Jeffrey Pfeffer ... In some countries, public authorities have the power to .... As Dennis Bakke, the chief executive of the independent global power producer, AES.
Research Paper No. 1592
Labor Market Flexibility Do Companies Really Know Best?
Jeffrey Pfeffer
RESEARCH PAPER SERIES
GRADUATE SCHOOL OF BUSINESS STANFORD UNIVERSITY
LABOR MARKET FLEXIBILITY: DO COMPANIES REALLY KNOW BEST?
LABOR MARKET FLEXIBILITY: DO COMPANIES REALLY KNOW BEST? The accepted wisdom about labor market policy is that individual companies understand their own interests and needs best and act rationally to further their individual economic performance, in the process enhancing the performance of the economies of which they are a part. Even if individual firms fail to adopt the best management practices for managing the employment relationship, for instance, competitive dynamics are presumed to ensure an efficient result in the aggregate. “Economic selection pressures in either labor or output markets would tend to encourage entry by firms with appropriate contracts and management; this in turn would lead to the bankruptcy of existing firms failing to adapt to the superior organizational form.“’ Therefore, many observers believe that company management should be left alone and regulation of the employment relationship is almost always counterproductive.
This belief in the efficacy of unfettered markets, originating largely in the United States and then spreading to the United Kingdom under Margaret Thatcher, today enjoys growing acceptance around the world. Governments including New Zealand and Australia as well as Germany and The Netherlands have experimented with varying degrees of labor market deregulation as well as with policies weakening the role of unions in the economy. These more market-based policies have been pursued in spite of empirical evidence questioning their results. For instance, longitudinal data from a number of countries indicate that: 1) various indicators of economic performance, such as job growth, the growth of GDP, and the unemployment rate are not invariably highly correlated; and 2) the number of jobs created in the United States is more determined by labor force demography, produced by immigration policies and the divorce rate, than by some public policy wisdom.2 There is also evidence that the performance of the British economy under the Thatcher policies was actually quite poor, the public rhetoric about the British economic miracle notwithstanding.3 At the same time, studies of economies such as Singapore’s, invariably hailed as one of the most competitive in the world, show much evidence of government policy intervention and an inclusive role for labor unions.4
Government policies and actions matter. The growth of contingent employment’ and the decreasing average job tenure observed in the U.S. are consequences of government policies
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about benefits (contingent and part-time employees don’t often get benefits, and therefore, employing people in these arrangements saves on labor costs) and a reluctance to regulate either contingent work or employment security. Similarly, the observed pervasive decline in union 6
density is not solely the result of changing preferences on the part of employees or ineffective union strategies- t h e changing role of labor unions reflect the results of the choices of both corporations and govemments.7 There are many countries and companies seeking to emulate the U.S. economic performance (or their often rosy view of that performance) that have been tempted to copy its policies of non-intervention in the employment relationship, even if political and institutional realities have occasionally precluded the full adoption of this market-based approach.
One topic domain where this debate about unfettered employer discretion has particular relevance is the issue of labor market flexibility. It has been common in many countries to restrict employers’ use of temporary help and contract labor, for instance by specifying a maximum amount of time a “temporary” can be considered a temporary. It is also common to see policies that require advance notification of layoffs and that make laying people off quite costly, often by requiring large severance payments and joint consultation with employee representatives and even governments. In some countries, public authorities have the power to approve or delay layoffs.* These policies have been criticized for causing labor market inflexibility that results in higher unemployment and slower job growth. As Christopher Buechtemann so nicely summarized this prevailing view, “Institutional wage-setting systems, social security provisions, rigid working-time regimes, and legal layoff and dismissal restraints imposed in many European countries came to be widely regarded as essential in causing laborcost ‘stickiness’and employment inertia adjusting to the more volatile economic environment.“’ The available evidence, however, is inconsistent with the idea that labor market regulation in Western Europe has caused so-called “Eurosclerosis.” Instead, research suggests that labor market regulations tend to follow, rather than constrain, employer preferences and, moreover, that differences across countries in labor market flexibility in adapting to changes in GDP have been tremendously exaggerated. lo
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In the remainder of this paper, I document the rationale that has been articulated for leaving management free of constraint in making decisions about the employment relation and labor market flexibility. I then show the adverse effects of downsizing, even on the companies themselves let alone the societies of which they are a part. This evidence on downsizing’s effects is accumulating all the time and is further documented in the research reported in many of the other papers at this conference. These results on the effects of downsizing beg the question: If downsizing doesn’t benefit society or even the companies that do it, why does it occur? I explain how and why it is possible for managers to take actions that are contrary to the long- (or even short-) term interests of their organizations. The reality that management decisions can be inconsistent with they know to be in the best interests of their companies means that there is a potential role for outside agents and policies that influence company behavior to be more consistent with what we know about achieving long-term economic competitiveness.
WHY LEAVE COMPANY MANAGEMENTS ALONE?
The rationale that company managements know best and will act in their best interests is predicated on a set of facts, some of which are not in dispute, although there is disagreement about the conclusions that are sometimes drawn from these facts. There is an increasing alignment of management interests and incentives with corporate performance, at least as measured by profitability and particularly by stock price. There has been growing acceptance of total shareholder return-defined as increases in stock price and dividend payments-as the measure of company performance, reflecting the belief that “the most importance purpose of corporations is to make money for sharehoZders.“11
Accompanying this emphasis on the importance of stock price, there has been growing use of performance-based bonuses and stock options and other share ownership schemes that tie managerial compensation to the company’s stock price appreciation. I2 Examining 45 large industrial companies, Michael Useem noted that in 1982, some 37 percent of the compensation of the top seven executives was variable. By 1995, the comparable proportion had increased to 61 percent. The change in CEO compensation shows an even more dramatic change, with the variable component rising from 41 percent in 1982 to 70 percent in 1995.13 Nor have these
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changes in compensation structure affected only senior management. Compensation schemes that depend on company profits and performance affect a larger and ever-growing proportion of the work force and constitute a larger proportion of total compensation in companies today than they have in the past. A survey of Fortune 1000 companies by Buck Consultants, reported that between 1993 and 1997, the proportion of companies offering bonus plans to their hourly workers had increased from 26% to 37%, and the proportion of salaries comprised of bonuses had increased from 4.5% to 7.8%.14 Many companies in the United States now routinely offer stock options to all of their employees.
This trend in the increasing use of performance-based pay has also spread well beyond the United States, in part promulgated by the compensation consulting companies that have world-wide scope. Because of these acknowledged changes in incentive structures, many observers maintain that potential so-called agency problems that arise from management attempting to pursue its own agenda have been remedied. Management’s interests are ever more closely aligned with those of owners to maximize the value of the company. If managers, who obviously possess the most knowledge of an organization’s immediate economic circumstances, are motivated to do their best for the company, all that public policy intervention (or, in some versions of this argument, union involvement) can do is to simply get in the way of their making the best decisions.
However, this growing alignment of management and shareholder interests argues for leaving management alone only if one believes: 1) that maximizing shareholder value is the best goal for the corporation, 2) that incentives are an effective way to encourage managers to pursue shareholder value, and 3) there are no important market externalities that make the pursuit of shareholder value inherently difficult. All three of these conditions are problematic, however.
The idea that shareholder interests should be not just prepotent but omnipotent is open to question. Contrary to what is commonly asserted and believed, as a matter of securities law, even in the United States, considering all affected constituencies (including employees) in a management decision is legally permissible.15 Commenting on the responsibility of corporate directors and what they can and should consider in making decisions, Bagley and Page noted:
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The “profit maximization” view of directors’ duties ignores the historical reasons why corporations were given special privileges, such as limited liability, by the state...This broader [stewardship] view is consistent not only with the values of a free market economy, but also with modem corporate jurisprudence.t6
As Dennis Bakke, the chief executive of the independent global power producer, AES Corporation, has noted, shareholders have invested their capital and are entitled to a return on that capital. But, capital is, by definition, what is left over when wage income has been otherwise spent.17 Why, he asks, “should the corporate purpose give higher priority to the
Others have questioned whether such a prominent focus on share price leads to sound management decisions. “‘The [stock] market is a separate issue from what it takes to make the company work as a business,’ says Arnold Ross, a partner at compensation consultants Hirschfeld, Stem, Moyer & Ross . . .Volatility, he and other critics add, also makes the stock market a poor arena in which to judge a manager’s performance.“r9
Even if share price maximization is the goal, it is far from clear that merely tying CEO compensation to share price automatically produces enhanced shareholder value. A study of CEO compensation in the United States concluded, “the relationship between the number of long-term incentive plans in which the CEO participates and the company’s ten-year total return to shareholders.. . [is] negative.“20
Graef Crystal, a well-known compensation consultant,
explored the relationship Ibetween the sensitivity of CEO pay and wealth to total shareholder return. He found that, contrary to the arguments made by Jensen and Murphy21 about the benefits of more strongly linking CEO pay and wealth to shareholder return, there was little or no effect of their measure of CEO compensation sensitivity on a company’s return to its shareholders.22 Reviewing numerous studies of CEO pay plans and their effects, Michael Jacobs concluded, “ After assessing how these plans work in reality, not just in theory, it is easy to conclude that management pay is not an effective motivator. When it does work, it often
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motivates the wrong kind of behavior.“23 These results call into question whether incentive alignment actually produces superior shareholder returns.
It is also possible and, indeed, likely that there are important externalities for decisions about employment policy that are not captured in the returns to individual companies or the incentives paid to their managers. These externalities make adopting efficient decisions and practices less likely. A market failures argument was advanced by David Levine and Laura Tyson in their review of the literature on employee participation. Concluding that participation frequently had a positive effect and almost never a negative effect on corporate performance, Levine and Tyson asked, “ If employee participation often has positive effects on productivity, why don’t we see more of it?“24 Their answer is that the environment matters. Participatory systems are more costly when there is more variability in product demand, so the general economic environment will influence the adoption of participatory management. The labor market environment also matters. Low unemployment, narrow wage dispersion, and universal just cause dismissal policies work to the advantage of participatory firms. These environmental factors are heavily influenced by the actions of governments and employee representative organizations. And the capital markets also influence the ability of companies to implement participation regimes:
. . .capital markets are inherently biased against the hard-to-monitor human capital and trust that are prerequisites for participation; takeovers that result in companies reneging on their commitments “can in the long run result in the deterioration of trust necessary for the functioning of the corporation”; and transaction costs can be larger for participatory firrn~.~~
Consequently, under certain conditions, practices that produce higher levels of company performance may not be implemented almost regardless of their benefits. “As a result, the economy can be trapped in a socially suboptimal position.“26
There is yet another line of argument frequently raised against public policy or nonmanagement (such as union) intervention in a company’s decisions about the employment
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relationship. It is true almost by definition that any form of government policy intervention in the labor market is seldom tailored, and can not be, to the unique circumstances of specific firms and industries. Therefore, laws and regulations have a broad brush. Moreover, laws and regulations result from legislative and administrative processes that are often somewhat cumbersome and consequently resist frequent change and adaptation.But if company and industry circumstances are both unique and changeable, subjecting organizational management to more universalistic and permanent policies, pressures, and regulations interferes with the ability to make decisions that foster competitiveness and innovation.
But this argument also withers somewhat under scrutiny. The idea that corporations are flexible and respond fluidly and rapidly to changes in the environment and don’t suffer from inertia is empirically suspect.27 Whether or not internal organizational political systems and processes are more responsive to shifts in circumstances than are external or macropolitical structures is an empirical question, not something that can simply be asserted to be true in all circumstances. There are clearly conditions inside organizations in which people and perspectives get entrenched, poor performancenotwithstanding.28So, it is possible that at least on occasion regulatory and other macroinstitutional regimes may enhance rather than retard adaptation and change.
THE EVIDENCE ON DOWNSIZING
One important domain where the evidence about what to do to enhance corporate performance and actual managerial behavior diverge considerably is the issue of economic restructuring and employment security. There is now a great deal of evidence about layoffs and other forms of employment insecurity, including their pervasiveness and effects.
Downsizing began in the United States in the early 1980s as a response to a severe recession. However, even after economic conditions improved, downsizing has continued, seen as an effort to cut costs and thereby increase productivity and profits.The idea is that if labor costs are a significant fraction of total costs, cutting labor costs by cutting the number of people working decreases costs. Holding everything else constant (a critical assumption that presumes
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that service, product innovation, quality, and other important factors affecting business success don’t change), cutting costs increases profits. What has become a relatively new phenomenon is that cutting employment now occurs in good times as well as during recessions, and not just in companies that are doing poorly but also in those that are doing well, as all companies face pressures from the capital markets to do even better. Anthony Carnevale has stated, “Business organizations are downsizing at the rate of more than 600,000 employees a year even in the best of times in the most successful companies.“29 What is also new is the phenomenon of companies announcing layoffs and restructurings even as they add jobs. Surveys show that in 1996, for instance, 3 1 percent of companies were adding and cutting employees at the same time.30 The American Management Association surveys on downsizing show that since 1990, almost half of U.S. companies announced workforce reductions every year, on average reducing their employment by 10 per cent.31 Between 1987 and 1995,85 percent of the Fortune 1000 companies in the United States announced layoffs and restructurings, in the process cutting 5 million jobs.32 Downsizing has spread well beyond the United States. Even in Japan restructuring is increasingly common and there is a “surge in a new underclass of part-timers who...are easily jettisoned in troubled times.“33
All of this downsizing has had one predictable effect: it has created fear and insecurity in the workplace. A nationally representative survey of 2,400 adults in the United States conducted by Princeton Survey Research Associates found that fewer than 40% of the workers trusted employers to keep their promises, 16% withheld suggestions for improving work efficiency out of fear of costing someone their job, and only 38% felt confident of their ability to quickly find new employment.34 A survey of 1970 Bucknell University graduates discovered that 9 1 percent of the respondents believed that companies had become less loyal to their employees and 75 percent had either been laid off or knew someone who had.35 Nor are these effects confined to the United States. A survey by the Henley Forecasting Centre reported that “almost two-thirds of British workers claimed to be ‘very’or ‘fairly’concerned about losing their jobs.“36
Does downsizing work to make companies more efficient or effective? The available evidence suggests that downsizing is notoriously ineffective in solving management or
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organizational problems or improving organizational operations. A review of the evidence shows that: l
Morale suffers. “Study after study shows that following a downsizing, surviving employees become narrow-minded, self-absorbed, and risk averse. A survey by Right Associates.. . among senior managers at recently-downsized companies [found that] seventy-four percent said their workers had low morale, feared future cutbacks, and distrusted management.“37 An American Management Association survey reported that 86 percent of the large companies that downsized reported that morale declined.38 As one manager at a large industrial gases and chemicals company said to me about the aftereffects of a large layoff, “‘it took us two weeks to make the decision, two months to execute it, and two years to recover.”
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Stock price suffers. Although on the day of a layoff announcement stock price sometimes rises, a study by Mitchell and Company found that two years later, more than half of the companies had underperformed the stock market as a whole and 75 percent had underperformed comparable companies in their industry.39 Research using event study methodology for 300 layoff announcements of companies listed on the New York Stock exchange reported a statistically significant negative five-day cumulative return of 1.78 percent4’
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Productivity does not increase. A study of 140,000 establishments using longitudinal U.S. Census of Manufacturing data to estimate Cobb-Douglas production functions concluded: “In contrast to the conventional wisdom, we find that plants that increased employment as well as productivity contributed almost as much to overall productivity growth in the 1980s as the plants that increased productivity at the expense of employment.“41
An American Management Association study of
companies that had downsized between 1989 and 1994 reported that only about a third reported higher worker productivity, with the rest reporting either constant or declining productivity.42 And, “more than half the 1,468 restructured companies surveyed by the Society for Human Resources Management reported that employee productivity either stayed the same or deteriorated after the layoffs.“43 l
Often labor costs do not decrease. When a layoff announcement is made, there is frequently a delay as the specific details are determined. During this delay, people
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voluntarily leave. Those leaving are not always the people that the company wants to leave (in fact, it is often the best people who can most easily find alternative work who depart), so some need to be brought back. An American Management Association survey of some 720 companies showed that one-third had brought back laid-off employees as contractors or temporary help.44 There are also the costs of severance, training people to do new jobs or to do more work, more use of overtime, and the possibility that too many people are lost, requiring the company to rehire.45 l
Performance deteriorates and the presumed benefits of downsizing are not realized. A four-year study of 30 companies in the automobile industry reported that “most deteriorated relative to their ‘pre-downsizing’ levels of quality, productivity, effectiveness, and human relations indicators.“46 A survey of more than 1,000 companies by Wyatt Company reported that less than one-third increased profits as much as expected, only about one-fifth achieved reasonable improvements in returns on investment; and less than half reported that the cuts reduced expenses enough over time, “because four times out of five, managers ended up replacing some of the very people they had dismissed.“47 The American Management Association survey mentioned above found that just 50% of the companies reported an increase in operating profits following downsizing, with 29% reporting no change and 20.4% reporting that profits actually decreased.48
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Downsizing often stops quality improvement initiatives in their tracks and causes erosion in quality. A study of a Total Quality Management Program at the electronics company, Analog Devices, reported that after layoffs of 12 percent of the work force, a plant that, in 1989, had been number one in Hewlett-Packard’s list of ten best suppliers became number two on HP’s list of ten worst suppliers in just two years.49
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Downsizing substantially hinders efforts to implement high performance work practices such as self-managed teams. A study of a Hewlett-Packard surface mount manufacturing facility reported that “the impending downsizing curtailed any remaining effort to implement self-managing teams because employees became more concerned about their jobs than about redesigning the center. “” Recently, manufacturing problems at Boeing have been widely reported. These problems have meant the company has earned very little profit even while manufacturing a large
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number of planes and enjoying a large backlog of orders. A study of the company indicated that layoffs and the way they were handled contributed substantially to the company’s difficulties. “My colleagues and I have been showing them how destructive to ‘survivors’ the last major downsizing was.. .especially during a period in which the company was trying to introduce workplace innovations that required the enthusiastic involvement of their employees.“51 l
Downsizing results in the loss of knowledge and corporate memory, as experience departs. This loss of knowledge and experience causes companies to repeat mistakes and to become less effective. For instance, following a re-engineering effort that resulted in the loss of 12,000 jobs, Delta Air Lines “seemed to ‘forget’that service was what gave it an edge, and lost the loyalty of many customers.“52
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Downsizing adversely affects innovative product development activity inside companies. A study of twelve large companies concluded that “downsizing disrupts an organization’s capacity to innovate, specifically by breaking the system of entrepreneurial networking that is used to work out strategic linking problems.“53 Because innovation frequently requires interaction among people from multiple functions and departments, downsizing, which eliminates existing social relationships with those who are gone, interferes with product innovation by disrupting channels of information exchange.
The fact that downsizing is ineffective should not be surprising. In and of itself, simply cutting the number of people will not solve problems of reducing cycle time in bringing products to market, providing better customer service and building customer loyalty, increasing innovation, enhancing flexibility, or increasing product quality. In fact, common sense suggests that downsizing is likely to make all of these business processes worse. The irony is that because downsizing doesn’t work, after the layoffs occur the problems persist. This often results in yet another round of layoffs. The 1994 American Management Association survey on downsizing concluded that “downsizing tends to be repetitive: on average, two-thirds of the firms that cut jobs in a given calendar year do so again the following year.“54
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Downsizing also inflicts tremendous social costs. In addition to obviously affecting incomes and the economic viability of a geographic area, “a job also has a psychological value. It boosts an individual’s confidence and helps integrate him into society.“” Research shows that people who have been laid off have higher mortality and morbidity, higher rates of depression and divorce, and in general experience problems that create more demands on the social welfare and support system. Because of the social and economic costs of downsizing, when Volkswagen was confronted with low profit margins and surplus labor, it opted for a solution that maintained employment by reducing the work week. Peter Hartz, the head of human resources for Volkswagen, has expressed the company’s philosophy and perspective well:
Throughout the world, mass unemployment has become one of the most pressing problems of modern times. The automotive industry has been hit by a crisis of restructuring and excess capacity. It would have been easy enough for Volkswagen to follow the example of many other companies and simply shed jobs. But as “Every Job has a Face,” the company.. .decided.. . to break out of the vicious circle of mass unemployment. It is all very well for market trends, technological progress or productivity to define personnel requirements-but these factors alone should not be allowed to dictate the nature of the solution to the problem.56
Some economists maintain that layoffs and downsizing actually free up resources to move to higher and better uses. This may be true in theory, but the existing evidence is not always consistent with this view. For instance, a study of restructuring in the British steel making, coal mining, and port transport industries, concluded:
Redundancy has contributed more to a sustained rise in (long-term) unemployment than to a better allocation of labour resources within employment.. .Most notably, redundant workers, in the jargon of neoclassical economics, become labour market “lemons.“. . .in the absence of perfect information, employers infer that all redundant workers must be of low quality.57
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THE IMPORTANCE OF EMPLOYMENT SECURITY
If downsizing has negative effects on organizational performance, then logically one might expect the opposite, employment security, to have positive effects on organizations. And, in fact, there is a great deal of evidence consistent with this view. There is a large literature documenting the positive effects of high performance or high commitment work arrangements on organizational performance.58 Employment security is an element in many of these systems. For instance, Lincoln Electric has offered employment security to employees with more than three years of service for decades, and this employment security is an essential component of Lincoln’s system for achieving outstanding levels of productivity. When the old General Motors automobile assembly plant in Fremont, California, that had been closed reopened as Toyota-GM joint venture called New United Motors Manufacturing (NUMMI), returning workers were promised job security. They were also given the highest wage in the industry, and in turn, were expected to cooperate with management in making the plant more efficient and profitable. The new plant, using the same equipment with a workforce consisting almost entirely of people who had worked at the old plant, was more than 50 percent more productive and produced cars of higher quality. PSS World Medical, a successful distributor of medical supplies and equipment to physicians and hospitals, also offers employment security. When the company closes a branch sales office, people are offered jobs elsewhere in the firm. Patrick Kelly, the founder and chief executive, explained the rationale:
Every businessperson knows how important it is to have loyal employees and loyal customers. No company could last more than a week without at least some sense of reciprocal obligation between employer and employee.. . .You Carl build an organization based on mutual loyalty, even in today’s economy. But you can’t do it if you treat people as disposable.59
Employment security is probably one of the most fundamental management practices a company can have. It defines the nature of the relationship between the organization and those who work in it-whether that relationship is one of mutual commitment and loyalty, or whether
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it is a relationship based more on spot-market transactions with the expectation that it will be of limited duration. Almost all other high performance work practices, such as investing in training, sharing information, and putting people in self-managing teams, depend on continuity of employment. Without the expectation of employment of long duration, no company will invest in training. Without employment stability, there won’t be the trust necessary to practice open book management and share information. And working in teams requires that the team composition be stable enough so that people learn how to work with and learn from each other effectively. Employment security is also virtually a requirement for having people share their knowledge and insights with each other and with the company. “One of the most widely accepted propositions. . . is that innovations in work practices or other forms of workermanagement cooperation or productivity improvement are not likely to be sustained over time when workers fear that by increasing productivity they will work themselves out of their jobs.‘160
Some organizations, even in cyclical industries, have begun to retain employees during downturns. For instance, there have recently been efforts to retain oil rig workers even though drilling activity has fallen dramatically. Although it may at first seem costly and unwise to keep people around doing repairs and upgrading equipment on idle rigs, this practice can actually save money in the long run:
“The crews get used to working together, which means you have fewer accidents on the rigs.. . When things pick up, you have trained people, which means you save on training costs.“61
Retaining people during downturns can also save on recruitment and training costs. Companies all too frequently “buy high” and “sell low,” laying off people during slack times and then competing with many other similar companies for this same talent when economic conditions improve, sometimes offering large signing or recruitment bonuses to get people to come to work. Again, the oil drilling industry typifies this problem. After laying people off during the last downturn, firms incurred the costs of this behavior when demand for oil drilling improved:
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. . .only a year ago the oil industry was scrambling to find skilled workers
to run rigs, which were in high demand . . . .The industry was plagued with safety and quality problems as companies hired inexperienced workers.. . .To cope with the shortage of workers, many companies set up expensive training programs.62
WHY DO COMPANIES DO THINGS THAT DON’T WORK EVEN WHEN MANAGERS KNOW BETTER?
Why do companies downsize, if doing so has such adverse consequences, and when providing employment security is so fundamental to building high performance work places with all the attendant performance advantages? There are many answers to this question, and each undoubtedly provides only a partial explanation. Part of the answer for the persistence of downsizing as a management strategy is the tendency to follow the crowd, the institutional pressure to do what others are doing. Following management fads is something that executives seem to do, even if they know they shouldn’t.63 The power of informational social influence, looking to others and doing what they do, should never be underestimated. “The principle [of social proof’j states that we determine what is correct by finding out what other people think is correct.“64 This principle does empirically help to account for downsizing and particularly its spread and persistence. A study of the adoption of downsizing programs by the Fortune 100 companies over the period 1979- 1994 reported an “adoption effect”-the greater the cumulative percentage of downsized companies, the greater the likelihood that a given company would initiate workforce reductions.65 What this study suggests is that the more pervasive downsizing becomes, the more companies will do it, almost regardless of its actual consequences. To not have engaged in at least some employment reduction is to cause management to stand out from what everyone else is doing.
When company managements do what is expected, they get rewarded. This is true in the case of reducing the work force, also. A study by the Institute for Policy Studies in Washington, D. C., reported “that CEO compensation rose an average of 30% in 1993 in 23 of the 27 companies announcing the largest staff reductions from early 1991 through early 1994.“@’
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These results suggest that another reason that companies downsize is because their CEO’s (and possibly other senior managers as well) get financially rewarded for doing so.
Once having downsized, its persistence, regardless of the results achieved, can be partly explained by the phenomenon of escalating commitment.67 Few people or organizations want to admit they have made a mistake. One way of rationalizing, at least to oneself, that you have done the right thing is to continue to do it. As the research by Barry Staw and others nicely demonstrates,6* there is often a tendency for people to invest even more resources in failing endeavors and to justify past decisions by escalating, or at least maintaining, their commitment to already chosen courses of action. This psychological process of commitment holds for downsizing as well. Having once downsized, companies and their managements are likely to remain committed to this strategy for enhancing performance, almost regardless of what it has accomplished.
There are a number of other factors also operating to favor downsizing regardless of its ultimate effects on companies or the larger society. Several of these factors relate to accounting issues and the capital markets. Michael Useem has argued that increasing role of large institutional investors in the capital markets has changed the relationship between companies and their employees. Most of these money managers have limited experience outside of finance and very limited practice in managing others.69 They also have no personal connections or attachments to the corporation’s people. Consequently, they are eager to see them discharged if there is some possibility that this will reduce costs and increase profits. For instance, when in 1993 Xerox announced a 10 percent reduction in its workforce, a First Boston analyst commented: “We are just starting to see these types of restructurings. These guys are ahead of the curve.” When the pharmaceutical company Merck cut 2,100 people, a securities analyst at Alex, Brown & Sons noted approvingly, “They are aggressively moving to reduce head count and streamline manufacturing to increase efficiency.“70 Mergers and acquisitions, also driven partly by capital market pressures, have added to the downsizing because they typically lead to consolidations that result in layoffs.71
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There are also accounting and financial reporting angles to massive layoffs. If a company lays off a significant number of people at one time as part of a restructuring announcement, the associated costs such as severance, outplacement assistance, and closing of facilities are not charged against operating earnings but are recorded as a special charge. Special charges appear to have less effect on Wall Street’s estimates of a company’s underlying earnings power and, consequently, have a less negative effect on stock price. So, from the stock market’s point of view, it is better to lay off a lot of people at once and be permitted to take a special charge than to lose people slowly over time and have the costs more directly affect reported earnings. Unfortunately, special charges and write-offs have become so common that earnings predict stock prices less strongly now than in the past.72
Secondly, every company’s earnings are capitalized by the market at some multiple, the so-called price-earnings multiple. Consequently, if a company lays off 1,000 people and thereby presumably saves $100 million a year (assuming a cost per employee of $100,000 reflecting both salary and benefits savings), the company has increased its market value by a large multiple of that amount, invariably by more than $1 billion. That is why companies are so keen to reduce their work forces and will often incur nasty labor disputes and other costs to do so.
Third, related to the above, it is the character of accounting systems that they are a) inwardly focused and b) focused on the past. As a consequence, typical financial reporting systems can reasonably precisely measure what employees have cost but are almost useless (unless employed in some creative ways) in ascertaining what will be lost, for instance in service, quality, or new products or technologies, or even revenues if the employees aren’t there. Moreover, the cost savings are immediate and the problems of understaffing and the loss of expertise will unfold only over time. Confronted with certain current apparent savings balanced against uncertain possible costs incurred in the future, most managers, being both risk averse and compensated based on meeting short-term budgets, will opt for the current and known savings.
It is interesting that these problems of budgets are well-known, even if few organizations do anything about them:
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. . . budgets don’t help companies focus on the performance drivers of today’s businesses. Significant metrics such as innovation rates, service levels, quality. and knowledge sharing don’t lend themselves to easy budgetary quantification.. . . Budgets treat all employees the same-as costs.. . .The conventional up-and-down information flow of the budgeting process effectively compartmentalizes a company into small units.73
Budgets and the budgeting process, along with the influence of the capital markets, exert real influences on organizational management. Much of this influence is to create pressures for downsizing even when cutting employment doesn’t solve the real problems and actually makes them worse.
The issues associated with budgeting and the capital markets are made more relevant by the increasing dominance of people with financial backgrounds in senior management positions, at least in the United States. CEOs at the beginning of the twentieth century had backgrounds as generalist entrepreneurs. Then, manufacturing became the dominant background of chief executives, and subsequently, it was marketing. Now, most chief executives have a background 74 which makes them particularly susceptible to the accounting and capital market pressures just described.
The fact that companies don’t always act on their knowledge-that there is a gap between knowing and doing--’ IS a general phenomenon that extends well beyond issues of downsizing and labor market flexibility.75 The president of Cleveland, Ohio, consulting firm has called this the performance paradox: “Managers know what to do to improve performance, but actually ignore or act in contradiction to either their strongest instincts or to the data available them.“76 to This gap between knowing and doing does suggest the possibility of a positive role for institutions and organizations that can help companies close this gap, and actually implement what they know.
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IF COMPANJES DON’T ALWAYS KNOW BEST, WHO DOES?
We have seen that there are a number of factors that have caused managements to overvalue and excessively pursue labor market flexibility, accomplished through downsizing and layoffs, even in the presence of evidence that downsizing seldom, if ever, works to solve organizational performance problems. There is also little evidence that labor market flexibility, per se, is associated with favorable results at the macroeconomic level. Downsizing has obvious social costs. These facts make it tempting to advocate more government policy intervention to limit or otherwise constrain companies in their pursuit of flexible employment arrangements, and to see a positive role for the involvement of labor unions and other outside parties who have different interests and perspectives on the employment relationship.
There is, no doubt, potential merit in wisely crafted public policy and in the involvement of employee representative organizations in decisions about the governance of the employment relation. The transformation of Singapore into a high value-added manufacturing, financial, and transportation center has been stimulated by government policies and mandates. These include a training levy to encourage the development of skills in the work force and policies to increase wages to force companies to move to more high value-added activities. The ability of German banks to hold onto market share in both deposits and loans better than their U.S. counterparts was facilitated by policies that made laying people off more costly and difficult. Consequently, instead of pursuing a strategy of downsizing, deskilling, and outsourcing, German banks used the relationships built by their long-time employees to compete on the basis of economies of scope.77
Similar positive effects have occasionally been observed from union involvement. Donald Petersen, the former CEO of Ford Motor Company who led its transformation in the 1980s as it implemented employee involvement and became the most profitable of the U.S. auto manufacturers, has stated that the unions were helpful in this transformation process. That is because the collective bargaining agreements mandated ongoing commitments to training and work redesign so the company persisted in these efforts even in the face of temporary financial setbacks and pressures to renege on commitments made to the work force.
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However, pointing out the problems in company management decision making with respect to downsizing and the potential positive benefits from the involvement of other parties does not necessarily guarantee that these other actors will inevitably advocate or implement wiser practices. These social actors are, after all, also affected by the forces of social proof and escalating commitment, can be trapped by their own history, and have their own measurement issues and goals to contend with. Many observers of the corporate governance scene argue that what is needed is consideration of all of the company’s stakeholders, and it is probably useful for the various constituencies themselves to define and advocate their own interests.78 That is why something like the model followed in Western Europe in countries such as Germany79, The Netherlands, and Sweden is so sensible. By building corporate policy and strategy on the informed involvement of all of the interested parties, and by grounding these decisions in empirical data instead of just empty, ideologically-based rhetoric, there is a much improved chance of actually taking actions that will enhance competitiveness and social welfare.
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