Why Cutting Back in Recessionary Times is Not Beneficial to Business
The past summer has been one of economic malaise, with unemployment rates in America staying sky high, and the markets experiencing violent fluctuations. Companies, feeling uncertain of the prospects of an economic recovery, have begun laying off people in earnest to cut costs. Merck will begin cutting jobs at the end of October, and it plans to cut around 12 percent of its total workforce, or 100,000 workers, worldwide. Other big corporations like Viacom and Goldman Sachs have also announced layoffs recently. These rounds of ‘rationalization’ by large corporations are a big reason why employment remains stuck persistently around the 9 percent mark. And with people unemployed, demand for products and services falls, so companies cut back further, creating a vicious circle.
But laying people off is often not the best idea for businesses in a recession. When forming business plans, business owners should take the entire business cycle into consideration. This means understanding that there will be bad times, like recessions, and boom times. Thus businesses should manage through, instead of manage for, recessions, so they can be ready for the inevitable upturn.
Why do companies lay people off? Most of the time, it is to maintain profit margins, and it can be a kneejerk reaction to the economic cycle, as a company tries to avoid losses by cutting costs. But it’s important to examine the type of losses companies report, which are often non-cash losses such as goodwill impairment, asset writedowns, and not operational losses.
Let’s look at goodwill impairment, for example. Say Company A buys Company B for $X, when B’s book value is actually $X-5. The amount that A ultimately pays over and above the book value of B is its goodwill value, and this amount goes into A’s assets sheet as an intangible asset labeled Goodwill.
Periodically, companies have to do impairment testing that basically determines what the value of the company they bought is at the time of testing if it had not been acquired. During an economic downturn, chances are that however A tests it, the value of company B would be significantly lower than what A had paid because asset values typically fall in a recession. So goodwill is then impaired or written off almost entirely, which creates an expense in the income statement, basically reducing your net income, and swinging your company to a paper loss.
When large companies like A make a loss, it’s usually not a cash loss. They still have cash coming in. On an adjusted basis, accounting for one-off non-cash items, these companies are still operating profitably. There might be some accounting technicalities that make them report a loss, but on a strictly operational basis, they’re profitable. Profit margins might be reduced, but they’re still profitable!
With that in mind, companies like A should theoretically be constructed to go through the entire business cycle. Sometimes, profits will be great; sometimes they’re not. But well-run businesses should have a plan that is constructed around this reality. As long as you’re making money, as long as cash is still coming in, you can still operate, albeit with squeezed margins.
Consider the example of Bear Stearns. Yes, you read right. I’m using Bear Stearns as an example of good business management. When Alan Greenberg (a completely different era from James Cayne’s management in its last years) was CEO of the now-defunct company, he was known for making most of his big hirings during recessions when others were laying people off, because that’s when you can get talent at lower wages. Greenberg was so tight with expenses even in good times that when business turned sour, he could weather the storm easily. When you have consistently low expenses, your revenues can take a bigger hit than others because you can still be profitable.
Another policy businesses could implement to ensure they can ride out recessions without layoffs is installing a flexible wage system with a monthly variable wage component that can be reduced in harder times, or a larger annual variable component, so workers get huge end-of-year bonuses in boom times, and smaller ones when the economy slows.
Of course, laying people off comes at a cost too, because you are paying severance and unemployment. When the economy recovers and you have to hire again to meet demand, you need to pay signing bonuses, recruiting fees and spend the time retraining your workforce. It doesn’t seem like the most efficient system to me.
As a business that doesn’t cut back in tough times, you improve your position with customers, because you do not have to pull back on services for them. You become the company that is there throughout, as opposed to others who become pseudo-ambulance chasers who only seek economic good times. This is something customers appreciate.
There is a lot of debate in economic circles on the cause of our economic doldrums. Some believe that regulations and healthcare reform of the Obama administration or other regulations are making companies uncertain about the future. Others argue it is a lack of demand, and thus the government has to step in to plug that gap, at least temporarily. The paradox of thrift is a real and present problem. Yet, the economic downturn is only exacerbated when businesses start laying people off en masse. It’s tempting to go to layoffs when times get tough. However, well-run companies who refrain from doing so by wisely planning ahead for their resources and needs will reap the rewards of foresight when the good times roll around again.
About Sterling Wong
Sterling is a New York City transplant from Singapore who studied economics and politics at Sarah Lawrence and Oxford. Having been exposed to both heterodox, liberal economics and orthodox classical economics, he is most fascinated by the differing perspectives each school of thought offers. At Good-b, he aims to explore these two contrasting outlooks on business issues, in particular the Chinese relationship with the U.S.
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