Downsizing may damage your recovery efforts

For many companies facing financial distress, cutting the fat is the natural way of reducing costs in a business. However, this may not always be the best solution.

One always has to approach this decision asking: what will ultimately add value to the company’s shareholders? However, it is more complicated than that. I recently read an article by the Harvard Business Review which discusses this exercise in greater detail.

A global movement

The article points out that, during the Great Recession of 2008, companies around the world downsized their workforces. American firms alone laid off more than 8 million workers from the end of 2008 to the middle of 2010. Even in healthier financial times, such as now, firms often downsize because it is seen as a way to reduce costs, adjust structures, and create leaner, more efficient workplaces. Despite the prevalence of downsizing, researchers and businesspeople alike continue to disagree on the viability of this common organizational practice. We add to this debate with our new research, which indicates that downsizing may actually increase the likelihood of bankruptcy.

Proponents of downsizing argue that it is an effective strategy, with benefits such as increased performance and sales. Detractors, on the other hand, point to negative consequences including performance and productivity declines, decreases in customer satisfaction, and adverse effects on remaining employees, such as increased stress. As the debate continues, high-profile firms continue to downsize, as demonstrated by recent announcements or actions by Victoria’s Secret, Lowe’s, and PepsiCo.

The article adds that the team of researchers from Auburn University, Baylor University, and the University of Tennessee, Chattanooga set out to better understand the consequences of downsizing in large, U.S.-based corporations. In our recently published work in the Journal of Business Research, we tested the theory that downsizing could lead to a host of problems that eventually increases the likelihood of bankruptcy.

Among these:

• downsizing firms lose valuable knowledge when employees exit; remaining employees struggle to manage increased workloads, leaving little time to learn new skills; and
• remaining employees lose trust in management, resulting in less engagement and loyalty.

Many of these effects may have long-term consequences, like reduced innovation, that are not captured in short-term financial metrics. We sought to investigate whether these effects could increase the likelihood that firms would declare bankruptcy.

Extensive research

To investigate these potential consequences, we examined 2010 data from 4,710 publicly traded firms and determined whether they declared bankruptcy in the subsequent five-year period. These firms spanned 83 different industries, including the service, high technology, and manufacturing industries. We did not examine financial firms, as changes introduced by the Dodd-Frank Act changed the bankruptcy landscape for these firms. We found that 24% of our sample firms reduced their workforce by 3% or more in 2010, including Ford, Petmed Express, and Regal Cinemas.

To ensure the accuracy of our results, we controlled for known potential drivers of both downsizing and bankruptcy. These included the size of the firm, changes in market capitalization, prior performance, profitability, trajectory toward bankruptcy (using the Altman Z score), a large number of employees per sales relative to their industry peers, and other indicators of financial health. As firms might differ in number of employees they downsized, we controlled for the percentage of employees reduced in each downsizing event. We also accounted for the number of acquisitions in the previous five years (since downsizing often occurs after acquisitions) and industry differences. We further confirmed our findings across a different time period (1995–2000).

A prime candidate

The HBR article points out that the research found that downsizing firms were twice as likely to declare bankruptcy as firms that did not downsize. While downsizing may be capable of producing positive outcomes, such as saving money in the short term, it puts firms on a negative path that makes bankruptcy more likely. While not always fatal, downsizing does increase the chances that a firm will declare bankruptcy in the future.

Given this finding, we sought to understand why some firms were able to survive the negative effects of downsizing while some were not. We speculated that examining firms’ remaining resources could shed light on this question. Accordingly, we examined intangible resources (captured through Tobin’s q, a measure of the value of the firm not captured by its balance sheets), financial resources, and physical resources.

The HBR article adds that the research found that having plentiful financial and physical resources did not replace the downsized employees, who fulfilled multiple roles as workers, knowledge bearers, and cultural contributors within the firm. Having ample capital is often viewed as a corporate panacea, so it was unexpected and interesting to find that financial resources did not contribute to the prevention of bankruptcy for downsizing firms.

The research found that intangible resources helped to reduce the likelihood that downsizing firms would declare bankruptcy. Intangible resources can be redeployed in unique and perhaps innovative ways following downsizing. For example, existing employee knowledge can be utilized to revamp processes that have been interrupted or to replace these processes with more effective ones. Similarly, because these resources can be used in a multitude of ways, firms may be able to use them to attract partners that can fill the gaps left by downsized employees and thereby soften the blow for downsizing firms.

Consider the weight of the decision

The HBR article points out that the findings of the research suggest that, prior to deciding to downsize, company leaders should consider whether any positive short-term returns from downsizing will outweigh the potentially severe long-term consequences and examine the specifics of their resource portfolio to determine whether their firms are adequately protected from downsizing’s negative consequences. Any moves that eliminate important intangible resources may limit the ability of managers to counteract the negative effects from employee layoffs.

The article adds that, given that downsizings are often part of a larger restructuring plan, managers must ensure that they retain the resources that can decrease the odds of negative outcomes. Most important, firms planning to downsize must focus carefully on their intangible resources, rather than financial or physical ones, because they will be essential if the company loses valuable employees.

Moses Singo is a Partner at Genesis Corporate Solutions and is a Junior Business Rescue Practitioner