Layoffs

Our discussion of risk has focused mostly on pay, but we noted earlier that performance risk also can be allocated through changes in levels of employment. In a fragile economic environment no discussion of risk would be complete without considering the role of layoffs and reductions in force. Even when companies try to use forms of reduced pay to soften the blow and hold on to their employees, as Schwab and Agilent did, the pressure to cut costs often forces them to resort to workforce reductions. In these situations the systematic risks of the macroeconomy filter down to employees in the most severe form of all.

Are there any lessons to guide companies as they make decisions about the number of people they will employ? Businesspeople are inculcated with the notion that labor is a variable cost. The economics textbooks they read in school made that very clear, and in a limited sense it is true: Labor costs vary most directly with short-term changes in the volume of production. However, this is a superficial view of cost that fails to account for the investment component of human capital. To the extent that the capability of an organization’s workforce resides in firm-specific human capital, labor may be the least variable cost of all.

Idle a plant or sell off machinery and a company can always buy them back. But shed firm-specific human capital through layoffs and those assets are basically gone forever. Reacquiring that asset is generally a costly and lengthy process. What’s more, by using layoffs to buffer the bottom line a company may have destroyed the foundation of trust on which rebuilding must rest. Rock-solid firm-specific human capital requires an implicit contract between employer and employee that recognizes the value of employee commitment and uses rewards to induce employees to invest in specialized capabilities that are worth more inside the company than outside it. Because firm-specific know-how increases employee vulnerability even as it benefits the company, employees rely on the company to shelter them from volatility. Companies that are too quick to lay off employees break the implicit contract and damage their ability to reconstitute the workforce when they need it.

Some companies understand this and manage accordingly. Nucor Corporation, a highly productive and profitable steelmaker, resisted using layoffs even though it operates in a highly volatile industry. One of its four management principles is “Employees should be able to feel confident that if they do their jobs properly today, they will have a job tomorrow.”^[9] Instead of laying off employees during business downturns, Nucor uses that slack time for training, cleaning, and maintenance. This keeps everyone employed and keeps Nucor’s highly productive work teams together.

The bottom line: Before making decisions about how to balance pay and employment adjustments for employees in the face of a recession, executives need a clear picture of the human capital on which their organizations rely. They need to know the relative worth of general versus firm-specific human capital for different parts of their businesses and for different occupational groups. People with general skills may be replaceable, but people with strong firm-specific skills are not. This is at least as important a consideration as current compensation expenses. For example, the firm-specific human capital of Sears’s sales associates is probably limited and easy to rebuild with new hires. For that company the advantages of shedding and then rehiring sales associates as consumer demand fluctuates probably would outweigh the benefits of maintaining those employees through thick and thin. The opposite would hold for a private investment firm. The relationships between that firm’s professional employees and its clients are worth millions. An investment consultant must have intimate knowledge of the client’s needs and preferences, and the client must have full confidence in the consultant’s ability and integrity. These are characteristics that only build over time. They cannot be bought, and when lost they are not easily replaced. Clients who use private investment services will not tolerate churn among the individuals who advise them. Therefore, the investment firm must be extremely careful in how it adjusts to market fluctuations.

These two examples focused on the extreme ends of the human capital spectrum. Most organizations lie somewhere in between. Moreover, the nature of human capital often depends on the function or the occupational group involved. When it does, negotiating the trade-off between layoffs and variable pay or, for that matter, deciding whether shareholders or employees will bear more risk is unquestionably more complex.

In the end it boils down to understanding a company’s human capital, knowing the sources of its value to the company. Do you know where your company stands on the human capital spectrum? Do you know where the greatest value resides in your workforce? Do you know which segment of your workforce is the most productive? These are complex questions, but, thanks to the new science of human capital management, you can answer them.

^[9]See Nucor Corporation Web site, http://www.nucor.com/aboutus.htm, April 18, 2003.