The magic bullet Downsizing! Is it really helping?

Dr. Jonas Steeger

In search of a liquidity boost, especially in times of crisis, the topic of lay-offs and short-time work - also known as downsizing - is often discussed. Before you decide to take this drastic step, we have examined the scientific results on the long-term consequences of these measures for you.

The savings potential of downsizing can be simplified to the following simplified formula:

Liquidity boost = Personnel Savings

This corresponds absolutely to the perceptual reality of the (German and English) business world. A measure that we see again and again in exactly this form with our customers - so often that even economists deal with this avoidable microeconomic phenomenon (for example Meuse, Vanderheiden, & Bergmann in 1994 or Marr & Steiner in 2003).

Why is the measure so prevalent? We claim that measures sometimes find their way like water: they seek the path of the least resistance. The immediate liquidity effect and easy planning make dismissal of employees attractive for entrepreneurs in financial difficulties and the financing banks that often back them up.

What does research say about downsizing?

However, it turns out that only in the rarest cases the wave of dismissals leads to lasting success - although it usually reduces the possible symptom in the short term, it does not treat the cause of the problem sustainably. This is proven by various researchers, such as Cascio (1993) and 2002 or Gittell (2006). Like painkillers for broken bones. It helps quickly against the pain - but that’s all..

Downsizing in the context of the financial crisis

One of the biggest waves of layoffs followed the global financial crisis. In 2010, European, American and Asian companies planned to reduce their workforce by an average of 11%, as Murillo Campello, John Graham and Campbell R. Harvey (2009) found out in a scientific survey conducted by the Duke University and the University of Illinois (link to the study). A huge and economically relevant reduction. Research - but also practice - does not agree on whether the effect of the financial crisis has already been overcome.

Long-term effects of downsizing

One of the most recent studies comes from Maertz, Wiley, Le Rouge und Campion (2010). They investigated the effect of downsizing on 13,683 American companies. They show that although downsizing survivors performed better in the short term than comparable companies that did not perform downsizing, they had to live with significant performance losses in the long term.

Negative effect in the long term

The reasons for the long-term negative effect of downsizing are manifold. One of the main causes seems to be the signal effect. Many of the best employees usually leave the sinking ship before the big wave of layoffs. Meanwhile, the remaining employees are struggling with often negative corporate cultural developments - the possible fear of renewed cost-cutting measures certainly does not help their motivation. The corporate climate is suffering drastically.

The As-Is case as a false assumption

Problems can also arise on the market side. Suppliers and customers often react nervously when press releases announce layoffs. In the worst case, the payment terms become shorter and the turnover decreases at the same time. That is the crux of the matter. Because the basic assumption of downsizing is usually that all other costs and above all sales remain constant in the broadest sense. This is the famous Ceteris-Paribus or All-Else-Equal assumption. In other words, the company's performance is updated on a linear basis - in the worst cases even completely flat.

This process is often referred to as an As-Is case. In many cases, however, the as-is case lacks the underlying interrelationships of business processes and is not linear. The liquidity boost is therefore usually reduced in the short term by these effects and in the long term by the lack of investment opportunities.

When can downsizing be successful?

So, when does downsizing make sense? The research is ambiguous. But there are some indications, such as Love & Nohria (2005), that can help in practice:

  1. Value creation: When the ratio of employees directly contributing to value creation to employees indirectly contributing to value creation becomes increasingly smaller, while revenues remain constant.
  2. Business model transformation: When downsizing is not a stand-alone measure, but is accompanied by a change in the business model. This is the only way to break the vicious circle surrounding the As-Is case - because when will it remain "As-Is" if more than every tenth employee has to leave?
  3. Timing: When downsizing takes place proactively in times of stable profitability.

Give up now? No!

Especially the last point makes downsizing so difficult. Because layoffs don’t come to mind - perhaps fortunately – in good times. It is easier to constantly (or at least at planned regular intervals) think about the lived business model and its future. And if you are already there, measures can also be derived directly. We will be happy to help you! Talk to us!


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