One of the best CEO’s I ever worked for had previously been at a company where his first duties after taking over as chief executive was to layoff a significant number of the staff. The layoffs continued as that company went out of business.
    He was chastened by that experience and when I worked for him, at a different company, he made sure to prevent that kind of situation from repeating. Sure, that meant a very lean staff that worked hard and were conscious of doing more with less.
    I admit, it took time for me to understand the value of this approach, but I ultimately was rewarded by being able to stretch my abilities and grow; it gave me a better understanding of business and opened opportunites for me that I am still benefiting from today.
    While sometimes layoffs are unavoidable, there are other options when dealing with down times that can go a long way in benefiting the company and the employees that work for it.

  6. peterwtc March 17, 2010 at 2:15 am #

    To a greater extent I agree that layoffs are a hindrance to corporate performance. Take a look at publicly-traded corporations, during a downturn,they feel investor pressure to cut costs and meet earnings expectation hence massive layoffs. However,what senior managers tend to forget is that such practices do not add value in the long-term. The sources of value creation are in peoples know-how and their passion to perform and I believe organizations should create environments that allow such talent to shine. An environment where there is constant talk of layoffs always result in demotivation of better-performing employees and in some cases leading to unplanned earlier departures by key employees. Management must strive to increase bottom-line performance by getting more from existing resources rather than remove them with layoffs.

  7. denpeartree March 18, 2010 at 7:34 am #

    Thanks for the insight. Reducing the workforce may be necessary when demand for products and services decrease. However, because of the focus on stock prices, layoffs may be viewed as a quick way to to boost stock prices in the short run and increase corporate management’s wealth. Stock prices always seem to increase immediately after a layoff announcement.

  8. Adam Kern March 21, 2010 at 6:14 am #

    Layoffs are always a very difficult proposition. Sometimes, however, they can be a good cost cutting measure. I think that many people sometimes overlook the fact that layoffs sometimes just include hiring freezes as many companies include open FTE’s as current headcount. I was very interested in some of the comments of your instructor. Coming from my own experiences, it is a challenge to keep a good moral and work ethic in a very unstable environment. The current ecomonic conditions are creating unique issues vs. anything that I’ve seen in my career. I do believe that if companies take the time to nurture their internal resources and boost moral that you will see a revamped organization who are all dedicated to improving the comapany in all facets: Product development, sales, marketing and of course financial results. It’s a shame that managing the share price seems to usually dictate the path of an organization. Sometimes you need a drop to walk downhill to see the brighter picture.

  9. Rob March 21, 2010 at 4:56 pm #

    Jeffrey and Robert’s book got me to thinking not only about the “half truths” that are perpetuated, but how they are perpetuated. At some point, people need to come up with theories (e.g., layoffs increase profits) then these theories get perpetuated by consultants and even built into analytics systems that likely have some bias towards proving the theory true. If I’m a manager, it is easy to ask and answer the question, “how much operating expense will I save and how much will my one time charges be to downsize x%”, but virtually impossible to come to the less tangible, indirect costs. Now, that would be one great predictive analytics solution that could do that!

  10. jenster April 12, 2010 at 9:53 am #

    How do we ensure that layoffs happen (if the company chooses to do so) in the right places when making that honest evaluation of the business? I get steamed when I read that our software developers in Germany have guaranteed jobs through 2014. How can we be competitive globally when we make such promises? (ps- can our organization make sure we have the same rights as marketeers here in NA??!)

  11. Madhur A April 18, 2010 at 9:17 am #

    A flip-side view to this is:

    1. Measured and carefully thought through lay-offs can improve organization performance because they weed out the underperformers/free-riders. This can motivate the middle 60% of the organization who are doing a good job and feel lumped with the bottom 20% (the top 10-20% always get rewarded anyways.)

    2. They can provide management the necessary HC to infuse new, higher/different skilled talent in the organization in an era where net new HC is very difficult to come by.

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