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Knowledge at Wharton

Management

How Layoffs Hurt Companies

Issuing pink slips should not be standard operating procedure

Published: Thursday, May 5, 2016 - 15:02

Time was, layoffs were seen as an emergency strategy, the last resort in a downturn or crisis. Today, however, layoffs are a standard tool for doing business. As the economy continues to heal and job indicators improve, a number of firms have announced a fresh wave of layoffs—Nordstrom, Sprint, and American Express among them—citing the need to improve profitability.

Studies have shown that layoffs don’t generally result in improved profits. And yet, firms continue to keep the pink slips at the ready. Why?

It’s about the triumph of short-termism, says Wharton management professor Adam Cobb. “For most firms, labor represents a fairly significant cost. So, if you think profit is not where you want it to be, you say, ‘I can pull this lever, and the costs will go down.’ There was a time when social norms around laying off workers when the firm is performing relatively well would have made it harder. Now it’s fairly normal activity.”

The layoff mentality has become culturally ingrained by way of both positive and negative developments—the Great Recession, as well as the new economy. “In Silicon Valley, the big thing is to be disruptive,” says Wharton management professor Matthew Bidwell. “It’s the ultimate, ‘Who are we going to disrupt, and how?’ What does that mean? Laying people off. A lot of these layoffs reflect that. As new forces come in, some jobs go away.”

Layoffs “have been pretty constant over the years, and it seems to happen no matter what the economy is doing,” says Wayne F. Cascio, a global leadership professor at the University of Colorado at Denver, who has studied layoffs for decades. “When the economy is down, it’s always the argument that we’ve got to cut costs, and when it’s doing well, we often hear we need to improve profitability because it’s the best time to do it. The tune hasn’t changed.”

But some are suggesting it’s time for a change. If several decades’ worth of research now shows layoffs to be a poor way to boost profits, while other strategies may in fact work, perhaps there are ways of changing the dynamic between what’s happening on Wall Street and decisions that get made in the boardroom and on the shop floor. Says Cobb: “The challenge is: How do we get back to a more socially responsible way of handling employment, given the influence of financial markets on corporate decision making?”

Layoff myths and mirages

“Firms that are laying off are almost by definition in trouble.”
—Peter Cappelli

Contrary to popular belief, there’s not much evidence that layoffs are a cure for weak profits, or to use the current euphemism, that they reposition a firm for growth going forward. “It’s very difficult to sort out the relationship because firms that are laying off are almost by definition in trouble,” says Peter Cappelli, Wharton management professor and director of the school’s Center for Human Resources. “The research evidence has not found any support for the overall idea that layoffs help firms’ performance. There is more support for the idea that where there is overcapacity, such as a market downturn, layoffs help firms. There is no evidence that cutting to improve profitability helps beyond the immediate, short-term accounting bump.”

The effectiveness of layoffs as a tool for profitability varies from industry to industry, and case to case. Sometimes, layoffs are necessary. “Underlying this is the idea that business is constantly changing, and so you may find a set of activities that were really important to the business 10 years ago you no longer want to be doing,” Bidwell says. “Either you’ve become uncompetitive in the market, like BlackBerry, or there are markets that grow and disappear. I saw a terrifying graph the other day about how advertising revenues have skyrocketed, while TV advertising is flat, and at newspapers they have fallen through the floor. Obviously, if you are a newspaper publisher, you can’t go on as you were.”

“Underlying this is the idea that business is constantly changing.”
—Matthew Bidwell

As a cure for corporate ills, however, layoffs are a chimera that can come back to bite a company. “There is some evidence that when shareholders are more powerful, companies are more likely to engage in layoffs, and yet announcements are usually met with declines in share price, so it’s not clear that it’s a great sign,” says Bidwell. “Shareholders love it, but it may punish them even more.”

Companies continue to use layoffs because it’s a way to be seen as responsive, he says. Such was the case a year ago when American Express was making money, but not enough to quell investor concerns. The company had a revenue growth target of 8 percent, which it chose to help meet by cutting costs. After announcing that it would shed 4,000 jobs, the stock price of American Express took an immediate slide, and remains down by about 25 percent since the announcement.

Employers also often underestimate the cost of layoffs in immediate financial terms, as well as in the lingering burden it places on remaining resources—both financially and emotionally. “There is definitely a huge problem in HR generally that the stuff that is easy to put on a spreadsheet outweighs the stuff that isn’t,” says Bidwell.

The toll of layoffs is high. In many industries, layoffs beget lower productivity and profits. When sales are slow, for instance, many retailers cut staff. But several studies show a correlation between bigger staffing and substantially higher sales.

What about profitability? One study that examined a large specialty retailer found that conformance quality (how well an employee executes prescribed tasks) has a higher effect on profitability than service quality (defined as the extent to which the customer has a positive experience). According to a Harvard Business School working paper, “The Effect of Labor on Profitability: The Role of Quality” by Zeynep Ton, stores that cut staff were unwittingly cutting profits, and yet the practice was standard. Why? “An emphasis on minimizing payroll expenses and an emphasis on meeting short-term (often monthly) performance targets,” the study found. Another consequence of understaffing at this retailer was lowered morale, a finding echoed in other studies.

“Layoffs may look good on paper because they have an immediate effect on costs. Yet in reality there are a lot of costs that layoffs impose on firms.”
—Adam Cobb

Layoffs are going to reduce costs immediately, says Cobb. “But what does that mean two or three years from now, when the firm is growing and now has to ramp back up by hiring a bunch of people? Now the firm must incur all these costs to hire and train workers.” In addition to the laid-off employees, he adds, other workers may now leave voluntarily, all of which is disruptive for the firm and lowers productivity. “Layoffs may look good on paper because they have an immediate effect on costs. Yet in reality there are a lot of costs that layoffs impose on firms that might not show up on an income statement quite as clearly.”

Cascio is in the home stretch of a project that analyzes the S&P over three decades, looking at firms that downsized to track financial performance in the years following. He expects to have results in a few months.

Tenure rates—the length of an employee’s stay at one company—have remained relatively steady in the past two decades. But one recent study indicates that the U.S. worker is becoming increasingly unmoored to the full-time employer. The percentage of workers engaged in alternative work arrangements—temps, on-call workers, contract workers, and freelancers—rose from 10.1 percent in Feb. 2005 to 15.8 percent in late 2015, according to “The Rise and Nature of Alternative Work Arrangements in the United States, 1995–2015” by Harvard’s Lawrence F. Katz and Princeton’s Alan B. Krueger. The study, released in March 2015, shows that workers hired out through contract companies showed the sharpest rise, increasing from 0.6 percent in 2005 to 3.1 percent in 2015. “A striking implication of these estimates is that all of the net employment growth in the U.S. economy from 2005 to 2015 appears to have occurred in alternative work arrangements,” the study concludes.

Investing in innovation and people

What is clear, Cascio notes, is that plenty of firms have handled internal and external stresses without resorting to layoffs, and come out the other side with positive results. He points to Southwest Airlines, which, like the rest of its industry peers, suffered during the Great Recession. “People were not flying as much, so they took their job recruiters—who are typically great with people interaction skills—and instead of laying them off, redeployed them into frontline customer service jobs, which made flying on Southwest a better experience for its customers. And as the economy recovered, they transitioned back to their original jobs.”

Cascio says another approach was taken by Steve Jobs, who took advantage of downturns to focus on innovation. When the dot.com bubble burst, Cascio notes that Jobs’ response was, “We are going to invest our way through the downturn.”

“Look back at when the introduction of the iPod was, and the iPad,” says Cascio. “It turns out that shortly after the 2001 recession ended was when the iTunes Store opened. Then after the Great Recession, Apple brought out the iPad in 2009 and 2010. So while the economy was bad and people were being laid off, the company was actually investing in R&D. People really need to hear examples like this.”

Other countries—Germany in particular—have regulations that help to temper the knee-jerk impulse to lay off staff. Cascio doesn’t see that happening in the United States, but other strategies might work—such as a program in some states where companies, in lieu of laying off staff, can have the state labor department kick in partial unemployment benefits. “U.S. business responds to positive incentives rather than penalties for doing something, and that’s a positive incentive and it keeps people on the job,” says Cascio.

For Wharton management professor John Kimberly, the key question is how leadership thinks, in the short run and long run, about the way it wants to manage its human capital. “I am always amazed when times get a little tough how quickly the layoffs happen, and when they are not so tough that they start pulling the trigger—that’s even more mystifying,” he says.

Kimberly says that if a company can manage through a rough patch with creative strategies without laying off, employees will emerge with a greater sense of loyalty, and that loyalty will pay off for the company. “I believe at the heart of the issue, that is going to motivate outstanding performance, in any company, no matter what business they are in,” Kimberly notes. “I think the data are clear that outstanding performance comes when people are motivated to do their best, and that they are motivated to do their best when there is some reciprocity between senior management and employees and what they do on a daily basis.”

Cobb says options before getting to layoffs include offering early retirement, slowing down hiring, and retraining workers. There is some indication that firms, worried about loss of talent, are using these options more than they once did, according to the Society for Human Resource Management. But real change would take a shift: understanding that getting long-term gains sometimes means taking short-term lumps. University of Michigan professor Gerald F. Davis argues that for a long period, large corporations were a dominant force in the United States—through employment practices, expansion choices, and community connections—and that now, the United States has a finance-centered economy. Corporations are no longer the organizing agent of society, Davis argues in “The Rise and Fall of Finance and the End of the Society of Organizations,” published in the Academy of Management Perspectives in 2009, and in his book, The Vanishing American Corporation.

“As Professor Davis argues, the shareholder value model has been the undoing of corporations in a way,” says Cobb. “There has been a stark decline in the number of publicly traded companies in the United States over the past few decades. As firms have more and more ability to use outside contractors in place of full-time employment and production, many firms do not need to resort to an IPO to raise the amounts of capital as did firms for a century prior.”

Today, Cobb adds, many firms that do an IPO do so not to raise capital, but to provide a return to early shareholders and employees. So firms like Google and Facebook are publicly traded, but their ownership is highly concentrated among the founders, and the companies use dual-class shares to ensure that the control of the firm remains with the founders. Other firms, like Dell, have gone private, which allows them to make longer-term decisions without the fear of missing quarterly earnings targets. “And the firm has seemed to perform much better” Cobb notes. “Thus, in its quest to ensure that firms are flexible and efficient, Wall Street has seemingly helped to foster an ecosystem of firms that are considerably less reliant on Wall Street to raise capital.”

One might imagine, Cobb suggests, a world where Wall Street has less influence on corporate decision making. “In that world, short-term pressures to boost profits and meet earnings targets are balanced by longer-term interests, and lay-offs might, once again, be a practice employed as a last resort,” he says.

However it plays out, there’s a fundamental tension underlying the interplay of forces to which Bidwell admits feeling conflicted. “The individual wants stability and security, but as a society we worry about becoming too sclerotic,” he notes. “One person’s dynamic economy is another person’s risk and insecurity. And the question is where we strike the balance between them.”

First published April 12, 2016, on the Knowledge@Wharton blog.

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Knowledge@Wharton is the web-based research and business analysis journal of the Wharton School of the University of Pennsylvania. Launched in May 1999, its goal is to disseminate business knowledge and insights to readers around the world. The Knowledge@Wharton Network offers free access to analysis of current business trends; interviews with industry leaders and Wharton faculty; articles based on the most recent business research; conference overviews, book reviews, and links to relevant content; and a searchable database of more than 1,500 articles and research abstracts.